2. How Markets Move

Is this a good time to buy stocks, and where in the market cycle are we? Figure 2-1 shows that markets move in cycles. These cycles usually take several years to complete.

Figure 2-1. The market moves in cycles. (Source: Rydex/SGI Investment Management)

Figure 2-1 shows that starting in 1896, the market climbed for 9 years and had a cumulative return of about 149 percent, a good return. Then the market went sideways for 18 years. Money invested during these 18 years was dead money. Although the cumulative loss for those 18 years was only about 4 percent, the opportunity loss could have been substantial. If a person needed cash during this long period, he might have sold stocks out of necessity in one of the down legs and not had a chance to get back to even.

Opportunities to Trade Market Moves in Bear and Bull Markets

Markets make wide swings, which can be opportunities, especially since the new ETFs offer exposure in many ways.

In the years 1929–1954, the market moved sideways. It is no comfort to know that from 1926 through March 2007, the S&P 500 Index has had a compounded average return of 10.46 percent a year, including reinvested dividends, not counting taxes or expenses (Source: Standard and Poor’s). That return is for more than 80 years. There are few investors who want to hold stocks for 25 years without getting some sort of return.

In 1982, the market started a 17-year bull run and made about a 1,000 percent gain. This was followed by a stock market decline, an implosion in housing prices, and a worldwide drop in the asset class values. Worldwide monetary liquidity had been created by extreme leveraging and the marketing of flawed assets, necessitating a period of deleveraging and concomitant market declines that continue to this day.

Figure 2-1 shows that there are steep drops and robust advances in secular bear and bull markets, often 10 to 20 percent moves. Market timing to take advantage of these moves, even with a small part of your portfolio, can improve performance. You can trade about 20 percent of your portfolio, you can trade stocks, and you can short those sectors you think are too high or buy those sectors you think are cheap. Holding a portfolio of indexes pays off if history repeats itself.

Some of the new ETFs are made for short-term trading, such as enhanced and inverse ETFs. Of course, there are greater risks using enhanced securities. Inverse ETFs attempt to return the inverse daily performance of an index. For example, an inverse S&P 500 Index attempts to go up about 1 percent on the day that the S&P 500 Index goes down about 1 percent.

With the new ETFs, you don’t have to be in stocks when the stock market is going sideways or declining. Investors and traders can buy into asset classes that are low-correlated or not correlated to the stock market. You also don’t have to buy and hold because you can trade easily using ETFs. In the sideways market we have been in since 2000, buying and holding broad market indexes hasn’t worked well, although buying and holding certain asset classes, such as small- and mid-cap indexes, would have worked out better. In bull markets, such as the one that started in 1982, buying and holding almost any broad market index worked out. In 1982, you could have bought several broad market ETFs and held them for 17 years and received a good return, because that bull market went up about ten times. Investing and trading must be adjusted to the type of market you are in. For a buy-and-hold market, ETFs are often a better way than picking stocks.

Using ETFs to Maximize Returns in Sideways-to-Down Markets

Figure 2-2 shows 4 bull markets consisting of 42 years and 4 bear markets consisting of 71 years. The bull markets lasted an average of 10 years, and the bear markets lasted an average of 18 years. Even though there were fewer bull market years, the cumulative gains in the bull markets were substantially more than the cumulative losses or slight gains in the bear market years. The bear years were more sideways markets than big down moves. A factor in bear years is opportunity cost, because there are probably better places to put money than in the stock market. Bull markets are vigorous and active, whereas bear markets just sort of hang around with periods of gloom interspersed with periods of hope. This is the sort of market cycle we have been in for more than 10 years.

Figure 2-2. Four bull markets and four bear markets. (Source: Rydex/SGI Investment Management)

Because there are more bear market years, it is important to get the best return you can in those years. If you buy broad market ETFs that are weighted in a way that produces a good return, or good-performing sector ETFs, or ETFs in countries that have robust growth, or non-stock market-correlated ETFs that perform, you can make money in a bear market. Figure 2-2 shows that long-term return market bias has been on the upside, so it is worth staying in the market for the long term.

The Importance of Picking the Right Sectors

In good markets and in bad markets, the performance of different sectors varies widely. Often, there is a 40 percent yearly difference between the top-performing sector and the bottom-performing sector. Take a look at Figure 2-3.

Figure 2-3. The top and bottom sector performances. (Source: Standard and Poor’s)

You can see in Figure 2-3 that there are big differences between the top and bottom sector performances every year. The difference was about 70 percent in 2000, for instance, and about 56 percent in 2009. The average difference between the top sector and the bottom sector for the years 2009 through 2010 is about 40 percent. An investor or trader, instead of picking which stock moves no matter what sector the stock is in, can concentrate on finding which sector moves the most and buy an ETF in that sector.

There are many ways to use ETFs to profit from the difference in sector performances. You can buy regular or enhanced inverse ETFs to short the sectors you think will decline and regular or enhanced ETFs to buy those sectors you think will go up. You can adjust your exposure in broad indexes by using sector ETFs. For example, if you are long SPY and are bullish on the energy sector, you can overweight it by buying an energy sector ETF, either regular or enhanced. Or, if you are long SPY and are bearish on the energy sector, you can underweight it by buying an inverse energy sector ETF, either regular or enhanced. Enhanced ETFs have enhanced risk. Because they attempt to return two, three, or more times the daily return of an index, their risk is also increased in the enhanced amount. If held for more than one day, enhanced ETFs run into compounding factors, which affect their longer-term performances.

One sector that can be bought as a hedge against inflation is the energy sector. The Energy Select Sector SPDR (symbol XLE), which uses the same stocks as the S&P 500 Index energy sector, is one of the ETFs that offers energy sector exposure. XLE’s P/E ratio is about 14 times, which is reasonable, and as the demand for energy increases, the price of oil can increase and there can be a multiple expansion.

The drug and pharmaceutical sectors have good prospects and can be overweighted. Around the world populations are growing older, and this creates the need for more and better medications. The substantial research going into finding new ways to treat diseases and ailments creates new opportunities for pharmaceutical and biotech companies. Two good buys for this sector exposure are PowerShares Dynamic Pharmaceuticals Portfolio (symbol PJP) and PowerShares Dynamic Biotech & Genome Portfolio (symbol PBE). PJP is comprised of 30 U.S. pharmaceutical companies that are engaged in developing and distributing drugs of all types, and at 12 times earnings, is reasonably priced. PJP employs the PowerShares Intellidex system to select companies, which uses a variety of criteria, including fundamental growth and risk factors. PBE is comprised of 30 U.S. biotechnology and genome companies that are engaged in research, development, and distribution of biotechnology products, and sells at a 17 price/earnings ratio, which is reasonable for this sector. PBE also uses the Intellidex system to select companies.

Two other buys for health care exposure are Pharmaeutical HOLDRs (symbol PPH) and iShares Global S&P Healthcare Sector Index Fund (IXJ). PPH has a decent yield at about 3.25 percent and sells at a low price/earnings multiple of 11 times. The ETF is highly concentrated, with only 10 U.S. companies making up 94 percent of its assets. More diversified is IXJ, which includes companies in the U.S., Switzerland, Japan, and other countries. IXJ covers the health-care sector—including companies engaged in pharmaceuticals, health-care equipment, and services—and sells at a reasonable 14.47 times earnings multiple.

Risk Cycles and Market Returns

Is this a good time to buy stocks, and where in the cycle are we? Figure 2-4 offers some perspective.

Figure 2-4. The performance of stocks versus bonds. (Source: Rydex/SGI Investment Management)

Stocks are riskier than bonds, so stock buyers expect more reward for taking more risk. Stocks usually outperform bonds, especially over long time periods. Figure 2-4 shows how stocks performed compared to bonds over several 10-year periods. The figure shows six “fishhook” performance diagrams of a portfolio of stocks and bonds. There are boxes on each diagram, each box showing the difference of a 10 percent mix of stocks and bonds in the diagrams. The circle in each fishhook represents a mix of 60 percent stocks and 40 percent bonds.

There are no guarantees in the stock and bond markets, but bonds are relatively safer than stocks. With stocks, there is no price guarantee, and they sell at the price of whatever people will pay for them. Bonds are different in that if bonds are held to maturity and the company has the resources, the bonds will be paid off.

Stocks outperformed bonds in all the 10-year periods shown in the fishhook graphics until the 2000–2009 period. In that decade, the performance is inverted and bonds outperformed stocks. A stock investor would have about broken even, and a bond investor would have made about 7.5 percent on average per year. In the past 100 years, there have been short periods when bonds outperformed stocks, but over longer periods, stocks have outperformed bonds. In the 1960–2009 period, which is shown in Figure 2-5, stock investors were rewarded for taking more risk as stocks outperformed bonds.

Figure 2-5. Stocks outperform bonds. (Source: Rydex/SGI Investment Management)

Almost every investment beat stocks over the last 10 years. Treasury bonds, silver, gold, platinum, oil, junk bonds, the 10-year Treasury bill—all of these had a better return than the stock market. Investments have cycles, and outperforming asset classes do not outperform indefinitely. Usually when people have given up on an asset class, the assets are selling the cheapest. History suggests it’s time for the stock market to outperform again.