Most investment services (and indeed bank strategists) tend to have a distinct bias in terms of sentiment and focus, for instance falling into the Goldbug or Permabear camp. Although all claim a unique insight, often from esoteric chart analysis, it would be naive to think that hugely complex markets, which are both an economic discounting mechanism and an emotional barometer of investor sentiment, are amenable to such simplistic, one dimensional, analysis.
I have learned over the years to pragmatically blend a variety of techniques which have proven highly reliable in predicting high-probability investment outcomes. I'm neither a bull nor bear by inclination, nor do I have any particular asset preference. I aim to be strictly rational and agnostic and judge any market on its fundamental merits at any given point in time.
1. Fundamental Macro Economic Analysis
Mutual funds market themselves on their unique stock-picking skills 'we have 200 analysts who meet 1,000 companies a month etc'. Utter, shameless, nonsense; every major mutual fund group systematically underperformed major indices in the 2008 crash. Academic studies of asset performance attribution are unequivocal; the biggest contributor to investment performance is getting the big picture macro calls right, then asset allocation across asset classes like equities, bonds and cash, then sectoral/geographical allocation within equities and bonds (duration for bonds, cyclical/defensive etc for equities), and finally, marginally, individual stock selection. Mutual funds and other long only investors should sack most of their stock analysts and invest in seriously good economists and strategists. I focus as an absolute priority on setting the right economic framework to hang market opportunities on. Ironically, it's easier to get the big macro calls right than picking an individual stock, given levels of transparency and disclosure. Generally I prefer sectoral exposure to individual stock plays on a given theme, as it reduces specific risk and thus volatility.
2. Asset valuation metrics, both in terms of history, and relative to other assets.
The S&P has been in a bear market since 1998. Fact. Which isn't surprising when you consider that US equities were more expensive on a cyclically adjusted basis in 1998 than in 1929; your purchase price is the strongest determinant of performance, and equities have been historically expensive for the past decade, which is fundamentally why they have generated negative compound returns. Now, after a brutal crash, US equities look reasonable value on any long term basis with the potential to generate high single digit compound returns, and bonds look extremely overvalued. It's key to focus on very long-term (25 year plus) market valuations, particularly measures such as price-to-book value or free cash flow, and strip out peak and trough earnings. Again, when these measures outside their historic range, it can signal risk or opportunity. Remember it's always easier to forecast the market with a high degree of confidence a few months or even years ahead than a few days.
3. Technical Analysis
Charts, in reflecting price action, are a useful visual summary of market sentiment and liquidity, but their interpretation should be made with great care. I use deviations from the LT moving average as a sell and buy signal,for instance, to help time fundamental views. When a commodity like oil trades 3 Standard Deviations above its 200 day MA, as it did when it reached $147 last July, betting on a reversion to the mean is a low risk strategy. Markets regularly get excessively oversold and overbought, and recognizing these sentiment extremes offers lucrative and low-risk trading opportunities, even in recent volatile conditions. Buying and selling pressure, as reflected in the volume and breadth of market movements, also give useful pointers to the sustainability or otherwise of price trends. In terms of moving average analysis, I watch the 50 and 200 day MA trends as support/resistance levels, although sometimes longer term perspective is useful in terms of deviation from trend. For instance, in November 2008, I noted that the S&P had hit its 25 year support moving average level for only the third time since 1942, which was a signal for a fast 20% bounce. In March 2009, I explained that the divergence between bond and equity performance had reached 3 standard deviations above its long term average, indicating a reversal was close at hand.
4. Market Psychology
For a contrarian investor, the easiest returns are made at extremes of market sentiment, and the trick is in recognizing them as such and thus timing entry points. Indicators of investment sentiment and behaviour include put/call ratios, adviser sentiment indices, market breadth, volatility, mutual fund cash positions and net hedge fund exposures.When these indicators reflecting investor optimism and pessimism reach extreme levels, it increases the probability of a contrarian position being highly profitable. High volatility as reflected in say the VIX often precedes a change of trend. I'm a keen student of behavioural finance, a relatively recent area of economic research that focuses on the psychological element in investment behaviour, the madness of crowds if you like. The chart summarizes the typical pattern of an investment mania, whether tech stocks in 1999-2003, commodities and resource stocks in 2005-08, or indeed US housing which is still in the latter stages of the capitulation phase.
There is always a new paradigm and bubbles always have a plausible narrative to begin with, but they become enormous Ponzi schemes driven ultimately by the greater fool theory as prices lose all relationship with historical fundamentals. Government bond markets entered the delusion phase of this stylised model in late 2008.
