The Best Investment Strategies For A Sideways Market

Events in Europe have been unfolding ever so slowly. It’s testing even the most patient investor. But according to finance celebrity George Soros, you won’t have to wait much longer. ‘Unless that is resolved in the next three days, then I’m afraid the summit could turn out to be a fiasco. And that could be fatal.’ That’s right, three days to Eurocalypse.

If you think we’re exaggerating, consider that Merkel won’t accept Eurobonds ‘as long as I live’ and Italy’s technocratic PM declared that ‘If the Chancellor [Merkel] does not give up I will tell you that I resign because if things do not change [we] are not able to bring Italy out of the abyss.’

Yes, either Merkel dies or Italy is abyss-bound.

So who’s going to save us? Is it European politician Nigel Farage, who was right to pooh-pooh the euro all along? Or perhaps Angela Merkel will change her mind and agree to share Germany’s credibility with the countries that lack it by issuing Eurobonds. It might be Federal Reserve Chairman Ben Bernanke, the world’s money printer, who comes to the rescue of European banks again. Or his colleagues at the European Central bank with their own liquidity spray.

None of these supposed saviours can do anything about the pain the Eurozone will experience. They can just vary when and how it happens. Inflation or deflation? Now or in the future?

By the time you read this, the 3 days Soros warned about will have passed. From memory, Bloomberg tallied the amount of similar summits at 19 so far. We doubt anything monumental will have come about. Not that people won’t claim something monumental has happened.

So now what for Australian investors? Buying your average stock amid a global sovereign debt crisis is rather risky. But doing nothing is just frustrating.

Today’s Markets and Money is all about the restless feeling you get in times like these, and the mistakes that feeling causes you to make. It should have been written back in 2011. Plenty of investors boarded the stock market train on its way to a brick wall back then. They got restless. And felt like they’d missed out on the rally from 2009. Those are two of the worst possible reasons to buy into the stock market. And yet, they are two of the most common reasons people do buy.

Now we’re about 20% below the 2011 high in the Australian stock market. Impatience turned out to be expensive. So far anyway. Not that patience doesn’t take a toll too. Especially when it involves periods of turmoil as long as this. The last comparable ‘go nowhere’ market for the Americans started in 1965, and lasted for more than 15 years.

S&P500 1950-2012

S&P500 1950-2012
Click here to enlarge

Source: Yahoo Finance

Australian stocks have gone nowhere for seven years, which pales in comparison. From 1987 to 1997 the All Ordinaries index also went nowhere.

In other words, periods of long-term sideways moving markets are common. You can expect a few in your lifetime. But there are plenty of strategies to make money in times like these. And there are a few strategies that make waiting bearable. We’ll take you through a few below. As well as highlighting a rather timely one.

Before we go on, let’s be clear. This article is assuming that things don’t get seriously worse in coming years. Or days… And by serious we mean very serious. Quite frankly, there is a good chance they will. Every tell-tale sign is in place for a collapse so bad that your investments in the stock market will not be high on your list of priorities. But things change and investment strategies cannot presume you know the future. So here are some ways to prevent you from doing something stupid out of impatience and boredom while the ASX continues to grind sideways.

   1. Only make buying and selling decisions based on carefully pre-considered conditions.

It’s important that you don’t buy shares based on a feeling of missing out on rallies, or on a ‘got to do something’ mentality. Think of a sport or board game you’re good at. There are plenty of times when doing nothing significant is the right strategy. You can often tell the best players from their ability to be patient. In squash, it’s the player who’s most active that’s being led about by the less active one.

If you pre-determine what conditions must be met for you to commit your money, or pull it out, that rule will help you stay out of trouble. For example, buying companies below their so-called ‘book value’ worked for many famous investors, even in tough times. Also, reducing how much you invest in each company can keep your funds out of trouble.

   2. Find ways to make regular income rather than steady capital gains.

There are plenty of stock market strategies that you can investigate and master while markets are flopping around:

  • Options writing
  • Dividends
  • Small-cap punts
  • ETFs
  • Short selling/CFDs
  • Trading

Adding some of these to your armoury is a good idea anyway. Doing it while a simple buy and hold strategy won’t pay off is ideal. But beware of the risks involved in each one.

   3. Don’t let low and falling interest rates fool you.

Poor returns on your savings might be disappointing, but they aren’t a reason to go and lose money elsewhere. Rather than watching the nominal interest rate, look out for the real rate. The real rate is the nominal rate less inflation. If interest rates are 5%, but inflation is 3%, that’s no different in terms of real returns to a 2% interest rate when there is no inflation.

   4. Pay down debt

If you can’t use your cash effectively, pay down your debt. A dollar of paid interest saved is a dollar earned. It might seem illogical to pay down debt just when rates are low. But keep in mind that low rates can rise dramatically. Your mortgage payments can easily and quickly double from a low base – say 4% to 8%. That could be quite a shock waiting for you in the future.

   5. Spend

A financial crisis is a great excuse for a mid-life crisis. Especially if you’ve been financially responsible while the rest of the world went on an epic debt boom and bust. Things will be cheap. Why not enjoy them?

   6. Stop paying so much attention.

According to the website Zerohedge, Goldman Sachs provided this useful bit of analysis recently:

‘Stocks off just shy of 1%, which erases most of yesterday’s gains, which erased most of Monday’s losses. After tomorrow, will you be able to say that Thursday’s gains erased most of Wednesday’s losses, which erased most of Tuesday’s gains, which had erased most of Monday’s losses? With apathy running high and conviction low, that sounds just as reasonable as anything else.’

In other words, why listen to the market’s antics more than once a week or month? If there is a good reason for you to do so, fair enough. The same goes for those who find it entertaining to watch the confusion. But most people should be enjoying themselves in a different way. Sticking to developments that are not minute to minute, hour to hour or day to day will stop you feeling out of control. And, best of all, the world’s developments will begin to make a lot more sense if you watch their progress occasionally rather than constantly.

   7. Don’t throw the kitchen sink.

In response to the crisis, policy makers have been growing increasingly desperate. Don’t copy their lunacy:

‘Sir Mervyn King, the Bank of England Governor, said that the “industrialised world have thrown everything bar the kitchen sink” at the global economic meltdown but that even “bolder action” was now required.’

Mervyn King’s claims that even the kitchen sink must be thrown aren’t very wise. Making important decisions during market turmoil is a bad idea for you, too. It can be quite tempting to go all in, in the hope of recovering your losses or making a massive gain. Or it can be tempting to put on a larger and larger position to profit from smaller and smaller moves during a sideways market. Don’t give in to the temptation. It could backfire enormously. If you must make changes while markets are going haywire, make them on a predetermined rules basis. A good example is to set your position sizes and use stop losses – predetermined points at which you exit a losing position.

   8. Realign your stocks and asset allocation.

Some investments are less volatile than others, and there are ways to make some investments balance out the performance of each other. So if you don’t want to escape the market completely, there are ways to minimise the volatility of your portfolio. For example, you could pick less volatile stocks, corporate bonds, and commodities. Or invest according to the ‘Permanent Portfolio’ – an equal weighting to stocks, bonds, gold and cash. The idea being that each of the four offset each other’s volatility.

   9. International diversification

Why not retire overseas for a few years? Your cost of living could tumble if you choose wisely. That might mean saving money or living like a king. If the red dirt of home lies too close to your heart, why not move a large part of your investments to somewhere that isn’t at risk of a financial crisis? That’s what Dan Denning’s book The Bull Hunter is about. And it’s the reason Dan came to Australia in the first place. He saw the makings of a commodity boom back then. We’ll let you know if he disappears off to Myanmar or Mongolia next, so you and your investments can follow him there.

   10. Invest backwards

Rather than thinking about maximising your gains in wealth, think about what would be enough wealth and come up with a plan to achieve that ‘enough’. Going about retirement in this way allows you to reduce your risk dramatically, because you’ll shift away from speculative and unpredictable assets. Instead, fixed income and other types of more predictable assets will dominate your strategy. But you need to be very aware of risks like inflation.

Following this strategy for a while, even if you abandon it at a later date, could keep you out of trouble. If the trouble lasts, you’re more likely to be one of the few who comes out just fine.

Now on to the timely strategy we promised you…

Strategy of the Day

Slipstream Trader Murray Dawes sent over this rather fascinating chart:

Copper and the S&P500

Copper and the S&P500
Click here to enlarge

Source: Slipstream Trader

It shows the copper price(black) and the American stock index S&P500(blue) over the past eight years. Before 2008 (near the middle of the chart), the two were very loosely correlated. The idea being that the copper price and the S&P would both go up in good times and down in bad, but not precisely copying each other. Then 2008 and the GFC hit (about halfway through the chart). All of a sudden, the index and copper are tied together by a rubber band. They began mimicking each other perfectly. Whenever they diverged, the rubber band pulled them back together. But towards the end of 2011, the two prices began to diverge again. If the rubber band is still in place, the S&P is set to plunge, or the copper price is set to jump. We’ll explain why the correlation has happened another day. Here’s how to profit from the divergence:

Sophisticated hedge fund traders will play this divergence by short selling the S&P500 and going long the copper price. The idea being that the two will meet somewhere in the middle, creating a profit on both positions. That’s possible using some trading platforms, although it’s difficult to get the proportions right. Still, this strategy is one you can use to profit while stocks go nowhere over the medium term.

Murray has taken a view that one of the two – the S&P 500 or the copper price – is right and the other is wrong. One of them is about to move big time – 20% according to Murray’s email. We can’t give away which, but you’ll probably figure it out if you read Murray’s latest and most concerning prediction yet. He’s calling it Big Wednesday, and he’s positioned his subscribers at Slipstream Trader to profit. The last time Murray stuck his neck out, one subscriber ended up sending him a rather expensive wine bottle paid for by rather expansive profits.

Back to our ten strategies and why you need them in the first place.

It’s always difficult to accept a new normal, like that of a sideways, trendless stock market. People usually feel miserable or do risky things to make themselves feel miserable. Like taking increasingly larger punts. If you can be one of the first to recognise a new normal, and change your investment strategies to suit, you can profit handsomely. But that means letting go of the old normal. In this case, the old normal was a steadily rising stock market. The new normal is a sideways market.

Until next week,

Nickolai Hubble.
Markets and Money Weekend Edition

About the author: having recently escaped from academia, Nick decided to drop his tights (the required attire of a trapeze artist) and joined Port Phillip Publishing. Instead of telling everyone about the Markets and Money, he now spends his time writing for the weekend edition.

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Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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