The wait is over.
It’s time for part 2 of my market cycle series.
In my last essay, we were using a simple but effective methodology to determine where we are in the market cycle, and whether this is the time to be aggressive or defensive with our investing.
So, if you haven’t already, please read my last essay first by following this link.
What we’ve discovered so far from the first five investment criteriums is that two are suggesting we should be aggressive, two that we should be defensive, and one pointing in neither direction.
With the score even, let’s see what the other five can tell us.
Different Criteriums, Same Answer
Criterium #6 is Investors’ Sentiment.
Investors are typically the most optimistic, greedy, about future returns just before the market turns for the worse.
In such times, stocks are performing well, and there are no significant risks on the horizon. So, investors, optimistic that the good times will continue, rush into stocks.
This mania elevates valuations to the point where stocks become priced to perfections. Unfortunately, when the outlook is perfect, there’s little that can happen to push the prices higher, and even the smallest shift in sentiment can result in a substantial decline.
That is why you want to be fearful when others are greedy and act defensively during times of extreme optimism.
Right now, we are in such a period where most investors blindly believe that because the Fed has their backs, stocks will continue going up regardless of other conditions. Meaning, you should be defensive.
Surprisingly, the situation was exactly the opposite just three months ago during the March stock market collapse, when fear reigned, and it was a great time to act aggressively.
Criterium #7 is Markets.
During downturns, financial markets are starving for attention. The underperformance, the losses, and the all-around negative sentiment surrounding them scare investors away. They don’t see much sense in being involved with something that’s losing money.
This is precisely when you want to turn aggressive.
The reverse is true when financial markets are crowded, and there is too much money chasing too few deals.
This is what’s happening now, with investors crowding into stocks, paying little attention to their quality or price. Again, this indicates it’s time to be defensive.
Criterium #8 is Funds.
In particular, this refers to the difficulty of investment funds raising money.
When stocks are doing well, more people wish to be invested and participate in the profits. This overabundance of capital makes it easy for funds to raise money.
On the other hand, when stocks are performing poorly, only the best of the best can attract capital.
The way to profit from these trends is to act defensively when the former is true and aggressively during the latter.
At present, funds are still raising capital with ease, indicating a defensive posture is more appropriate.
Criterium #9 is Recent Performance.
Something I’ve mentioned before is performance.
Near the market peaks, recent performance is excellent. This, however, doesn’t mean you should be chasing stocks in hopes that the trend will continue.
At the beginning of February 2020, the stock market’s performance was about as good as it gets. It was also the absolute worst time to enter it, since just a few weeks after, the global health crisis caused it to crash.
Conversely, on March 23, the stock market was down -30%. A recent performance was terrible, yet it turned out to be the perfect time to start buying stocks.
The lesson here is that you want to act aggressively when recent performance is terrible, and defensively when it’s great, like at this moment.
The rally that started in late March, and is ongoing, is one of the best in history. A correction is due, and you don’t want to end up on the wrong side of it.
Criterium #10 is Popular Qualities.
The final criterium is popular qualities among investors.
Near market peaks, people revere the most courageous investors—those who have the “cojones” to take on the riskiest trades.
On the other hand, near market bottoms, investors look up to those who had the caution and the discipline to stay on the sidelines and, because of that, didn’t incur any losses from the downturn.
Looking at the investing landscape today, it’s clear that we are experiencing the former. The best investors today are those that picked the cruise lines and the airline stocks—one of the riskiest trades on the market.
Again, this indicates it’s better to be defensive in the current environment.
Be Fearful When Others Are Greedy And Invest Safely
When I tell people that I’m an investing professional, the first question they ask me is almost always the same—Are stocks going up or down?
And my answer is always the same—I don’t know. I can’t tell what’s going to happen in the future no more than you, or Warren Buffet, or any other person in this world.
However, what I can tell is what the chances are depending on the prevailing conditions. And the methodology displayed in this essay is a great way to estimate those chances.
The more criteriums indicate that I should act defensively, the higher the chance that we are near the end of the market cycle, and that stock returns are going to be lackluster.
The more they point into the other direction, the greater the chance that an aggressive investing posture will yield higher results.
Right now, seven out of ten indicators are indicating that it’s better to be defensive, one is neutral, and only two are suggesting to be aggressive.
It’s a clear-cut message that it’s better to invest defensively.
One way to do this is by selecting stocks that might look boring to other investors, but because of their stable business models and re-curing cashflows, they are a perfect late-cycle investment.
I’m going to talk about one such company in the next issue of my True Retirement Wealth, which goes out one week from now.