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How the Market Works

Investing at the Top of the Market: How the Market Works

Posted by kdadmin on October 18th, 2016.

Investing at the Top of the Market: How the Market Works

Investing at the top of top of the market is much like that old children’s story, The Tortoise and the Hare. In that story, the Hare had a chaotic race of ups and downs and all arounds, while the Tortoise just plodded along with consistency.

Look at the chart above. I bet you can guess that is the Tortoise is the bond market, and the Hare is the stock market. But, more importantly, how does this help you going forward?

Investing at the Top of the Market

The chart above is what a stock market top looks like. Because there is no longer a clear force driving the market up (lower price to earnings ratio OR quantitative easing), the market just flounders randomly reacting to whatever bit of tripe floods across the airwaves.

This chart begins with the top of the market in 2015 (May 23rd) and runs through Friday(10/14/16). That’s nearly 17 months to go nowhere. Of course, we’ve had a couple of exciting market meltdowns during that period in the stock market, but finished at a 1% capital gain. Though the stock market’s dividends paid rough 2-3%,we’ve made roughly 4% per year in bonds with far less risk or fanfare.

Now consider how much time and effort the media put into covering every single little blip of the market eventually going nowhere. This is why it pays to simply get the facts and follow the leading market indicators, while skipping the hyperbole and 20/20 hindsight of mainstream financial media.

Just the Facts, Ma’am

Just before May, 23, 2015, the USA’s revised GDP (Gross Domestic Product) numbers came out. They showed a distinct drop at the end of 2014 and in the first quarter of 2015 (see below). This broke a long term escalating trend. In the financial field, we’re more concerned about the growth rate of the GDP than the raw GDP itself.

Since GDP is a the value of all final goods and services in the market, broadly speaking, it’s not possible to have a rapidly escalating stock market when the growth rate of GDP is dropping. In other words, if the value of what companies are producing isn’t going up, then those companies are not likely producing an increasing amount of goods and services, thus their profit is not going up, nor, ultimately, is their stock price. This is how the market works.

The Value of Leading Indicators

GDP is a leading market indicator. It’s one of about six. Leading market indicators provide just that, an indication of what is going on, broadly, in the market. While the movement of one indicator isn’t enough to hang your hat on in any given market cycle; if several, or even all six, are sending the same signals, it is NOT something to ignore.Take our current market cycle. GDP isn’t the only one of the six leading indicators that’s foretelling a market contraction. Of the other five, including, consumer demand, manufacturing demand, inflation, interest rates, and unemployment, several are pointing in that direction as well. We’ll cover them one by one in a future installment.

Have a look at the chart above. It shows the correlation between the stock market (in blue)and the US Real GDP (in orange) over the last ten years. Look at what happened in 2008 and where we’re at now. Though we haven’t yet seen the massive contraction in GDP growth rate that we saw in 2008 (when it dropped from growing at 3.5% to dropping at 8.5%), our trend over the last nearly two years has been down.

That’s not good for the stock market.

TheBottom Line: Bonds

I probably sound like a broken record by now. Bonds, bonds, bonds.

Wouldn’t you be? Imagine you manage tens of millions of dollars. You see the stock market is flat, the indicators tell you so, and you can see chaos up ahead. Your clients want to make money, and in addition to the 1% capital gains, their bond portfolio is paying a handy 3-4% in interest.

Yes, the dividends from certain stocks may generate about 2-3% in the broad market, but there is a HUGE chance of catastrophic loss with a limited long term upside.

Sure, there are other investments, alternatives, derivatives, futures, options, all sorts of illiquid, volatile and crazy things that promise quick cash at the risk of total loss. Pass.

In this market, I think I’ll stick with bonds and the Tortoise. Slow and steady wins the race.

The Next Steps?

Learn about bonds. Start here.

Then, contact me to review your portfolio.

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