From Cabot Wealth Advisory, January 26, 2010 Sign up for free Cabot Wealth Advisory e-newsletter
Here we are, 10 months into a new bull market, with most investors feeling giddy, and hundreds of stocks hitting new 52-week price highs (at least until late last week). In my experience, when the market is running and profits are abundant, most people want to focus on individual stocks—new stories, growth figures, earnings, you name it.
So, given that, what am I going to write about today? Market timing ... specifically, the importance of NOT LOSING money. When everyone's thinking about one thing (buying stocks and making money), it's important to remind yourself of how to handle the next cycle ... even if that cycle is just a correction that knocks down a few leaders.
I want to demonstrate the value of not losing by citing an article I came across a few days ago in the Wall Street Journal. It pertained to the performance of all equity mutual funds with at least $100 million in assets; 2,301 of these stock funds have been around since the start of 2008 (a mind-boggling number by itself).
Not surprisingly, these mutual funds had a great year in 2009, up an average of 34.9%, according to Morningstar. That's fantastic, and it was one of the industry's best performances in many years.
Unfortunately, as we all know, last year's gains came on the heels of the 2008 horror show. The average equity fund lost a stunning 40.5% that year, so last year's gains weren't even as large as the prior year's decline.
On the surface, most people might look at those two numbers and think, "Gee, last year was a good comeback and made up most of the prior year's debacle (up 35% vs. down 40%)." But that is not how the math works!
As it turns out, if you have $10,000 and lose 40.5%, you're left with $5,950. And if you then gain 34.9%, that brings you back up to ... $8027. Said another way: Despite last year's huge rally, the average equity mutual fund is still down 19.7% during the past two years!
Another amazing statistic: Of those 2,301 equity funds, just 63 (or 2.7%) had positive returns during the 2008-2009 period. Wow.
All of this happened because of what we call the loss curve—when you lose money, you have to make back a greater percentage just to get back to breakeven. And the more you lose, the more the math works against you.
For instance, if you lose 10%, to get back to breakeven, you have to make 11.1%. That's not too harsh.
If you lose 20%, you need to make 25% to get back to even.
Down 33%? You need a cool 50% return ... again, just to get back to where you were before the decline.
And if you're the average equity fund, losing 40.5% in 2008, you need to gain 68% just to get back above water!
Now, just to be clear, I'm not writing this to scare you about any upcoming market meltdown (while the market's intermediate-term trend has turned down, the odds are very, very small that we're beginning a prolonged decline), or to scare you into refusing to take any risks. The fact is you're going to lose money sometimes in the stock market, and you have to be willing to lose some if you're going to gain over time.
But these figures are an illustration of the importance of not losing money; great performance is not always about posting a +30% or +40% year. Sometimes it's more about not getting crushed during a bear market or prolonged correction, as so many investors do.
Gain by Not Losing (i.e., the Loss Curve)
All of this brings me back to market timing, something every investor was focused on a year ago. Good market timing helped Cabot Market Letter avoid most of the bear market. But now, after the market has motored higher for months, few are concerned with market timing, and as I mentioned above, that's a mistake.
The key to good market timing is to keep it simple. There is no perfect system, of course, but we think getting too technical and following too many indicators will lead you off course. That's doubly true if those indicators focus on what we call secondary or tertiary indicators ... things like sentiment, interest rates, the U.S. dollar, the economy, etc. None of those have a consistent record of successfully calling major market turning points.
Instead, we have found that the most reliable indicator of future market moves is the market itself. In Cabot Market Letter, which I edit, we have three key market timing indicators.
One is called the Cabot Trend Lines; it's a long-term trend-following indicator. Its signals are less frequent (last signal was a buy back in early April 2009) but when they appear, they are usually important.
The second is the Cabot Tides. It's our intermediate-term trend-following indicator. Combining the Trend Lines and Tides, you can never be on the wrong side of the market for long.
Last but not least is our Two-Second Indicator, which gives us a clue to the broad market's health. Its real value is by signaling major, bear market-type market tops way ahead of time—it began flashing red, for instance, in June 2007, and continued to do so for most of the bear market.
These are the indicators I use and they've treated us (and our subscribers) well. Maybe there are others that you know of that also consistently point you in the right direction.
But the main point here is that you need to have some system that will get you out of the market the next time it heads down for a few months. Doing so will help you avoid some steep losses ... which, as we saw above, will make it easier for your portfolio to keep stretching to new heights.
Editor's Note: From the market's bottom in March 2003 to the low in March 2009, the S&P 500 lost 18% in total and the Nasdaq lost 3.5%. Cabot Market Letter, however, advanced a total of 94% during the past six years (nearly 12% per year).
More on Cabot's market timing indicators