The reason for some institution's refusal to sell their positions that have appreciated dramatically (and that are most vulnerable to decline) can be deeper than the impression desired by publishing the positions. Management's compensation is usually a set percentage of the market value of the assets managed. If a profitable position is sold, the gain may be subject to taxation and paid out to clientele as a capital gains distribution. This effectively reduces the amount of money being managed and the associated fees.
The problems associated with selling positions that have profited most can be particularly acute in small mutual growth funds that have followed the practice of "taking losses and letting profits ride" for an extended period. The result is that their portfolio consists of only a few issues. By having locked themselves into holding a few profitable stocks, the fund's value becomes a function of the value of the rigid holdings and has nothing to do with the overall ability of management.
Keep in mind that money managers are human beings with basic needs such as food and shelter, which require employment. Also recognize that, especially in the larger institutions, clientele are not aware of the identity of the individual analyst making the investment decisions. This anonymity is often strictly enforced and a prerequisite for employment.
In this environment, the individual analyst (whether a genius or an idiot) is under pressure to conform to the crowd. To be too good or too bad relative to one's peers involves risks of criticism or resentment with the associated occupational hazards. This effect is obvious to anyone familiar with the financial media. When an analyst (usually independent) becomes popular because of accurate forecasting and then stumbles, the mistake (even though the overall return over time has been far superior) is pounced on. On the other hand, a spokesperson for a large institutional analytical service that has consistently been wrong, but that is one of the crowd, attracts media attention when making forecasts without criticism of past mistakes.
Understanding the structural aspects of institutional investing practices and employment pressures, you would logically conclude that the average institution would underperform the market, with the underperformance magnified by the fees involved. Yup.
External
Aside from the difficulties associated with internal structure and characteristics, institutions have the added problem of dealing with their clientele. Discretionary clientele who do not properly understand the stock market, although they have entrusted their investment decisions to someone else, often have a tendency to self-destruct. This is particularly evident in mutual funds, whose investors are continually adding or withdrawing (redemptions) money. People tend to add money when the market is highand the mood optimistic. Redemptions tend to dominate when the marketis low and the mood pessimistic.
The institutions are forced to invest the money—that is what they arebeing paid to do. Therefore, with more money coming in when the market is high, the institutions so affected are forced to buy at relatively high levels. Conversely, when redemptions dominate and the market is low, the institutions are forced to sell at depressed prices to fulfill the investor'sdemand for cash.
From the professional standpoint, the process is marvelous. We knowwe have buyers at high prices and sellers at low prices because of the demands of discretionary clientele creating a supply/demand imbalance. When they are doing their forced buying, it creates underlying buying demand and we can raise our prices. When they are forced to sell, we know there is "overhanging supply," and we can lower our purchase prices.
This buy-high/sell-low behavior (required to fulfill clientele's wishes) is not limited to mutual funds. It can affect any funds that can redeem or add capital according to their client's emotions: bank trust departments, pension funds, and the like. An important exception is closed-end mutual funds where the capital base is fixed and the investor must buy/sell shares in the open market rather than affecting the funds' specific holdings.
The market is a business. The purpose of the business is to acquire the monies of others through the process of buying low and selling high. Because of the anonymous nature of trading structure, it is very difficultto specifically identify the individual to whom you are selling or from whom you are buying. Consequently, physical coercion to create losingbehavior among fellow market participants cannot be applied. People do not enter the market to lose. However, they must be placed in a situation in which they will willingly part with their money. The only way to elicit losing behavior is psychological pressure. The most effective tool for applying the pressure is a change in market price. Faced with "paper" losses, those vulnerable to the emotion associated with "apparent" losses will capitulate, accepting the loss in the form of cash to relieve thepsychological strain.
The discretionary manager is subjected to the same emotional pressuresas all other market participants. It is not uncommon for discretionary managers to buckle under the pressure and sell low in direct conflict with historical or statistical precedent to alleviate pressures both self- and clientele-imposed. Conversely, when prices are too high, the emotionallure of greed can stimulate buying when prices are most vulnerable to severe decline. Those who conduct themselves professionally are acutelyaware of the psychological effects of price on institutional managers and take advantage. Such advantage is possible only by strict adherence to a methodology that prevents being lured into the irrational (emotional) behavior of the crowd. This is easily accomplished by having predetermined buy/sell points dependent upon market condition, not price in itself.
The forced behavior of institutions provides one of the most important profit centers for the true professional.
There are many of the difficulties encountered by institutional management. In this discussion our interest is on identifying pressures that often make discretionary managements conductthemselves in predictable, repetitive patterns. There are two basic sourcesof pressure:
- Internal factors, primarily influenced by institutional structure.
- External factors, primarily influenced by the actions of clientele who have placed their funds under discretionary management.
Internal
Institutional management, whether the contributions are voluntary or involuntary, incorporates two basic elements: sales and performance. Of the two, sales is more important because if no reason is given for the contributor to entrust monies, the contributor is not going to do so. And with no money to manage, there is no institution. Elementary.
The primary institutional sales tool is image. Astute, presumably educated, well dressed personnel, plush surroundings, organizational names indicating solidarity, and other superficial characteristics are effectively utilized to project an image. Most investors buy the impression.
The average investor neither wants to take the time nor has the inclination to make objective comparison of the relative performance of the many institutions. Often the institution is chosen without any comparison because of a personal friendship with the institutional manager or salesperson, response to advertising, or media hype. For these poorly informed investors, the greatest influence on their choice of discretionary management is paid advertising, which makes the larger (more heavily advertised) institutions appear preferable. We do not intend here to demean sales. Salesmanship is an integral part of all societies; it is involved in politics and religion, as well as in the overall economy. Our point is to emphasize the sales aspect of institutional structure because it is often overlooked byinvestors, and it forms the basis of some predictable institutional market behavior.
While most investors are not keenly aware of the differences in performance among institutions, most institutional managers definitely are. With their firms having costumed and situated themselves in similar surroundings, the managers must do something more to enhance their sales. The obvious factor to emphasize is performance. However, this creates a dilemma since most institutions fare relatively poorly over time. Irrespective of what the institution has really accomplished for clientele, it isobligated (to assure its existence) to make past performance look as good as possible.
For those institutions that publish their holdings, the easiest way to project the image of superiority is for the holdings to have appreciated dramatically since the time they were purchased. The accomplishment of this task is within the grasp of any attentive third-grade student: sell holdings that are losing and retain those that have appreciated. Then—ah ha—when the institution's holdings are published, it will provide the image that the institution has a fantastic ability to achieve superior results. To add to the image, right before the holdings are to be published, the manager determines which stocks have gone up the most and are receiving the most positive media attention, and then buys some irrespective of the current high price. The end result is a published portfolio that is stuffed with winners and the "hottest" current stocks. The impression is that the institution has both a history of winning and continues to be "on top of the market" by having positions in those stocks currently in vogue.
This process of adjusting portfolio for the sake of appearance—window dressing—is most pronounced when the majority of institutions publish their quarterly portfolios, on or near the last day of March, June, September, and December. As might be expected, the window dressing effect is most dramatic during December when it is combined with selling by the public and others for tax reasons.
The problem with window dressing is, of course, that it not only involves the precise formula for loss (buying high and selling low), but also precludes optimal profit capture by retaining positions that are too high and destined to fall.
To those who conduct themselves professionally, being aware of the influence of window dressing adds to the benefits obtained by normal shifting in relative strength. In effect, window dressing aggravates pricing, making prices too high/low than they would be without the effect. Being aware of the window dressing pressures in combination with normal rotational shifts in relative strength can, in itself, more than double the return available from the market as a whole as measured by the popular averages.
The risks associated with portfolio modification for the sake of appearance are magnified in management techniques stressing "growth" stocks. Retaining a position simply because it has attained an exceptionally large gain could involve the stock's being in the attainment phase of the life cycle concept. In this phase quality stocks are most vulnerable to steep, often sudden price declines.
When we developed our investment methods, we assumed that using P/Es based on projections rather than lagging P/Es would create a significant difference in results. Over the many years that this basic portfolio modeling has been published and applied in actual market endeavors (covering a wide range of market conditions and thousands of individual stock positions), to our surprise, that the results obtained by using earnings projections in P/E calculations has not (to date) resulted in significantly better results than using lagging P/Es. In other words, although the authors use projections in their analysis, lagging P/Es so far have provided almost identical results. Whether earnings projections or lagging P/Es are utilized, taking the calculations to two decimal points is necessary to maximize the number of buy/sell points.
Since P/E is a function of price, we must consider whether price (a much easier measurement, the week's closing price) can be substituted. The answer is yes, but there will be some (to date quite minor) loss of accuracy. For example, if a stock's earnings suddenly declined dramatically and the stock's market price also declined, the decline in market price might not be directly proportional to the decline in earnings. The price would go down, but the P/E (price now divided by lower earnings) might go up because the earnings drop was proportionately greater than the price drop. Watching for changes in price, without paying attention to earnings changes as well, will prevent your gaining a refined perspective of true supply/demand.
If you choose to substitute price change for P/E change, the accuracy differential can (in most cases) be compensated for by raising the required percentage of issues that must be down or up in price to 80 percent. There will be fewer buy/sell points derived by using price rather than P/E, but (to date) the price method would have identified all major buy/sell points. Consequently, the essential elements for an indication are:
BUY: 75 percent of the P/Es or 80 percent of the prices of the stocks monitored must be down.
SELL: 75 percent of the P/Es or 80 percent of the prices of the stocks monitored must be up.
A question is now raised: Would it not be easier just to see if the market averages had gone lower and take that (or the P/E of the Dow or some other average) as an indication? The answer is no. The averages can be misleading. They can be significantly influenced by dramatic price moves in stocks and stock groups that do not warrant consideration (that is, stocks not on the Master List) as an indicator of investment. An attempt to gauge market conditions by the average of a conglomeration of unrelated stocks brings in extrinsic factors that are unpredictable. Our stock selection is designed to make the most important extrinsic factor (earnings) predictable.
To attempt to incorporate past changes in market averages as forecasting tools for future changes can be done, but it requires extensive calculations, including degree of price change in relation to volume change for each stock involved. It results in lower levels of accuracy than achieved by our technique. In our method, the design is not only to achieve superior results; it is also designed to be as simple as possible. In our method to get a signal from our primary indicator, the degree of decline (what percentage decline in P/E or price occurred) is not a necessary measurement. For example, if 80 percent of the stocks monitored declined in price only 1/8 of a point from their previous price level, the essential criterion for a buy indication would be met. The ancillary criteria are designed to filter for the magnitude of the primary criterion.
Why (for the basic portfolio modeling techniques) do we not consider it essential to wait for some upward price movement to occur to ensure that the effect of selling pressure is gone? Conversely, why not wait for some downward price movement to occur to ensure that buying demand is gone? The reasons are twofold.
First, often when price reversals occur, they are very rapid, and a significant portion (sometimes almost all) of the anticipated price change can occur before positions can be taken.
Second, the authors are in the business of stock trading on a scale that involves many millions of dollars. We are not engaged in theoretical observations that include the naive belief that infinite amounts of stock can be bought or sold at the prices quoted. Stated flatly, for us to acquire stock in large amounts at appropriate prices, it is necessary to have adequate sellers; to sell stock in large amounts at appropriate prices, it is necessary to have adequate buyers. Real people and real money are involved. Stock purchased at acceptable prices is available only when sufficient sellers at the acceptable prices are in place; which is usually as prices are declining, not after the price decline. Selling stock at acceptable prices can be accomplished only when there are adequate willing buyers, which is usually as prices are advancing, not after the advance.
Our determination of buy/sell points is based on a logical understanding of the structure of the market and of the behavioral patterns of fellow market participants. We are not concerned with waves, angles, astrological configurations, or other such data, which by some magical force are presumed to be satisfactory indicators of future prices.
The purpose of our timing technique is to help facilitate our objective to take the monies of others in a repetitive, consistent fashion that minimizes risk in actual market endeavors. We have no interest in theoretica abstractions in that time so spent can only detract from fulfilling our of objective. At this point, we are attempting only to ensure acceptable accuracy in forecasting changes in the major market averages. The final goal is to develop profit consistency for our stock positions at the percent- age level we have chosen (90 percent minimal) within the average holding period we have decided to use (four to six months).
Because of the upward bias in the specific stocks we utilize, we do not need k the probabilities for accurate timing of the popular averages to be as high as those associated with the specific stocks. As discussed in the previous sections, our 95-percent accuracy rate with individual stock issues needs only around a 78-percent or better accuracy probability relative to the popular averages.
In actual market participation, decisions must be made quickly and without emotion. Our timing technique, therefore, must not be influenced by emotional "subjectivity," and it must be easily and quickly calculated to avoid time lags that would take away from maximizing the number of available opportunities.
Market timing is nothing more than reviewing statistically valid data to derive probabilities for future price moves. Consequently, because of the probability variances at any given time, not all buy/sell points are created equally.
The relative strength of any buy/sell point can be compensated for by altering the "investment level," that is, by varying the percentage allocation between stocks and cash.
At this juncture, our objective is to develop buy/sell points that meet our minimum requirements related to the purchase or sale of specific common stocks. Application to options, index futures and more speculative trading strategies require adjusting our timing probabilities upward from those that are the focus of this discussion.
Our discussion of the technique, at this time, is designed for the process of buying specific stocks, then selling. The basic elements are buy indications that increase the percentage of funds allocated to common stock investment (that is, increasing the investment level), a holding period, and then sell indications that would result in selling specific positions to adjustto a lower investment level.
This buy-to-sell aspect is stressed because you cannot assume the processcan be automatically reversed. That is, the same criteria cannot be used in reverse for short selling with the same degree of accuracy in specificpositions—selling short on sell indications and covering (buying back the short positions) on buy indications. The reason it cannot be reversed automatically is because of the upward bias in the stocks we utilize. For accurate short sale techniques, alterations (to be discussed) are necessary to eliminate this upward bias.
In this discussion, we are going to fully describe the criteria that we actually use. Some of the criteria might appear rather complex, and the information to implement exact duplication might be difficult for many investors to obtain. However, after such detailed descriptions, greatly simplified methods within reach of almost all investors will be described. In fact, the basic timing method can be compacted so it takes less than one hour each week without any need for complicated equipment. Nothing is necessary beyond the ability to read.
The factors we use to determine buy/sell points are of two types: essential (or primary) and ancillary. There is only one essential factor, and it must be present for any buy/sell indication. There are twelve ancillary factors; any six (or more) must coincide with the essential factor to have a buy/sell indication.
3. Familiarity with the Institution
Beyond knowing the specific investment techniques being employed and the specific analyst(s) involved; it is important to be properly treated by the institution itself. The better analysts who have achieved some notoriety will generally have many accounts and many millions of dollars to supervise. As such, it may be impractical (or physically impossible) for the analyst to be in continuous, personal contact with all clientele. Support personnel are necessary and investor's communication with the analyst's aides should be in a familiar, congenial atmosphere.
Support personnel can provide warning signs. If there is rapid turnover, terse responses, or any other form of discontent, it could indicate that there are problems with upper management's abilities to conduct themselves properly with employee's or clientele's needs.
Other warning signs can be the behavior of the specific analyst(s). It is Virtually impossible to properly manage money while repeatedly crisscrossing the country for interviews, constantly appearing in "dog and pony" shows (speech/seminar circuits), or being available for any media event that provides a chance for the analyst (or the organization represented) to get a picture or quote in the news. Proper money management takes time—lots of time involving continuous access to changing data that affect clients' goals and needs. Inordinate amounts of time spent on publicity tours can only detract from personal account supervision. It also raises a question: If the analyst is so well-known and so good, why spend so much personal time advertising?
As mentioned, it may be physically impossible for the manager to personally convey the logic for each investment decision to each client. However, the client should be aware of the manger's current basic reasoning. After all, maybe the manager went to that proprietary brain surgeon.
Most analysts whose client base is too large to allow individual verbal 1 communication will provide regular written correspondence regarding the reasoning behind portfolio positioning. If a manager does not provide such regular written or verbal communication, it could be a sign of laziness or pomposity, neither of which are characteristic of prudent account management.
The rewards, or the lack of them, associated with the selection of discretionary management are not limited to those who have personal control of their own funds and therefore have personal control of their own financial fate. Billions of dollars are taken from the earnings of people (employees, estates, trusts, and others) and turned over to discretionary management, over which the individual contributors exert little or no control. The abuses that can result from involuntary "contributions" (fat fees, funding the personal projects of managers, ludicrous costs paid to families and friends, kickbacks, and the like) are well-known. These abuses would stop if those making the involuntary contributions stood up and demanded their right to the three "familiarity" points just discussed. Such action would make a lot of nasty people angry, but would certainly provide a lot of nice people the money they deserve.
Although the emphasis is to assist individuals in developing and implementing their own investment strategies, we do not mean to imply that all money managers should be avoided. There are many competent managers.
Yet the selection of a manager cannot be taken lightly. The fate of the monies entrusted is most likely sealed at the time the manager is selected. It is no time to blindly follow friendships, media hype, or personal emotion. Almost all of the difficulties associated with the selection process can be eliminated by following three simple guidelines.
1. Familiarity with the Investment Technique
Money is a tangible: Either you have it or you don't. Generating money from money is a very specific process: Specific investments, must be chosen and the investments managed under specific techniques. Irrespective of how money is applied (even hidden in a mattress), there is an element of risk. To place the element of risk in a context suitable to individual resources, needs, and goals, it is mandatory that investors understand the specific investment techniques determining how monies are invested.
Obviously, avoid managers who stipulate techniques that have not produced suitable results when back-tested over a long period or who stipulate that their methods are proprietary (secret to all but themselves). Despite the glaring dangers, people seem to be attracted to proprietary "systems," the bait probably associated with greed. The fact is that the markets have been around for a long time. There is little that is not known and has not been adequately tested. In other words, would you entrust your life to a brain surgeon whose operational procedure was his own little secret? Suffice it to say that, within the financial community, there is ongoing communication among the ethical elements to provide clientele with superior products.
In effect, the investment method being utilized by the manager should be the same method you would personally use had you not decided to entrust the day-to-day investment routine to the expertise of others.
2. Familiarity with the Individual Analyst
Little known to the investing public, there has been a prolonged and ongoing battle within the financial community over full disclosure to clientele as to the specific identity of individual analysts managing the clientele's money in larger institutions.
Institutional management generally favors anonymity, stating that specific investment decisions (unless very bad and some underling is selected for blame) are a "team effort," and no one individual should be singled out as being better or worse than the team.
Many analysts counter that the "team" argument is a joke. It allows the institution to maintain fat salaries for dead wood ("good old boys") while inhibiting the advancement of truly superior individual analysts—sort of a slave labor relationship. These analysts further contend that the institution's desire for anonymity is to keep monies under institutional management. If the better analyst, known to clientele, were to leave the institution, the clientele would also leave to keep their funds with the superior analyst.
To us the bottom line is simple. You should know the specific analyst who is involved with your money and have some means of individual communication. It is your money and you have a right to know both the investment methods being used and the individual making the investment decisions.
In the world of investment techniques, the originators of the methods often manage money using those techniques. In effect, the investor often has access to the source. If the source is not in the money management business, he or she will probably be willing to direct the investor to a manager who has demonstrated a familiarity with the originator's work. If the originator is dead or out of business someone else will likely emerge as the best known analyst following the technique who can personally provide (or personally recommend another for) appropriate discretionary management. If you want the best, nothing can be lost by seeking it.
The Master List, whether all the issues are being monitored or only the minimal acceptable number, forms the core of the indication. These stocks, with their relatively high degreeof earnings predictability, we use both to gauge forces within the market and to make specific investments.
In effect, we are functioning in a market within a market. We want to buy low and sell high. By confining interest to specific stock issues that have demonstrated fundamental superiority, we have chosen stocks that have an upward bias relative to the market as a whole. This bias in itself, however, is far from enough to meet our goals. We are very much interested in the relationships between demand and supply. We want to purchase when there are strong signs that selling supply might be exhausted. In other words, we want to buy soon before or in conjunction with the last period in which the sellers are dominant. Once the selling dominance has been eliminated, buyers can dominate and prices can advance. Conversely, we want to sell soon before or in conjunction with the last period in which buyers are dominant. When the buyers have exhausted their influence, sellers can dominate and prices can decline.
The best indication of seller dominance is a downward shift in marketprice relative to earnings (the price/earnings ratio). Lower P/Es both provide stock at lower prices relative to earnings and indicate that sellers are using up their influence. Therefore:
- For a buy indication, it is essential that the P/Es of the stocks monitored are falling.
- For a sellindication, the P/E condition must be the reverse of that fora buy: It is essential that P/Es are rising to have a sell indication.
Since by the design of Drach's published Time Overlay portfolio modeling we are looking at the market weekly and comparing it to four weeks before to see the relative change, we are looking for upward or downward moves in P/E relative to the P/Es four weeks ago. The minimal acceptable level is that 75 percent of the stocks monitored have moved down or up in P/E from their level of four weeks before. If the percentage is less than 75 percent, there is no indication. To repeat:
- The essential factor for a buy indication is that 75 percent or more of the stocks monitored have declined in P/E from their level four weeks before.
- The essential factor for a sell indication is that 75 percent or more of the stocks monitored have advanced in P/E from their level four weeks before.
In the calculation of P/E ratios, both price and earnings are variables, that is, both change over time. In most financial publications, the P/Es listed are "lagging P/Es." That is, they are calculated by taking the corporation's earnings over the last four quarters (one year) and dividing the earnings into the current market price. Because earnings change and because one of the criteria for stocks to qualify for our Master List is earnings predictability, it is reasonable to assume that calculating P/Es using earnings projections covering the next four quarters (the next year) would be a more accurate gauge of the P/E shift, indicating that the stock was becoming (or is) under- or overpriced.
In Drach's publication, as well as in actual account management under the author's supervision, P/Es are calculated using earnings projections. Also note that the authors' P/E calculations are to two decimal points since this significantly expands the number of buy/sell points.
The primary criterion, be it P/E or price, will not always give a buy/sell indication. In fact, most of the time (and sometimes for very long periods) the primary criterion will not meet the parameters to form the preliminary basis for a change in basic portfolio modeling. The primary criterion (depending on which method—projected earnings, lagging P/Es, or price—is chosen) is by far the most time consuming aspect of our timing technique.
The ancillary criteria are designed to confirm or reject the primary indication. The ancillary criteria (aside from a few rare exceptions) will always be issuing a buy or sell bias. Without an indication from the primary criterion, there is no need to be concerned with the ancillary facets in basic portfolio modeling because there can be no change.
There are twelve ancillary criteria, which might at first seem too burdensome to calculate. However, most (if not all) can be determined by a casual glance at major financial publications (Barron's or The Wall Street Journal). A weekly review of the ancillary criteria can probably be attained within 10 minutes after the sources are identified.
For the ancillary criteria to confirm the primary criterion, a minimum of six ancillary criteria must be in place.
Institutional Cash Reserves
If all markets involve predator/prey relationships, to acquire the cash of others requires that the others actually have cash from which they can be parted. Because of the specific stocks we utilize, as well as the growing dominance of institutions in day-to-day trading patterns, those institutions against whom we compete are important sources of profit.
The term institutional cash reserves refers to the ratio of institutional holding of cash (or cash equivalents) to common stock. The higher the institutional cash reserves, the more money they have available for the purchase of stock. The lower the cash reserves, the lower the institution's ability to buy stock irrespective of sentiment. To emphasize the importance of this institutional cash:noncash ratio, it was all you needed to understand to avoid the crash of 1987. At the time, the institutions were so lured into the stock market and their cash reserves became so depleted, they could not support stock prices. It was an inevitable splat time because of the depletion of possible buying demand.
Institutional cash reserves are tabulated regularly by a variety of surveys that scan mutual funds and/or pensions (Lipper, Herzfeld, a wide variety of brokerage firms, and the like) and the results regularly published in major financial publications.
For our purposes, all we need to know is the change in the cash:noncash ratio relative to where it was four weeks ago (or the next nearest reporting period depending on the source utilized).
BUY: The cash amount has increased. We have isolated potential buying demand that can be lured into the market to push prices higher.
SELL: The cash amount has decreased. The institutions are depleting their buying power, making themselves increasingly weak (perhaps helpless) in providing price support and thereby allowing selling supply to more easily dominate and depress prices.
Public Cash Reserves
Because of the rapid growth of institution's dominating trading activity, it has become popular to dismiss the public as an important market factor. However, as we have discussed in detail in previous chapters, the public is a very important factor, not only because of the predictable behavioral patterns of individuals, but because of the effects these patterns have on the institutions in which the public has entrusted funds.
We monitor this group's cash status by the weekly reporting of the total assets of money market funds. Money market fund assets include monies from groups other than the public, but for our purposes the changes in money market fund assets is all that is necessary for this criterion.
The weekly money market fund asset figures are reported in all major financial publications. Our comparison period is four weeks.
BUY: The amount (gross, no ratio needed) has increased. This isolates potential buyers (buying demand) and the associated potential for higher stock prices.
SELL: The amount has decreased. The amount of potential buying demand is lessening, and selling supply can more easily become dominant to depress stock prices.
The two previous factors were designed to isolate specific participants and their ability to effectuate future behavior because of their cash/noncash position. The amount of money in the overall economy is also important and is influenced by the actions of the Federal Reserve.
The figures relating to available money supply are provided weekly by the Federal Reserve and reported by all major financial publications. The money supply calculations include various categories (M-1, M-2, and M-3 being the most popular in gross form). Because of the various components of the money supply categories and changes in the economy, there is an ongoing debate within the financial community as to which measurement (with a myriad of adjustments) is the most accurate. For the purposes of our basic market timing, time and brain cells need not be wasted in agonizing as to which "M" (money supply measure) is chosen. One need only be concerned with sticking with the M originally chosen. We use M-1, which is basically the amount of cash in circulation.
As a criterion in our basic timing method, we compare the gross (not ratio) amount of M-1 to its level four weeks before.
BUY: The amount is increasing. More money is coming into the system, a portion of which can be lured into the stock market in the form of buying demand. In addition, the increased amount of available money helps the overall economy to expand.
SELL: The amount is decreasing. The withdrawal of money from the overall economy creates cash needs, on which investors draw against their stock holdings (because of the liquidity) before selling most other assets. This selling supply can function to depress prices. And the lessened money supply is often a good indication of a coming constriction in the broadly based economy.
Gold Price
The stock market, as with any other market, is constantly in competition with other investments. Gold, because of its history and physical nature relative to paper money, is a good indicator of relative popularity. Real estate, collectibles, and other "hard" commodities could probably be substituted for our gold criterion; but we have selected gold for its liquidity (with the metal being actively traded in markets throughout the world).
Again using a four-week comparison, we simply look at the net change in price for our indication. We use spot prices, but futures can be substituted as long as the same contract month is being compared.
BUY: Gold is up in price. This can be a good indication that stocks have become unpopular and undervalued. When the gold price declines and the metal disappoints investors, their buying demand can more easily shift to the stock market.
SELL: Gold is down in price. This can indicate stocks have become overvalued and can precede a reversal in investor sentiment, creating increased selling supply in the stock market.
Bonds
There is an inverse relationship between bond prices and interest rates. Higher bond prices mean lower interest rates, and lower bond prices equal higher interest rates.
There is also generally a very strong, direct correlation between stock and bond prices.