The Investor's Guide to Active Asset Allocation: Using Technical Analysis and ETFs to Trade the Markets

385 Pages·2006·8.58 MB·English

by  Martin J. Pring

The Investor’s Guide
to Active Asset
Allocation
Using Intermarket Technical Analysis
and ETFs to Trade the Markets
Martin J. Pring
McGraw-Hill
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Dedication
To my daughter, Laura.
Copyright © 2006 by Martin J. Pring. All rights reserved. Except as permitted under the United States
Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or
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ISBN: 978-0-07-149159-4
MHID: 0-07-149159-7
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Contents
Introduction v
1. Some Basic Principles of Money Managements 1
2. The Business Cycle: Nothing More than a Seasonal Calendar 23
3. Useful Tools to Help Us Identify Trend Reversals 47
4. Putting Things into a Long-Term Perspective 73
5. How the Business Cycle Drives the Prices of Bonds, Stocks, and Commodities 101
6. Say Hello to the Martin Pring’s Six Business Cycle Stages 123
7. How to Recognize the Stages Using Models 141
8. Identifying the Stages Using Market Action 171
9. How the Stages Can Be Recognized Using Easy-to-Follow Indicators 185
10. If You Can Manage the Risks, the Profits Will Take Care of Themselves 201
11. How the 10 Market Sectors Fit into the Rotation Process 233
12. Sector Performance through the Six Stages 251
13. What Are Exchange Traded Funds? What Are Their Advantages? 275
14. How to Use ETFs in the Sector Rotation Process 295
15. ETFs and Other Vehicles as Hedges against Inflation and Deflation 321
16. Putting It All Together: Suggested Portfolios for Each Stage in the Cycle 335
Index 365
iii
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Introduction
Introduction
The CD at the Back of This Book
Strategic versus Tactical Asset Allocation
Why Do We Need to Allocate Assets?
The Seasonal Approach to Asset Allocation
Investing Is as Much about Psychology as Applying Knowledge
Introduction
Have you ever been in a situation where you were listening to a business
program on TV or reading a financial article in a newspaper and were
totally confused about how the people concerned came to their conclu-
sions? You probably heard comments such as, “Well, Jack, I think the mar-
ket is going up because consumers are starting to get optimistic about the
economy, corporations are likely to spend more on plant and equipment,
and” blah, blah, blah. The analysis from such opinions is typically subjective,
as the view is based on stringing together a host of factors that the person
believes will affect the particular market in question. They are confusing
because they fail to offer a way in which you can use this grab bag of ideas
and facts to make forecasts at a later date. To make matters worse, such
opinions are rarely backed up by proof that consumers are going to spend
more, or even if they do, that this relationship has worked in the past.
Indeed, the pickup in spending may already be factored into the stock mar-
ket, which almost always looks ahead. I call it mouthing from the hip. Take
the oil argument, for example. Lots of commentators will use the rising
price of oil as the basis on which to make a forecast of a recession. “In the
past we have had a recession whenever the price of oil has risen by so and
so.” Could it be that the recession was really caused by the deflationary
v
vi THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
Chart I-1 CRB Spot Raw Materials versus Spot Crude Oil (Source:
pring.com)
effects of rising commodity prices in general, of which oil is just one com-
ponent? Chart I-1 shows that oil and the CRB Spot Raw Industrials (a broad
commodity measure that does not include oil) often rise and fall in tan-
dem. It is not a perfect correlation, but it certainly illustrates the point that
oil is not the only suspect.
The explanation in this book comes at the subject from a totally differ-
ent angle. We will do our best to avoid such lose thinking by establishing
that there is, generally speaking, a certain degree of order in the markets and
the economy. We will show, for example, that the business cycle goes
through a set series of chronological events or economic seasons. The cal-
endar year moves through the four seasons and each one has specific char-
acteristics where it is the best time in the year to carry out certain tasks. We
generally sew seeds in spring and harvest them in the summer or fall.
Rarely would we sew them in winter, for in most situations they would be
destroyed. The same is true for the business cycle. There are specific times
when you want to own lots of bonds and income-producing assets and
times when you should own commodities or resource-based stocks instead.
Our objective here is to explain the characteristics of these “economic”
seasons and to lay out some techniques that can help us identify them. A
Introduction vii
calendar tells us about the 12 months of the year and how they fall. Our
task here is to set up a framework for the economy and financial markets
so you can see where they fall. In effect you will be provided with a road
map that can be used as a basis for allocating and rotating assets during the
course of a typical business cycle.
We know from historic records that the seasons begin with spring and end
with winter. Does that mean that every time we plant corn in the spring that
we are guaranteed to harvest it in late summer or early fall? In the vast major-
ity of cases the answer would be yes. After all, if the probabilities of planting
corn and harvesting it were not favorable, it would not be planted in the first
place. However, in some years it is possible that drought or other extreme
weather conditions will severely affect the harvest, in some extreme cases wip-
ing it out altogether. The same can be said of our seasonal approach to the
markets. Most of the time this methodology works. We can see this from
the rates of return from our barometers featured in Chapter 7. However,
there are exceptions where markets do not respond to the economic and
monetary environments in the traditional and expected way. A great example
occurred in 1968, when interest rates rallied at a time when the economic con-
ditions suggested otherwise. These exceptions are a fact of life and develop
with any methodology. However, we can minimize the damage in two ways:
First our approach uses an escape hatch in the form of long-term trend-
following indicators, just as a fighter pilot has an ejection mechanism.
Second, during the course of the cycle, different financial assets are going
their separate ways and occasionally moving in tandem. We can use ratios of
some of these key relationships as cross-checks. To site an obvious example,
during the inflationary part of the (four-year) business cycle, the ratio of
commodities to bonds should be rallying in favor of commodities; during
the deflationary part, bond prices should have the upper hand, and so forth.
These intermarket relationships are important to our approach because
they act as cross-checks against what the economic and monetary indicators
tell us should be happening. Remember, it is the markets and the action of
the markets that should have the final word. For example, it’s possible to say
that the law will protect you at a pedestrian crossing, but if a car is heading
straight for you, you need to get out of the way. It’s no good being protected
by a law when you are dead! Consequently, if the economic and monetary
indicators are pointing in one direction and the market itself is not respond-
ing or confirming, we need to go with the market’s decision because that is
where our money is. It is certainly not invested in the economic and mone-
tary indicators. It is the attitude of participants to the emerging fundamentals
that take precedence over the fundamentals themselves. If the fundamentals
were the only consideration, it would not be possible for market bubbles
or busts to exist because rational thought would predominate. Bubbles and
busts are irrational, as are market participants from time to time.
viii THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATION
The process of pricing in markets is one in which people look ahead and
anticipate what is likely to happen. The hopes and fears of all market par-
ticipants, whether actual or potential, are reflected in one thing and that is
the price. People do not wait for things to happen; they discount events and
news ahead of time. This is how we can account for the fact that a stock
price declines after the announcement of favorable earnings. In such situa-
tions the good news has already been discounted by the market and partic-
ipants are looking ahead at the next development. If it’s not so favorable,
the stock is sold and the price declines. Alternatively, the earnings may be
poor and the stock rallies. Often this is a result of money managers knowing
that a disappointment lies ahead. Because they do not know the degree of
disappointment, they postpone their purchase until the bad news is out
of the way. If it is in the realm of reasonable expectations, they immediately
buy from a public that is eager to sell due to the “unexpected” bad news.
In this book we are principally concerned with fixed-income securities
and equities. However, because new vehicles have recently been introduced
that allow smaller investors to conveniently purchase broad baskets of com-
modities and gold, this is also a relevant area to pursue. We will also take a
close look at the vehicles that will help us achieve these goals, as well as
explain the workings of the business cycle and the investment implications
for specific phases. For the most part, these will be the Exchange Traded
Funds or ETFs. ETFs began to gain a following at the start of the century.
They have the look and feel of stocks because they are listed on the major
exchanges and are quoted and traded on these exchanges on a daily basis.
They are continually being priced just like any other listed entity while the
exchanges are open. They differ from open-ended mutual funds, which are
valued only once a day. Most ETFs also pay dividends. However, their claim
to fame is that they are really a basket of specific stocks that exactly replicate
an index. This could be a measure of the market like the S&P or a specific
sector, such as energy, financials, etc. These vehicles are also available for
bonds, gold, and non-U.S. stock indexes. In all there are over 200 vehicles
and the selection keeps growing every year. ETFs therefore represent a
quick, easy, and affordable method for owning a basket of diversified secu-
rities aimed at a specific index.
The CD at the Back of This Book
At the back of this book you will find a CD-ROM that contains a substantial
amount of information to supplement explanations given in the book.
Included are historical data files for some of the economic, monetary, and
market indexes described. The CD also contains live Web site links so that
the data can be updated.
Introduction ix
There are several chapters devoted to Exchange Traded Funds, so links
to various ETF families are included, along with information on the S&P
and Dow Jones industry group classifications. Links to industry group com-
ponents have been provided.
Unfortunately, the book is limited to a black-and-white format, which
does not do justice to many of the charts. For this reason a wide-ranging
library of multicolored charts has been included in PDF format on the CD.
Many of these charts are not included in the book. All in all the CD will pro-
vide you with some really helpful background information to assist in the
execution of the strategies described in the book.
Strategic versus Tactical Asset Allocation
A successful investment strategy should be aimed at maximizing return but
not at the expense of undue risk. One way of achieving this is to allocate assets
among several investment categories. The degree of “undue” risk depends on
an individual’s psychological makeup, financial position, and stage in life. If
you are young, you can assume greater risks than someone who is retired, sim-
ply because you are in a position to recover from a sharp loss. Time is on your
side. On the other hand, if you are close to retirement, you do not have the
luxury of time. Alternatively, a highly paid executive will be less dependent on
current portfolio income than will a disabled person on workmen’s compen-
sation. The executive’s position therefore allows him to take a more aggressive
investment stance, and so forth.
The asset allocation process initially involves two steps. First it’s necessary
to make a general review of the three aspects discussed in the preceding para-
graph: personal temperament, financial position, and stage of life. From here
you can establish a broad goal. Is it current income or capital appreciation, or
a balance of the two? If you decide on capital appreciation, it is important
that you have the personality to ride out major declines in the market. On the
other hand, would you be better off assuming less risk in order to sleep more
peacefully? There is only one person who can make such decisions, and that
is you. So look into your financial position, psychological makeup, and stage
in life and decide for yourself. This process of formulating an investment
objective is known as strategic asset allocation. It is a process that sets out the
broad tone of your investment policy, and one that should be reviewed peri-
odically as your status in life changes. We offer some guidelines on these
aspects in the final chapter of this book.
Tactical asset allocation is the process in which the proportion of each asset
category held in the portfolio is altered in response to changes in the business
climate. Thus, an older person may be principally concerned with income
and safety while a younger one with risk-taking and capital appreciation. When