The Investor's Guide to Active Asset Allocation: Using... (PDF) (2024)

Page 1

Page 2

The Investor’s Guideto Active AssetAllocationUsing Intermarket Technical Analysisand ETFs to Trade the MarketsMartin J. PringMcGraw-HillNew York Chicago San Francisco Lisbon London MadridMexico City Milan New Delhi San Juan SeoulSingapore Sydney Toronto

Page 3

DedicationTo my daughter, Laura.Copyright © 2006 by Martin J. Pring. All rights reserved. Except as permitted under the United StatesCopyright Act of 1976, no part of this publication may be reproduced or distributed in any form orby any means, or stored in a database or retrieval system, without the prior written permission of thepublisher.ISBN: 978-0-07-149159-4MHID: 0-07-149159-7The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-146685-1,MHID: 0-07-146685-1.All trademarks are trademarks of their respective owners. Rather than put a trademark symbol afterevery occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefi tof the trademark owner, with no intention of infringement of the trademark. Where such designationsappear in this book, they have been printed with initial caps.McGraw-Hill eBooks are available at special quantity discounts to use as premiums and salespromotions, or for use in corporate training programs. To contact a representative please e-mail us at[emailprotected].This publication is designed to provide accurate and authoritative information in regard to the subjectmatter covered. It is sold with the understanding that neither the author nor the publisher is engaged inrendering legal, accounting, or other professional service. If legal advice or other expert assistance isrequired, the services of a competent professional person should be sought.—From a Declaration of Principles jointly adopted by Committee ofthe American Bar Association and a Committee of Publishers.TERMS OF USEThis is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGrawHill”) and itslicensors reserve all rights in and to the work. Use of this work is subject to these terms. Except aspermitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, youmay not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works basedupon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it withoutMcGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use;any other use of the work is strictly prohibited. Your right to use the work may be terminated if youfail to comply with these terms.THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NOGUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETE-NESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANYINFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OROTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED,INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FIT-NESS FORA PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that thefunctions contained in the work will meet your requirements or that its operation will be uninterruptedor error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for anyinaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom.McGraw-Hill has no responsibility for the content of any information accessed through the work.Under no circ*mstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental,special, punitive, consequential or similar damages that result from the use of or inability to use thework, even if any of them has been advised of the possibility of such damages. This limitation ofliability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract,tort or otherwise.

Page 4

ContentsIntroduction v1. Some Basic Principles of Money Managements 12. The Business Cycle: Nothing More than a Seasonal Calendar 233. Useful Tools to Help Us Identify Trend Reversals 474. Putting Things into a Long-Term Perspective 735. How the Business Cycle Drives the Prices of Bonds, Stocks, and Commodities 1016. Say Hello to the Martin Pring’s Six Business Cycle Stages 1237. How to Recognize the Stages Using Models 1418. Identifying the Stages Using Market Action 1719. How the Stages Can Be Recognized Using Easy-to-Follow Indicators 18510. If You Can Manage the Risks, the Profits Will Take Care of Themselves 20111. How the 10 Market Sectors Fit into the Rotation Process 23312. Sector Performance through the Six Stages 25113. What Are Exchange Traded Funds? What Are Their Advantages? 27514. How to Use ETFs in the Sector Rotation Process 29515. ETFs and Other Vehicles as Hedges against Inflation and Deflation 32116. Putting It All Together: Suggested Portfolios for Each Stage in the Cycle 335Index 365iii

Page 5

This page intentionally left blank

Page 6

IntroductionIntroductionThe CD at the Back of This BookStrategic versus Tactical Asset AllocationWhy Do We Need to Allocate Assets?The Seasonal Approach to Asset AllocationInvesting Is as Much about Psychology as Applying KnowledgeIntroductionHave you ever been in a situation where you were listening to a businessprogram on TV or reading a financial article in a newspaper and weretotally 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 theeconomy, 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 personbelieves will affect the particular market in question. They are confusingbecause they fail to offer a way in which you can use this grab bag of ideasand facts to make forecasts at a later date. To make matters worse, suchopinions are rarely backed up by proof that consumers are going to spendmore, 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. Takethe oil argument, for example. Lots of commentators will use the risingprice of oil as the basis on which to make a forecast of a recession. “In thepast we have had a recession whenever the price of oil has risen by so andso.” Could it be that the recession was really caused by the deflationaryv

Page 7

vi THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATIONChart 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 broadcommodity 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 thatoil 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 establishingthat there is, generally speaking, a certain degree of order in the markets andthe economy. We will show, for example, that the business cycle goesthrough 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. Wegenerally 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 bedestroyed. The same is true for the business cycle. There are specific timeswhen you want to own lots of bonds and income-producing assets andtimes 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

Page 8

Introduction viicalendar tells us about the 12 months of the year and how they fall. Ourtask here is to set up a framework for the economy and financial marketsso you can see where they fall. In effect you will be provided with a roadmap that can be used as a basis for allocating and rotating assets during thecourse of a typical business cycle.We know from historic records that the seasons begin with spring and endwith winter. Does that mean that every time we plant corn in the spring thatwe 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 plantingcorn and harvesting it were not favorable, it would not be planted in the firstplace. However, in some years it is possible that drought or other extremeweather 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 themarkets. Most of the time this methodology works. We can see this fromthe rates of return from our barometers featured in Chapter 7. However,there are exceptions where markets do not respond to the economic andmonetary environments in the traditional and expected way. A great exampleoccurred in 1968, when interest rates rallied at a time when the economic con-ditions suggested otherwise. These exceptions are a fact of life and developwith 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 goingtheir separate ways and occasionally moving in tandem. We can use ratios ofsome of these key relationships as cross-checks. To site an obvious example,during the inflationary part of the (four-year) business cycle, the ratio ofcommodities to bonds should be rallying in favor of commodities; duringthe deflationary part, bond prices should have the upper hand, and so forth.These intermarket relationships are important to our approach becausethey act as cross-checks against what the economic and monetary indicatorstell us should be happening. Remember, it is the markets and the action ofthe markets that should have the final word. For example, it’s possible to saythat the law will protect you at a pedestrian crossing, but if a car is headingstraight for you, you need to get out of the way. It’s no good being protectedby a law when you are dead! Consequently, if the economic and monetaryindicators 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 iswhere our money is. It is certainly not invested in the economic and mone-tary indicators. It is the attitude of participants to the emerging fundamentalsthat take precedence over the fundamentals themselves. If the fundamentalswere the only consideration, it would not be possible for market bubblesor busts to exist because rational thought would predominate. Bubbles andbusts are irrational, as are market participants from time to time.

Page 9

viii THE INVESTOR’S GUIDE TO ACTIVE ASSET ALLOCATIONThe process of pricing in markets is one in which people look ahead andanticipate 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 isthe price. People do not wait for things to happen; they discount events andnews ahead of time. This is how we can account for the fact that a stockprice 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 bepoor and the stock rallies. Often this is a result of money managers knowingthat a disappointment lies ahead. Because they do not know the degree ofdisappointment, they postpone their purchase until the bad news is outof the way. If it is in the realm of reasonable expectations, they immediatelybuy from a public that is eager to sell due to the “unexpected” bad news.In this book we are principally concerned with fixed-income securitiesand equities. However, because new vehicles have recently been introducedthat 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 aclose look at the vehicles that will help us achieve these goals, as well asexplain the workings of the business cycle and the investment implicationsfor specific phases. For the most part, these will be the Exchange TradedFunds 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 majorexchanges and are quoted and traded on these exchanges on a daily basis.They are continually being priced just like any other listed entity while theexchanges are open. They differ from open-ended mutual funds, which arevalued only once a day. Most ETFs also pay dividends. However, their claimto fame is that they are really a basket of specific stocks that exactly replicatean index. This could be a measure of the market like the S&P or a specificsector, such as energy, financials, etc. These vehicles are also available forbonds, gold, and non-U.S. stock indexes. In all there are over 200 vehiclesand the selection keeps growing every year. ETFs therefore represent aquick, easy, and affordable method for owning a basket of diversified secu-rities aimed at a specific index.The CD at the Back of This BookAt the back of this book you will find a CD-ROM that contains a substantialamount of information to supplement explanations given in the book.Included are historical data files for some of the economic, monetary, andmarket indexes described. The CD also contains live Web site links so thatthe data can be updated.

Page 10

Introduction ixThere are several chapters devoted to Exchange Traded Funds, so linksto various ETF families are included, along with information on the S&Pand 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, whichdoes not do justice to many of the charts. For this reason a wide-ranginglibrary 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 theexecution of the strategies described in the book.Strategic versus Tactical Asset AllocationA successful investment strategy should be aimed at maximizing return butnot at the expense of undue risk. One way of achieving this is to allocate assetsamong several investment categories. The degree of “undue” risk depends onan individual’s psychological makeup, financial position, and stage in life. Ifyou 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 yourside. On the other hand, if you are close to retirement, you do not have theluxury of time. Alternatively, a highly paid executive will be less dependent oncurrent portfolio income than will a disabled person on workmen’s compen-sation. The executive’s position therefore allows him to take a more aggressiveinvestment stance, and so forth.The asset allocation process initially involves two steps. First it’s necessaryto make a general review of the three aspects discussed in the preceding para-graph: personal temperament, financial position, and stage of life. From hereyou can establish a broad goal. Is it current income or capital appreciation, ora balance of the two? If you decide on capital appreciation, it is importantthat you have the personality to ride out major declines in the market. On theother hand, would you be better off assuming less risk in order to sleep morepeacefully? There is only one person who can make such decisions, and thatis you. So look into your financial position, psychological makeup, and stagein life and decide for yourself. This process of formulating an investmentobjective is known as strategic asset allocation. It is a process that sets out thebroad tone of your investment policy, and one that should be reviewed peri-odically as your status in life changes. We offer some guidelines on theseaspects in the final chapter of this book.Tactical asset allocation is the process in which the proportion of each assetcategory held in the portfolio is altered in response to changes in the businessclimate. Thus, an older person may be principally concerned with incomeand safety while a younger one with risk-taking and capital appreciation. When