The Only Way the 99% Should Invest in the Stock Market

I often get random questions from family members, friends, colleagues and social media followers that sound something like this: “I want to invest but I’m not sure what to buy, so can you recommend a few stocks.”

Or

I am saving for retirement (college fund, etc.), so where should I place my money (funds that they need to invest, commonly from an old 401k, a recent bonus, an inheritance, a stale IRA or whatever…).

They tell me that they trust my advice because I seem to know what I am doing. Perhaps it’s because I have a blog, twitter account or a Stocktwits following but I immediately reply by saying: well, be careful because I am not independently wealthy (yet), based solely on my market investments so take my advice with a grain of salt. I then go on to say: But if you are asking…

Index Funds!

What? INDEX FUNDS!

Says the guy who writes about stock investing and trading…?

I strongly suggest that the majority of people stay away from actively managed mutual funds, active investment managers, day trading, swing trading, trend trading, any trading, etc. I am not opposed to individuals buying and holding a handful of dividend paying blue chip stocks but why bother with the headache; go for the index fund and save your time for doing something fun.

2016_04-03_Actively-Managed-Odds

Place at least 90% of your available investment cash “the serious money” into index funds and then actively speculate with no more than 10% of the rest. This 10% can be used to buy your speculative investments like $FB, $AAPL, $GOOG, $AMZN, $TSLA, $V, etc…

William Bernstein (author of The Four Pillars of Investing) once wrote:

“It’s bad enough that you have to take market risk. Only a fool takes on the additional risk of doing yet more damage by failing to diversify properly with his or her nest egg. Avoid the problem – buy a well-run index fund and own the whole market”.

I agree: invest in one or more well-run index fund(s) that will promise a market return but with significantly lower fees. The average guy or gal in the 99% is not smart enough to “pick” the right stocks or mutual funds (or manager) at the right time. Heck, most fund managers in the 1% (Wall Street professionals) can’t do this either (data shows that greater than 80% of all fund managers fail to outperform the market over time).

Warren Buffett once noted that the moral of a story, as told in his 2005 Annual Report, is:

“For investors as a whole, returns decrease as motion increases.”

What does that mean? Well, let’s use a recent example of a bet Buffett made with a bunch of hedge fund managers back in 2007. The bet shows how an index fund mirroring the S&P 500 can outperform their actively managed funds, after fees, over a ten year period. They made a million dollar bet (winnings will be donated to charity) based on this premise and as of February 2016, eight years into the bet, Buffet is beating the all-star hedge fund managers 65% to 21%.

His Index Fund selection is crushing them and all he had to do was make a click or call to purchase the index fund and then he was done (not another minute was spent worrying about the investment). These managers (charging 2% on assets + 20% of performance) manage their funds daily and they are only 1/3rd of the return of Buffett’s choice (to date). So not only are they losing, they have spent eight years in their “professional job” losing to a fund that mimics the market.

Time = money so how do we even begin to quantify the hours spent by the hedge fund managers vs. the cumulative time that Buffett has saved doing other things. The extra time value is overwhelming so Buffett is much further ahead based on this ancillary bonus.

John Bogle (the founder of Vanguard) explains it this way in his book, The Little Book of Common Sense Investing:

“The way to wealth for those in the business is to persuade their clients, “Don’t just stand there. Do something”. But the way to wealth for their clients in the aggregate is to follow the opposite maxim: “Don’t do something. Just stand there.” For that is the only way to avoid playing the loser’s game of trying to beat the market.”

It means that the higher the level of investment activity, the greater the cost of investment fees and taxes, which ultimately results in a lesser net return for the investor.

I am an architect by degree so when I recall the famous quote by Ludwig Mies van der Rohe, “Less is More”, I suggest everyone apply it to investing as well.

Less activity equals more return for the investor while more activity results in more profit for the fund managers leaving you, the retail client, with less retirement money in your pocket (see the charts and expense ratio matrix below).

2016_04-03_Expense-Ratio-Chart-Diff

Charlie Munger stated:

“The general systems of money management [today] require people to pretend to do something they can’t do and like something they don’t. That is a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That’s the way it has to work. Mutual funds charge two percent per year and then brokers switch people between funds, costing another 3-4 percentage points. The poor guy in the general public is getting a terrible product from the professionals. I think it’s disgusting. It’s much better to be part of a system that delivers value to the people who buy the product.”

So based on what Buffett, Bernstein, Bogle and Munger have said…

Where do you now think the 99% should invest their money? What should YOU be doing with your money?
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My Wife’s Personal Mutual Fund Crushes the Markets, AGAIN

My wife’s so-called “personal mutual fund” returned 22.72% from August 5, 2014 through to last Friday, February 19, 2016 (approximately 18 months).

As a comparison, the following stock market indices performed as follows:

Dow Jones Industrial Average: -0.23%
S&P 500: -0.13%
NASDAQ Composite: 3.48%

Her buying habits CRUSHED the general markets, by a HUGE margin, just as they had from the day we were married back in 2004.

2016_02-21_Wife-Mutual-Fund-Image02

The personal mutual fund (as outlined in the blog post, My Wife’s Personal Mutual Fund Outperforms the Pros, back on August 6, 2014), highlighted 22 stocks of companies whose products or services she religiously buys or uses on a daily or weekly basis.

Of the 22 stocks, 20 show gains while only two show a loss ($KORS and $XOM). The top five leaders are as follows:

  • Amazon ($AMZN) leads the pack with a 71% gain
  • Home Depot ($HD – actually my store) is second with a 56% gain
  • Starbucks ($SBUX) comes in third with a 53% gain
  • Netflix ($NFLX) is up 47%, a service used by the entire family
  • Facebook ($FB) is up 43%: yes I admit it, we are both addicted (very bullish going forward)

This is simple investing logic (for our family) as we use the products and services of these five companies every day (HD being the lone exception for daily use, but monetarily, it may lead the pack).

Amazingly, 14 of the 22 stocks show a double digit gain:
$AMZN $HD $SBUX $NFLX $FB $V $TJX $COST $TGT $CVS $GOOG $MA $PEP $DIS

The other six positive stocks show a gain between 0.1% and 9.94%:
$VZ $JNJ $PG $COH $AAPL $WFC

For the second time in less than two years, I am convinced that my skills, or lack thereof, are no match for the power of my wife’s product and service buying habits. Hands down, her habits are kicking the market’s a$$ and my a$$ for that matter.

Who needs a financial advisor or one of these “trendy” new robo advisors when I can just copy what she is buying and doing?

As I said back in 2014:

Peter Lynch subscribed to the idea of “know what you own”. I know what my wife owns and can take the lesson that many other wives (and people in general) are buying what she is buying. Consumers = profits and profits typically lead to earnings which leads to a rise in share prices. Sounds like a simple formula.

The formula is WORKING!

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16 Trading Quotes & Books for 2016

“The obvious rarely happens, the unexpected constantly occurs.” – Jesse Livermore

“A speculator is a man who observes the future, and acts before it occurs.” – Bernard Baruch

“What seems too high and risky to the majority generally goes higher and what seems low and cheap generally goes lower.” – William O’Neil

“Successful speculation implies taking risks when the odds are in your favor.” – Victor Sperandeo

“Stocks are bought not in fear but in hope. They are typically sold out of fear.” – Justin Mamis

“Accepting losses is the most important single investment device to insure safety of capital.” – Gerald M. Loeb

“To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!” – Martin Zweig

“You have to master your ego & realize that being profitable is more important than being right.” – Martin Schwartz

“Losing a position is aggravating, whereas losing your nerve is devastating.” – Ed Seykota

“If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.” – Peter Lynch

“Risk comes from not knowing what you are doing.” – Warren Buffett

“You must learn that the market is a discounting mechanism, and that stocks sell on future and not current fundamentals.” – Stan Weinstein

“I was successful in taking larger profits than losses in proportion to the amounts invested.” – Nicholas Darvas

“The first rule of trading – there are probably many first rules – is don’t get caught in a situation in which you can lose a great deal of money for reasons you don’t understand.” – Bruce Kovner

“Intellectual capital will always trump financial capital.” – Paul Tudor Jones

“I have noticed that everyone who has ever tried to tell me that markets are efficient is poor.” – Larry Hite

Market Tops Take Time to Form

Market tops take time to form as the 2007-2008 graphic shows below. I developed the graphic due to several comments and inquiries following last week’s blog post titled “Calling a Market Top”.

Several stocktwits and twitter readers decided to comment without reading the entire blog post or did not read it at all. They were quick to judge and throw out “bear” connotations based on the title of the post rather than digest the content.

Today’s post further dives into the details and length of time the 2007-2008 market top actually took to form before fully breaking down (upwards of 10 full months). In contrast, the current market is barely a month into the first red flag, therefore, no one should be calling a definite market top – and I don’t believe anyone is, at least not around here.

2014_10-30_NHNL_Diff_NYSE_2007vs2014

The most interesting aspect of the 2007-2008 market top is the fact the market made new highs, after the first red flag. The NH-NL indicator also went back to positive territory after the initial negativity in July and August of 2007 (point #1 in the 2007-2008 side of the graphic).

New Highs averaged 129 per day while new lows averaged 252 per day in August 2007. The indictor turned more positive following the summer as New Highs averaged 135 per day while new lows averaged 59 per day in September and October 2007. This was a complete up-tick in activity. However, December’s average was 56 NH’s and 292 NL’s per day and it only deteriorated from there. The point being, the NH-NL ratio can start to look more positive as an overall market top is forming.

After the DJIA reached new highs in October 2007, the market took a big dive but made a higher low in late November 2007. However, the next red flag formed as the DJIA could not make higher highs and failed to recapture the 30-week MA (point #2). Another red flag was the fact the 30-week MA was starting to turn south (negative). Following these red flags, NL’s accelerated and the market made an even bigger drop into January 2008.

The final red flag took place between the months of April and June 2008, when the DJIA again failed to re-take the 30-week MA (as it was now trending downward) and fell well short of previous highs. New Highs within individual stocks were drying up and NL’s were starting to accumulate again. This was the final break in the overall market top formation. The market dropped an additional 50% from here.

Taking the analysis from above and incorporating it into today’s action, we can see that a market top (if one is beginning), is in its infancy and is likely to have several volatile swings up and down (both in terms of price and the NH-NL readings).

2014_10-30_NHNL_Diff_NYSE_2014-next1

A red flag is just a warning but it becomes a strong signal to take action when multiple warnings are registered. October 2014 is just a warning and I don’t know if it will lead to a more substantial correction but if it does, don’t be surprised to see higher highs before an ultimate breakdown.

If it doesn’t, well, jump back in and ride the trend higher because circumstances are constantly changing when trading the market. No one truly knows what will happen next (and if they do – they’ll be a lot richer than I am when it’s all said and done). The rest of us can only play the odds and manage risk.

My next post will focus on additional market tops so we can get a better feel for history, using charts.

Calling a Market Top

This post will set out to determine if we are currently forming a market top by identifying current warning signals and by using past examples, most notably the 2007-2008 market.

Calling an exact market top or bottom is fairly difficult and not a task that I aim to succeed at. However, I pride myself on gathering warning signs of a major change in trend whether it is a market top or market bottom. Major tops and bottoms don’t happen overnight and typically take months to materialize. And this is good for the longer term investor – it gives us time to make moves and protect capital.

Mr. Market, as some call it, will give the astute investor plenty of warnings as a major change in trend starts to occur, especially at a market top. The market will likely offer head-fakes along the way and this is all well and good provided you maintain your sell stops and follow rules. It can be frustrating to sell prematurely and possibly buy back-in at higher levels than where you previously sold but that is par for the course: simple money and risk management.

Let’s take a look at 2007-2008.

The market was in a prolonged up-trend from 2005 into much of 2007. The DJIA peaked in July 2007 before dropping quickly to end the summer. It briefly violated the 30-week MA but more importantly, the number of New Lows spiked dramatically, to levels not visited in years (this was a red flag). The NH-NL Diff 10d MA and 30d MA both went negative (July 26th and August 1st, respectively). It was the first time the 10d and 30d Diff had been negative since the previous summer but daily readings were much more dramatic this time around, reaching 500-1,132 new lows. The 1,132 New Lows registered on Thursday, August 16, 2007 was more than Black Monday (10/19/87 when 1,068 were logged – fewer issues on index of course). This was just the first red flag but not an immediate sell signal (watch positions closely, maybe raise some cash to be safe).

2014_10-23_NHNL_Diff_NYSE_2007-08

Following the August lows, the DJIA went on to make new highs in October 2007 and then quickly reversed with another batch of New Lows . The second red flag was the fact that New Highs did not exceed previous levels as the DJIA made a new high, a divergence which is telling. Further confirming this second red flag was the fact that the market once again crashed below the 30-wk MA (November 2007). Please note that the initial red flags span from July to November (4 months = “time”).

The third red flag occurred when the market attempted to re-take the 30-week moving average in December 2007 but failed, as New Highs dipped dramatically and New Lows started to creep back up. By January, the NYSE registered another 1,000+ reading (1,114 on Tuesday, January 2, 2008). By this time, the market had dropped more than 2,000 points or more than 15%. Many individual stocks had dropped much more. Sell stops should have been followed and long term investors should have been accumulating cash by this time. Take profits and cut losses when multiple red flags appear (you can always get back in if the correction doesn’t confirm)!

The fourth and final major red flag occurred after the market rallied in the spring of 2008 yet the DJIA could not overtake the 30-wk MA in April and May. Following this failure, the fear and bad news related to the housing and banking crisis were starting to spiral and New Lows confirmed the damage by reaching the greatest levels ever witnessed on the NYSE, culminating with NL’s surpassing 2,000 on two separate occasions, nearly touching 3,000 on Friday, October 10, 2008 at 2,901. The NH-NL diff 10d and 30d MA went negative on Tuesday, June 10, 2008 and Friday, June 20, 2008 respectively. The NH-NL Diff 30d MA did not turn back to positive territory until Wednesday, April 29, 2009 (essentially as a new up-trend was confirming). The market was still trading above 12,000 in June 2008 so any stragglers could have sold, even at a decent loss at this level. If not, that investor rode the market down to the 6,000’s by October 2008, or another 50% loss (remember, it takes a 100% gain to break even after a 50% loss).

Now, before I am called a Monday morning quarterback, visit these blog posts that I made in late 2007 and early 2008, well before the ultimate crash (the Cramer Post lists additional links from 2007):

01/24/2008: Cramer YELLED Buy, I wrote Sell

10/12/2007: Distribution Day

10/20/2007: Second Major Distribution Day

For a detailed look at the monthly New High and New Low data in 2008 and early 2009, please visit this blog post (some excellent and original analysis here):

Identify Market Tops and Bottoms by Doing this, Guaranteed!

Now let’s take a look at 2014!

The first red flag has been materializing over the course of the entire year: fewer New Highs as the DJIA makes all-time new highs: a divergence that’s telling (remember this from 2007).

The second red flag is the increase in recent New Lows, reaching levels not seen since October 2011 (which was the most substantial correction since the bottom in 2009). Furthermore, the NH-NL Diff 10d MA and 30d MA went negative on September 22nd and October 6th respectively. As of this blog post, the NH-NL Diff 30d MA has been negative for 14 consecutive days and will remain negative for at least another week, based on the figures dropping off and being added to the calculation. It will become the longest consecutive stretch since the correction in 2011 (which lasted 71 days). The 2008-2009 negative stretch lasted 215 trading days (June to April).

2014_10-23_NHNL_Diff_NYSE_2012-14_2

The third red flag and it’s early, is the fact that the DJIA has violated the 30 and 40 week moving averages. The market is allowed to do this during normal corrections but it becomes a red flag when the NH-NL diff is negative with increasing New Lows (which is the case in October 2014).

As of this week (October 23, 2014), New Highs are increasing and New Lows are decreasing but that is normal action as buyers and sellers fight to control the trend. This action is similar to October of 2007 (383 New Highs were registered on Thursday, October 11, 2007). Individual days will swing from time to time so it’s most important to step back and focus on the macro trends that are building.

There you have it: several red flags have been logged here in October 2014 so the caution flag has been raised. Just as in 2007, I can’t confirm a new major change in trend will take place but I can tell you to be prepared and watch for additional red flags and respect sell stops. Remember, you can always buy back in if a steeper correction does not confirm. What you cannot do is make up for a large loss if the market starts to free-fall.

As identified in 2007-2008, these changes in trend take time so we can be diligent in making decisions but we cannot lose sight that the market has given us a warning. Until told otherwise, this market is suspect so I am in the business of raising cash levels. I am not completely out of the market but I have tightened stops and raised cash. Cash is a position and I know I can always jump back in with both feet if an up-trend continues. I’m just managing risk!