Stock Market Basics Introduction There are some concepts you must clearly understand in order to learn market timing principles. Many of you can probably just scan this section because it is rather basic. However, please don't skip it altogether because you will miss information that is built upon later in the tutorial. The Stock Market The stock market is where shares of stock are traded. A share of stock is an ownership share in a corporation. For example, assume XYZ Inc. has issued 100 shares of stock. If you own one share, you actually own a 1.0% stake in XYZ Inc. Shares of stock issued by large U.S. corporations are publicly traded at stock markets or stock exchanges. The prices of these shares are constantly changing as they are determined solely by supply and demand. Anyone with money can buy shares in these corporations by simply setting up an account with a stock broker and submitting a purchase order. The order is electronically transferred to the stock exchange, where the order is executed. Stock Market Indexes A stock market index is a number computed from the prices of a group of stocks. It is computed daily to gauge the movement in the market for that day. Here are some examples: Dow Jones Industrial Average (DJIA) The DJIA is computed by adding all the daily stock prices of a group of 30 major U.S. corporations and dividing that total by a number called the divisor; this is called a price-weighed method. This divisor will change whenever one of the 30 companies declares a stock split. A company will split its stock when the price becomes high, making it more affordable. By changing the divisor, the index value is unaffected by stock splits. The DJIA has two disadvantages as compared to other types of indexes: S&P 500 Index The S&P 500 doesn't have the disadvantages of the DJIA. It is made up of 500 stocks. The total market value of each company is computed and summed. A company's market value is simply the share price times the total shares outstanding. The sum of all 500 companies' market values is then divided by a divisor. The result is that each company influences the index based on its total market value rather than its share price. This type of index is a capitalization- NASDAQ 100 Like the S&P500, the NASDAQ 100 is capitalization- Stock Mutual Funds A stock mutual fund is a portfolio of stocks that has been purchased by a fund manager using money that has been invested by many individual investors. At the end of each trading day, the total value of the portfolio is determined and divided by the total number of outstanding shares, resulting in the current share price. All new investments the fund has received prior to that market close (4:00 p.m. EST) are exchanged for shares in the fund using the share price. The fund manager then invests the new investment capital. For example, assume that before the market close on Thursday, November 10, 1991, you invest $1000 in a mutual fund called XYZ Fund. At the close on this day the fund has the following portfolio: Amount Company Value Total Value 1000 shares ABC Inc $25/Share $ 25,000 1000 shares DEF Inc. $35/Share $ 35,000 1000 shares GHI Inc. $45/Share $ 45,000 1000 shares JKL Inc. $55/Share $ 55,000 $30,000 Cash - $ 30,000 Total - - $190,000 At this time the fund has sold 20,000 total shares. This results in a share value of $9.50 per share. Therefore, your $1000 investment will buy 105.263 shares of the fund and there will now be 20,105.263 total shares outstanding. Note that 105.263 new shares were created, but the value of each share is still $9.50 per share ($191,000 / 20,105.263 shares). The next day the fund manager will invest the new $1000 as he so chooses. When you decide to sell your shares, the price per share you will receive is the computed share price at the next market close. There are some big advantages to investing in mutual funds: If you choose mutual funds as your trading vehicle, the most important decision you must make is your timing of buy and sell decisions. Stock Market Movement Most stocks move with the market. For example, if the general market is in a downtrend (a bear market), even stocks that are fundamentally excellent values, will trend downward. In fact, aggressive growth mutual funds whose portfolios consist of professionally selected stocks get absolutely devastated in bear markets. Many investors, who are not able to sit by and watch their funds lose 40-50% of their value actually end up selling out at exactly the wrong time. Whether you invest in stocks or funds, it is absolutely necessary to know when to be very conservative about your stock market investments. Positions Your position is based on which way you are betting the market will go. We refer to these positions as long, short, and cash. Long Positions If you buy stock or mutual fund shares hoping they will increase in value, you have taken a long position. Short Positions If you believe the market will fall, you can profit by selling short. This is referred to as a short position. Selling short is selling borrowed shares of stock or shares of a mutual fund, hoping to some day buy them back at a lower price and return them to their owner. For example, assume you borrow 100 shares of XYZ Corp. and sell them for $5 per share. You will receive $500 proceeds from the sale. At some later date, XYZ Corp.'s stock has dropped to $3 per share and you decide to buy the shares and return them to the person you have borrowed them from. This is called short covering. To repurchase the shares you will have to pay $300. Since you received $500 on your short sale, and paid $300 to cover your short, you have gained a $200 profit on the trade. This is a very common transaction. A stockbroker who will charge you a commission handles all of the details. Cash Positions If you are not short selling when you believe the market is going to fall, you will simply sell your long position and place the proceeds in an interest bearing account. This is a cash position. Buying On Margin If you buy stocks or mutual fund shares from a broker, you can leverage your purchases. That is, you can borrow money from your broker and buy more shares using your cash and the cash you have borrowed. The amount of cash you must provide is governed by the margin requirement that the U.S. Federal Reserve sets. For example, currently the margin requirement is set at 50%. Therefore, whenever you buy stock or funds you can borrow an additional 100% from your broker bringing your maximum invested position to 200% instead of 100%. When you purchase shares on margin, you must pay your broker interest on the borrowed capital. Mutual Funds can be purchased on margin at most discount brokers such as Jack White & Company. Beta Beta is a measure of volatility of a trading vehicle such as a mutual fund. The general market as measured by the S&P 500 is considered to have a beta of 1.0. Stocks or funds that gain more than the general market in bull markets and lose more in bear markets have betas of greater than 1.0. Conservative funds and stocks may also have betas that are less that 1.0. For example, assume you invest your money in an aggressive growth fund that has a beta of 1.5. If the S&P 500 gains 10%, this fund should gain 15% (1.5 X 10%). If the S&P 500 loses 10%, this fund should lose 15%. Stock and Mutual Fund Picking Rarely Works. In 1997, most investors believe that the market will always go up with only very minor corrections of less than 10%. This would eliminate the need for timing the market and would make an investors only job deciding which fund or stock will go up the most. Pick up a copy of any high circulation investment magazine. Month after month they have headlines that read, "10 Stocks that will go up..." or "The 5 Best Funds..." The entire investment industry is built on analysis that attempts to reveal the next Microsoft. There are some big problems with this approach: Time Magazine summed up the dilemma well in their January 15, 1996 issue: "86% of the most popular mutual funds did worse than the Standard and Poor's 500 index in 1995. This is more proof that the national pastime of picking the winning mutual fund is a wasted effort. Most people would be better off buying the so-called index fund that give them a guaranteed average return." The only problem with this advice is that an "average return" can be very negative. Bear markets can easily cause SP500 index funds to drop 30-40% in value. Investors cannot emotionally handle riding out losses like these. Spend Most of Your Time Deciding WHEN to Buy Instead of What to Buy. Do you really think that the wealthiest and smartest investors in the world are actually buy-and-hold investors? Individuals who have built multi-million dollar fortunes are not big on losing money. Sure, they may ride out losses on venture capital type investments just as a business owner wouldn't sell his business because of temporary losses. But, the majority of their portfolios are protected from bear markets with hedging strategies which is simply market timing. Your goal should be to incrementally move from a 100% cash position to a margined 200% invested position based on the probability that the market will rise. Until you have a developed a sound strategy for doing this, don't spend time deciding what to invest in. Simply invest in an index fund. Bear Markets and Buy-and-Hold Strategy Bear Market History A Bear Market is usually defined as a market that loses 15% as measured by a stock market index such as the Standard and Poor's 500 Index (SP500) which consists of the stock prices of 500 U.S. corporations. Bear Start (1) Bear End (2) Bear Length (Years) (3) Prior Bull Length (Years) (4) SP500 Loss (5) Sep 1929 Jun 1932 2.8 - -86.2% Jul 1933 Mar 1935 1.7 1.1 -33.9% Mar 1937 Mar 1938 1.0 2.0 -54.5% Nov 1938 Apr 1942 3.4 0.6 -45.8% May 1946 Jun 1949 3.1 4.1 -29.6% Jul 1957 Oct 1957 0.3 8.1 -20.6% Dec 1961 Jun 1962 0.5 4.2 -28.0% Feb 1966 Oct 1966 0.7 3.7 -22.2% Oct 1968 May 1970 1.6 2.0 -34.0% Jan 1973 Oct 1974 1.8 2.7 -48.2% Sep 1976 Mar 1978 1.5 1.9 -19.4% Nov 1980 Aug 1982 1.8 2.6 -27.1% Aug 1987 Dec 1987 0.3 5.0 -40.4% Jul 1990 Oct 1990 0.3 2.6 -21.1% Averages - 1.5 3.1 -36.5% The table above details all of the Bear Markets over the last 68 years. As you can see from the table: Our current bull market is 6.9 years old (as of 9/1/97). The second longest in the last 68 years. Obviously, we are far overdue for a major bear market. Growth Mutual Funds Will Stay Fully Invested Throughout a Bear Market. Here's Why: Bear Markets Take All Mutual Funds Down Severely. The Buy and Hold Timing Method The Buy-and-Hold strategy is a dream come true for the investment business. Mutual fund companies love it because you give them your money and never take it away or move it. This keeps their costs low and their profits high. Buy and hold is actually timing. You have to buy at some point and you do have to sell at some point. Without realizing it, buy and holders will use some sort of random timing method to time these purchases and sales. Buy and Hold Investors have been VERY lucky so far. Why buy and hold doesn't work over the long run. The Main Problem with Buy-and-Hold is Drawdown. There is a very big problem with the Buy and Hold Strategy that just isn't discussed much anymore, Drawdowns. A drawdown is an "unrealized loss". For example, assume that at some point your total account value is $50,000. Then the market falls a bit and your account value drops to $45,000. You have just suffered a 10% drawdown. (Drawdown = Loss divided by starting account value.) Now assume that the stock market skyrockets for a few years and your account grows to $200,000. Then, we get an average bear market of 35%. Your account will lose $70,000. You won't know where the losses will end. Everyone will be so negative on the future of stocks that the temptation to sell everything will be irresistible. Unfortunately, most investors will sell out very near the bottom and miss most of the ride back up. This is the problem with Buy and Hold. It's easy to stick with when the market is rising but impossible when the market is falling. If you think you're different and can ride out a bear market you'd better think again about how emotionally painful it will really be. General Market Timing Principles Stock Market Timing What is Market Timing? Market timing is simply the act of selling a portion of your stock market positions to a risk-free interest bearing account when odds favor a significant stock market decline. There are very few advisors that do not use some degree of market timing. Timing has some huge advantages. Random Timing Methods Do Not Work. Most investors use random timing methods. To make their timing decisions they use This is the type of timing that never works over the long term and gives market timing a bad name. It's driven by emotion and greed and always results in buying high and selling low. The analysts on TV and Magazines may very well know what they are talking about. But, analysts can change their opinions quickly. For example, you see a well respected expert on CNBC say that he see the market going much higher for the rest of the year. So, you feel confident about your existing positions and may even add to them. However, after a couple of weeks this advisor could easily reverse his opinion. You'd probably never even know. Your emotions will force you to follow another bullish advisor's opinion, as you desperately want the market to go higher. Following this type of random advice is a very bad strategy. Unproven Timing Methods Rarely Work. Using unproven methods for market timing is a close relative to random timing methods. Mechanical Timing Methods Mechanical timing means that you develop a strategy for timing purchases and sales of investments that does not require any type of expert analysis. A mechanical timing system simply generates buy and sell signals that you follow without question. Mechanical timing methods can be backtested against historical data to ensure that they are historically profitable. If a timing theory can't be represented in some mathematical form that can be back-tested by a computer, there's really no way to know if it is REALLY historically profitable. For example, you could use a stack of historical charts to test manually drawn trendlines, but no matter how hard you try to avoid it; the results will be skewed based on what you know about the future. Expert Timing Methods An expert makes decisions based on everything that he knows. As you can probably imagine becoming an expert is very difficult. An expert can do very well timing the market versus a mechanical method because: Most experts utilize mechanical timing methods to help them make decisions. They will then sometimes override the mechanical methods based on knowledge that can't be represented with computer modeling. "Same Day" Versus "Next Day" Trading This is a very important concept. Mechanical timing methods operate on stock market closing data. This data is only available AFTER the market closes. You can't act on buy or sell signal based on this data until the next trading day. With mutual funds, you always get the price at end of the NEXT market close. Most stock market timing advocates tabulate their historical results assuming that they can get the closing price on the SAME DAY as the buy or sell signal occurs. We call this SAME DAY trading. Tabulating results based on SAME DAY trading is misleading. SAME DAY trading can be approximated by using PRE-CLOSE stock market statistics. For example, at Rydex Mutual Funds you have until 2:45 PM CST to enter your trade to get the price at the end of that day. It is possible to use 2:30 PM CST stock market data and then enter your trade before the 2:45 PM deadline. NEXT DAY trading means that you use the actual closing stock market statistics to generate your buy and sell signals. Then, you just casually enter your trade sometime before the market closes the next day. Here's some advice gained from years of testing and experience: Market Timing Pitfalls You need to be careful when deciding on a market timing strategy, as there are many pitfalls. Here are some that you should be sure to understand. Many investors are now using strategies that are only tested back to 1988. This period in history is a very easy one for which to develop a strategy. It has been a period of unprecedented upward movement with very low downside volatility. An extremely rare period in stock market history. Basically, any trend following strategy that stayed invested 80% of the time worked very well. However, many of these strategies will fall apart dramatically when the market enters a more normal period of cyclical bull/bear markets with more downside volatility. Out Of Sample Testing During proper construction of a timing system, not all of the historical data is used during the construction process. Some of the historical data is reserved for testing the system in a pseudo-real- For example, assuming you have 55 years of historical data, you may reserve the oldest and newest 10 years of data for an out-of-sample test of the completed system. The only problem with this method is that you may have personal knowledge of the latest 10 years and you may use it in the construction process without realizing it. You can avoid this possibility by using the latest 15 years of data to construct the system and then use the earlier 40 years to run an out-of-sample test. This allows you to construct your system based on recent market action and use the earlier data to make sure the system doesn't bankrupt itself in a long out-of-sample test during different market conditions. In any case, the longer the out-of-sample test, the better. Be wary of any system that is not tested against out-of-sample data. Market Timing Systems vs. Futures Trading Systems Market Timing Systems vs. Futures Trading Systems There's a very big difference that many investors do not understand. Market Timing Systems Market Timing Systems (MTS) generate buy and sell signals that are profitable with little or no leverage. They are usually designed to trade and out-perform the S&P 500. In order to for a MTS out-perform the S&P 500 it must do two things. The MTS doesn't need to be perfect in order to outperform the S&P 500. In fact, a perfect MTS has never, nor will ever, exist.If an MTS can do these two things it will be very successful when traded against stock mutual funds. Any MTS that is profitable against the S&P 500 will be more profitable against aggressive growth mutual funds such as Rydex NOVA or Rydex OTC. If a MTS fails to ride a big stock market rally, your account will simply gain interest from the cash account. If a MTS fails to be out of the market during a market crash, your account will lose value but you won't be completely wiped out. A MTS can also be very well represented with historical testing. For example, mutual fund trading can be perfectly modeled due to the fact that the price you receive when buying or selling a fund is that of the next close. In fact, you can very accurately model S&P 500 Index funds for many decades historically. Futures Trading Systems Futures Trading Systems (FTS) are very different. For this discussion I'll talk about S&P 500 futures. A FTS attempts to capture small price moves with highly leveraged. investments. Losses must be kept small and closed out quickly. While there certainly are Futures Trading Systems that have been profitable in historical testing and in real-time usage, there are some major problems when it comes to the historical results of many of these systems. The Historical Testing Periods of Futures Trading Systems is Usually Very Limited. In fact, most that I've seen only go back a few years. This is not nearly enough testing to ensure that the model will not WIPE YOU OUT when this roaring bull market ends. The 1990's have been an easy period for which to design a strategy that makes a hypothetical fortune in S&P 500 futures. (There's only been one minor bear market and the rest of the time it's been straight up.) However, take that same system and run it against a more normal market period and it will completely fall apart. If you get caught in a market crash holding S&P 500 futures positions you will be devastated very quickly. Most of the Futures Trading Systems now being sold will eventually fail miserably and their users accounts will likely be wiped out. Remember, with futures one bad trade can erase your entire account. Believe it. It happens all the time. I remember a few years ago, reading about a well-known CTA's S&P 500 futures fund that was traded with a system. It posted a 97% loss in one month. Obviously, they switched to a new system. The Historical Testing of Futures Trading Systems is not an Accurate Model. Most of the historical results I've seen make major assumptions that are simply not acceptable. When you see, "$100 per trade for slippage and commission", get very worried. There is simply no way to know exactly what price you would have actually received during a real trade. Futures prices change constantly. You can't test against actual tick-by-tick futures prices because the data series would be massive. Even then, the data has to be adjusted because of contract expirations. There are also other considerations such as lack of liquidity, and bad order fills that cannot be represented in historical models. When you see impressive historical results for Futures Trading Systems remember that they are just an estimation. In real-live trading during the historical period the system may or may not have actually been profitable. Futures Trading Systems are Really not Very Accurate at Timing the Market. Here's a simplistic way to look at it. Assume that a Futures Trading System gains 50% in a year. If the leverage is 10 to 1, (i.e. $10k controls a $100k contract), the trading system actually only captured a market move of around 5% Now assume a Market Timing System (MTS) gains 20% in the same year without leverage. Which system actually timed the market better? If the Market Timing System had been trading with 10 to 1 leverage, it would have gained 200%! I'm certainly not advocating using Market Timing Systems to trade futures. They do not contain tight mechanisms to cut losses short. In other words, a mild 10% correction in the S&P 500 (which is totally acceptable to a Market Timing System) turns into a 100% loss with 10 to 1 leverage. Finally, Never forget that most futures traders lose money. Depending on whom you ask only 5% to 30% end up with profits in a given year. ere's a step by step method for developing a strategy. How often do you want to analyze the market? There are basically three viable options. Determine how many systems to use to make your decisions. For example, if you have $100,000 to invest you may want to use 10 timing systems to give you proper strategy diversification. Determine how to allocate your capital to each system. The simpliest case is linear allocation which would simply assign 1/10th of your capital to each system. Your possible overall positions would be 0%, 10%, 20%, 30%, 40%, 50%, 60%, 70%, 80%, 90%, 100% invested depending on how many of your timing systems were on buy signals. With ULTRA's Historical Analysis (Composite) feature, you can model any combination of systems with no limits on complexity.. Determine which systems to use. Now it's time to pick your systems. There are a few criteria to consider: Choose your investment vehicle. As I've said before I consider this choice secondary to your timing strategy. It's very easy to find funds that outperform the market when the market is rising. Here's some ideas: As you can see, implementing a multiple timing system composite strategy can be a bit involved. However, you can rest assured that a simple strategy of 10 weekly stock market systems with linear allocation, invested in Rydex NOVA is far more sophisticated than 99% of investors and most professional money managers. Regards,
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