Simple, Simple, Simple... but Powerful

By: Michael Kilbach | Fri, Apr 20, 2007
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Investment Scoring & Timing Newsletter
April 19, 2006

The objective of this article is to illustrate a powerful investment analysis technique by first examining a simplified hypothetical scenario. We will then explore this concept on the markets of today. To do this we will:

  1. Outline some basic investing rules to be used as guidelines.
  2. Present a hypothetical scenario for analysis.
  3. Guided by our rules, form a conclusion for the purpose of understanding the markets.
  4. Explain how we think this analysis applies to the markets of today.

1) Rules to guide investment analysis:

  1. All markets are cyclical. No investment is constantly a good or a bad investment. Where a particular investment is in its cycle is what is critical.

  2. There is always a bull market somewhere. When one investment class is at an extreme high, we believe there is always an investment at an extreme low. The trick is to invest in the investment class which buys the most of that asset for the least amount of money.

  3. All major macro market trends will not end until an extreme is reached in the direction traveled. Once that extreme is met, like a pendulum swinging, the new trend will start and will not end until the extreme is met in the other direction. Bull markets start when public sentiment towards an investment is extremely pessimistic following a major bear market and end during extreme public optimism.

2) Hypothetical Scenario for Analysis:

For this hypothetical scenario we ask the reader to ignore previous investment understandings and simply concentrate on the word problem below:

For this scenario assume there are only four major investment classes: Stocks, Bonds, Real-estate and Commodities. It is the year 2000 and as a general rule:

  1. Stocks have been in a bull market for about twenty years, and public sentiment appears to be at an extreme high.
  2. Bonds have been in a bull market for about twenty years, and public sentiment appears to be at an extreme high.
  3. Real-estate has been in a bull for about ten years and public sentiment appears to be aggressively climbing.
  4. Commodities have been in a bear market for about twenty years and public sentiment appears to be at an extreme low.

QUESTION:
Based on the rules in section one of this article, of the four investment classes outlined in this scenario, what investment is most likely to be starting a brand new, long term bull market?

3) Hypothetical Scenario Conclusion

ANSWER:
The answer is obviously (d) commodities. If we consider the above rules we know that all markets are cyclical and Stocks and Bonds are likely at the end of their bull market after a twenty year climb while public sentiment is at an extreme high. We also know real-estate is heading into its more aggressive growth phase as public enthusiasm picks up steam. However, considering our rule that bull markets are cyclical, the real-estate market is likely maturing rather than starting at an extreme low. Finally, commodities have been in a major bear market for twenty years. This asset class is practically hated as an investment opportunity and as a result ready to start a new long term bull market.

You may be wondering, since we are in the year 2007 and not 2000, how does this hypothetical scenario apply to our understanding of the markets today?

4) Understanding the Markets Today

The answer to that question is simple. The same rules expressed above can be applied to the markets of today. Why? Human behavior as a group is very predictable. Individuals can be unique but given a certain set of circumstances people as a collective will behave in a predictable manner. If a group of people outside are rained on, most will seek cover from the rain. Some individuals may enjoy the rain but most will predictably seek shelter. When dealing with an emotional topic such as money and finances this predictability is especially true. For example, if an investment is rising in value our excitement and greed tends to make us want to buy more. As a group we bid prices up until they are too high, the extreme is then met and the trend quickly corrects. We believe this is the predictable behavior of markets.

So if we apply the rules above to the markets of today how can we profit from this knowledge when we invest? We know that since 2000 until now:

  1. Stocks had a major correction starting in 2000 and have since bounced. However, public sentiment has remained high. We believe brand new long term bull markets do not typically start in these conditions. Additionally, in our opinion it is highly unusual for a major twenty year bull market to end and then start with only a two year correction in between. This is not nearly enough time for public sentiment to diminish and set the ground for a new prolonged bull market.

  2. Bonds typically follow the same pattern as stocks and in our opinion bonds are in the same situation as stocks in this scenario.

  3. Real-estate by our calculation hit an extreme high in price, public optimism, excitement etc. The indicators of the publics extreme "can't lose mentality" towards real-estate are simply too many to list in this article. Recently we have witnessed a correction, however in our opinion this is not nearly enough of a correction to offset the imbalance of the massive bull market advance.

  4. Commodities have been in a bull market for about four to six years depending on how one determines the bottom. We believe overall public sentiment towards commodities remains negative but awareness of this market is very slowly making it to the consciousness of the general public. In our opinion this is extremely bullish for commodities. The market is rising yet it seems most investors are not aware of the potential mega bull market.

In our opinion the commodities bull market is just getting started. As the general public realizes the commodities bull has been roaring ahead, they will likely jump on board and push up prices to dizzying, unsustainable heights. We think commodities are a long way from being overvalued and the time to invest in commodities is before the public becomes aware of this mega trend. We believe fortunes will be made in this bull market as early comers grow their wealth and late comers try to catch the trend, but fortunes will be lost for those who overstay their welcome.

Having a set of rules, understanding market behavior and incorporating a trading system around these principles helps an investor ignore the day to day noise and misinformation of media hype. Having a system helps an investor reduce common investor weaknesses such as emotional trading decisions.

We encourage readers who enjoyed this common sense approach to the markets to visit our website at www.investmentscore.com. Here you will find free commentary, learn about our unique system for investing in the markets and have the opportunity to subscribe to our free newsletter. You may also learn how we plan to determine when we will sell our precious metals investments.

 


 

Michael Kilbach

Author: Michael Kilbach

Michael Kilbach

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