What Stock Market Perfection Looks Like

Most investing media perpetuate the image of stock market participation as a fast-paced, frenetic activity requiring breaking news feeds and input from experts. Emphasizing this trader’s mentality makes sense for their business models, which require attracting viewers, listeners, and readers with tabloid bids for their attention. Falling prey to such productions is detrimental to investors, who eventually learn that expert opinions are wrong half the time — a high enough mistake rate to severely hamper performance. Following stock tips from media experts produces more activity and higher costs, but lower performance.

You might think I’m using the phrase “wrong half the time” to indicate a vaguely high level of inaccuracy. No, I mean right around 50 pct, a failure rate confirmed by numerous studies. My favorite among recent efforts is CXO Advisory’s review of 6,582 forecasts by 68 experts in the 2005-2012 time frame, which found a terminal accuracy of 46.9 pct. We’ll give the experts the benefit of the doubt, though, and call it 50 pct. Keep in mind whenever hearing some guru’s idea-of-the-day that he or she is just tossing a coin.

Part of luring investors to a trader’s view of the market involves the constant reminder that nobody is perfectly positioned for what’s going on right now. The media frequently use hindsight to select experts who got recent coin tosses correct, invite them to present their victorious coin tosses as triumphs of skill, then ask their opinions about what to do next. These new ideas offer the same 50 pct odds of being wrong, but preceding them with a review of the by-chance correct previous coin toss lulls the audience into believing they’re paying attention to a skilled participant who got the last call right and will probably get the next one right, too.

What makes for the most compelling media of all? Exacerbating the primary emotions of the market, which are greed and fear. Rising prices produce greed for more profit; falling prices produce fear of more losses. Like sharks on blood, the media smell these emotions and release experts they know will play into the prevailing mood. When prices are dropping, they emphasize how much farther they’re likely to drop. When they’re rising, they focus on how much higher they’re likely go rise. Fear elicits the media message, “Be more afraid!” Greed elicits, “Be greedier!” This happens like clockwork despite the majority of experts being proven losers to the market over time.

In my upcoming book, The 3% Signal, I call these coin tossers “z-vals” in reference to their zero validity. I first encountered the fabulous term zero-validity environment in description of the stock market when reading Thinking, Fast and Slow by Nobel Prize-winning behavioral psychologist Daniel Kahneman, and shorthanded it to z-val. It sums up everything wrong with the most prevalent (but wrong) approach to investing, which is attempting to divine the future direction of prices.

Because movements happen independently of past price movement, there is no way to know where they’ll go next. Financial market forecasting is fantasy, categorically invalidated by academic and industry research, but made to look authoritative with jargon, charts, impressive firm names, and other accoutrements to tempt another unsuspecting investor onto the trapdoor of trading.

It’s easy for a media outlet to display a chart of a stock or index price history with low and high points circled officiously. The implication is that moving entirely in at the lows and out at the highs is what stock market perfection looks like, and what the “smart money” (whoever that is) is doing all the time. In fantasyland, yes, but not in the real world. Because nobody can know in advance where those highs and lows will appear, forecasts are merely poor guesses dressed in rich clothing, and wrong half the time. Looking back at past highs and lows, which are known in hindsight, to urge guessing future ones, which are unknowable, is disingenuous.

Do you want to know what perfection really looks like in the stock market? A system based on reactive rebalancing, not predictive rebalancing.

Every buy and sell order is just an act of rebalancing, or reallocating, capital. Buying a stock or an ETF is just reallocating capital from cash into it. Selling a stock or ETF is just reallocating capital back into cash. In the common, media-encouraged approach to the market, such reallocation happens in advance of predicted movements. A guru will say he or she thinks the market is going up, or the market is going down, and recommend that you allocate accordingly. A way to get around the guesswork is to ignore future price forecasts and focus instead on prices that already happened.

The 3 pct signal system (3Sig) does precisely this on a quarterly schedule, using only a stock index fund and a bond index fund, and it runs circles around the z-vals. It drives them nuts to see a simple quarterly rebalancing plan built on mathematics and cheap index funds put their huffing and puffing to shame, but it does so time and again. The most recent example concluded just last week, and I’ll share it with you here as a picture of what real stock market perfection looks like. Alongside it, we’ll venture a peek at the awful world of z-val coin tossing.

The S&P 500 topped out at 2019 intraday on Sept 19, bottomed at 1821 on Oct 15, and closed last Friday at 2018. It drew a picture-perfect v-shaped pattern on its chart, the least expected development among commentators.

Let’s pull one blathering bunny from a hat filled with z-val rabbits. Dennis Gartman told the WSJ’s MoneyBeat in May that he’d been wrong calling for a correction back then because “the world’s markets have not corrected,” then concluded, “It’s so silly for me to think I can call a correction. The market will correct when it corrects. That’s what I’ve learned in my 40 years in the business.” One would be forgiven for asking how it could take a supposed expert 40 years of being wrong half the time to wake up to the fact, then expecting the awakened pundit to finally stop contributing to the volume of distracting noise. No such luck.

Gartman opened his mouth again on Oct 16, almost exactly the bottom of the recent v-shaped swoon, saying the selloff in stock markets around the world was set to continue as a new bear market took hold “for a long period of time,” and warned investors not to buy stocks. He waved his bear-market flag once more on Oct 21, then furled it the very next day, Oct 22, after the S&P 500 gained 1.9 pct in the prior session during which he’d been cautious. He changed his mind, said he “should have embraced last week’s weakness enthusiastically,” and then chirped “this does still remain a global bull market …”

Once your head stops spinning, peruse the play-by-play: Gartman was wrong about markets earlier in the year, admitted so in May, said he was silly to think he could forecast, but continued forecasting. In September, he failed to warn people out of the market before it began its four-week drop, but showed up at the bottom in October to tell them then they should avoid stocks, thereby causing them to miss the recovery from the bottom, at which point he changed his tune to saying it was a bull market after all and he should have just kept quiet.

Worthy rivals, these z-vals are not. A well-designed system easily trounces them. It’s much harder to beat relentless dollar-cost averaging into an index fund. The 3 pct signal system beats DCA and the z-vals. Following it will improve your performance while reducing market stress in your life.

Here’s how the signal navigated the recent downturn that flummoxed Gartman and many others I could list. At the end of the third quarter, about halfway through the four-week sell-off, it advised buying weakness. After doing so, it produced this fourth quarter’s growth target level, what I call the signal line. It’s a balance that the signal compares to the plan’s stock-fund balance at the end of the quarter to determine whether to buy or sell. Mid-quarter, it provides interim guidance for newcomers by making it obvious when there’s a green-light shortfall for entry. In this case, it was clear for the first few weeks of October that a buying window remained open. All people had to do was compare the stock fund balance to the signal line to see the shortfall.

This is why the signal’s advice to newcomers was to buy the weakness. On Oct 12, the signal indicated a 7.7 pct shortfall, so its advice was to begin the plan at the target allocations. This meant putting 80 pct of capital into the small-cap stock index fund it uses. A week later, the signal indicated only a 2.4 pct shortfall, but still a good time to begin the plan. It was easy to see that the buying window was closing, however. From the Sunday, Oct 19 Kelly Letter: “[With the plan] still about a calendar quarter’s worth of growth below target, the case to get started now is reasonable. Once it pokes into surplus territory, however, I’ll revert to the standard advice for newcomers, which is to wait for a buy signal to begin the plan.”

That happened just last Sunday. The temporary shortfall became a 2.6 pct surplus. People who followed the signal to buy weakness were already ahead. As for the buying window: “Alas, it is now closed, and advice for newcomers in the tiers is to await the next buy signal.”

This clear guidance through the six-week drop-and-pop happened without a single forecast. The signal was not predicting what would happen next. All it did was compare prices already on the books with the quarter’s signal line, determined with basic arithmetic. This automated buying of weakness and selling of strength on a quarterly pace nudges an investor’s performance higher than the market’s without the need to pay attention for even a moment to the coin tossers. As Gartman and other z-vals sputtered and slumped, the signal put money to work. In other quarters, it skims excess profit into a safe bond fund for use later when the z-vals are warning of disaster ahead.

The effectiveness of this approach is remarkable, and I encourage you to use it in your portfolio. It works best in a tax-advantaged account, such as your IRA or 401(k), but can also work in a regular account with less tax impact than you might think. Why? Because the plan sells only profits beyond its quarterly growth target, which puts a limit on the frequency and size of sales. Many quarters, such as this year’s third, produce buy signals, which create minimal tax consequence when selling shares of the bond fund to buy the stock fund. Still, there’s no getting around the fact that your retirement account is the ideal home for the signal system.

The 3% Signal will be released on Feb 24. It fully explains this approach, along with enhancements to the basic idea outlined above. Prior to the book’s release, subscribers to The Kelly Letter can see the plan in action every Sunday morning, with commentary on current markets and a wry look at recent z-val follies.

To recap, stock market perfection looks nothing like what media purport it to be. It’s not a forlorn quest to buy exact bottoms and sell exact tops through forecasting. Rather, it’s the habit of defining clearly what constitutes weakness and strength, then buying the former and selling the latter using the clarity of mathematics alone. People adopting this approach do not need — or want — forecasts of any kind.

After a while, adherents of 3Sig look upon stock market punditry with a kind of detached pity. They understand the people engaging in it are just poor z-vals doomed to a 50 pct mistake rate that relegates them to trailing the market, greatly underperforming the signal, and one day realizing they’ve wasted their life’s energy on a pursuit that was purposeless from the start.

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One Comment

  1. Wes
    Posted November 19, 2014 at 2:12 am | Permalink

    Well done describing the signal system. I started following you back in 2006/7 when CXO flagged you as a better than the average z-val 😉 . As a result, I’ve been looking forward to your guidance on a simple asset-class or general ETF approach rather than stock picking. Pre-ordered your book. The big guys can’t turn a $billion on a dime. We smaller investors can get in and, if necessary, out quickly just fine. Their advice doesn’t help us in what you describe as _what’s happening right now._

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