Within the contexts of getting the best retirement returns and the best equity returns, I’m often asked the question “How can I better predict future market direction and better time my stock purchases and sales?”
My answer will probably both disappoint and confuse you. My answer is that YOU CAN’T…..
Wow, you weren’t expecting that were you! Let me explain further …..
Let’s start with the definition of “The Market”. The market is the collective wisdom of its participants. Far and away the most important of these participants are the Mutual Fund managers. There are over 9,000 mutual funds in the US alone. They collectively have about $19 Trillion to invest and they control the market.
So “The Market” is both very large and very diverse. The problem is that the individual funds have so much money that they need to take major positions in stocks that they invest in. If they want to exit the market they must divest their portfolios in stages to avoid cratering the prices in the stocks that they are trying to unload.
One more important characteristic of “The Market” is the way the participants compete. In the mutual fund game it’s not the returns that are all important but rather your rank. Let me explain. Mutual fund marketing is all about your rank within your group. When the investment advisors start talking about which funds you should you should invest in, they bring out the charts. Top 10 mutual funds last year. Top 25 growth funds over the past three years, five years. Everything is about rank!
How is this characteristic important? Well, it creates a “follow the leader” effect concerning stock selection. Everyone tends to have the same leading stocks in their portfolios. No one wants to miss a big winner.
OK, so what does all this mean when trying to predict market direction? Well, first, look at the market size. $19 Trillion dollars being invested by over 9,000 funds is a mammoth investing machine. It’s too large to be a club. It’s too large to have any sort of core group that sets market strategy that others follow. And the participants don’t even strive to meet or beat specific return targets and instead aspire to be a return leader no matter what the returns are.
So, how do we predict market direction? Well, let’s review what you CAN’T do ….
- You can’t watch and follow market leaders! The Market really doesn’t have leaders because the market is so big and so diverse.
- You can’t predict what the market direction will be on any given day. Again, the markets size and diversity makes its near term movements unpredictable.
Well that’s disturbing! We can’t predict the market’s future direction. What CAN we do? How can we protect our equity investment account?
The answer is actually remarkably simple. While the market’s incredible size and diversity works against those trying to predict future market movement, these same characteristics actually provide the basis for setting rules for superior investment returns. You see the market players have so many shares and dollars in play that divesting in stocks must be done in an orderly fashion to avoid cratering stock prices. Players CAN’T dump individual stocks quickly! Players CAN’T dump entire portfolios quickly! The personal investor can use these facts when determining when to divest their own market positions.
Rather than trying to predict future market corrections, the personal investor can use statistical tools to determine when the risk of a major market correction becomes too great to remain invested.
One tool that I like to use is a measure of mutual fund disinvestment. Let me explain. It takes funds a month or two to exit equities while preserving stock prices. If all the funds are slowly dumping stocks a pattern develops, one that might look like the following:
- Day 1 – many funds selling – stock prices drop on big volume.
- Day 2 – stock prices recover somewhat as bargain hunters come out – lower volume
- Day 3 – stock prices flatten – again lower volume
- Day 4 – many funds again sell – stock prices fall on big volume.
- Day 5 – stock prices recover somewhat on bargain hunting – lower volume
And so this pattern continues. If the bigger funds are really exiting the market you’ll see a couple of big selling days on high volume (Day 1 and Day 4 above) every week or so. Over four or five weeks if you accumulate 7 or 8 of these major selling days then it’s time to exit the market.
Investor’s Business Daily, a major provider of investor tools and strategies, has actually quantified this approach to market exit warning indicators. They label institutional selling days as Distribution Days and monitor these in a 25 trading session moving average to create a barometer of market risk. I’d suggest you investigate their wide range of investment products if this approach to market risk appeals to you.
So where are we? Here’s a summary of what we’ve discussed:
- I don’t believe you can predict future market direction with any useful degree of accuracy. Market characteristics dictate this.
- I also don’t believe that Funds can divest of their portfolios quickly. Their size dictates this.
- I do believe that you can use market signals to gauge the risk of a major market correction on the horizon. One important signal is one that quantifies institutional selling.
Take comfort. While you can’t accurately predict market direction, you can protect yourself from major market corrections by reacting to important market statistics.
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