Thursday 29 March 2012

How to invest in a zigzag economy?

Are you in the right sectors of the stock market for this point in the economic recovery? Solid data stretching back to 1945 show that certain industries and sectors outperform during specific stages of any economic recovery.

No argument from me on that. I think investors should do everything they can to put the power of the economic cycle behind their portfolios.

What is the economic cycle?

Just a couple of questions, though: Where exactly are we in the economic cycle? And in the new global economy, does it still make sense to think about over- or underweighting sectors, just on the basis of where the U.S. stands in the economic cycle?

My answers to those questions are complicated (and take up the rest of this column). The short response is that the U.S. economy is in the early recovery stage of the economic cycle. That means you should be overweighting the sectors that do best in that stage: basic materials, as well as industrials near the beginning of this stage and energy near the end.

But my best estimate is that the global economy is further along in the recovery cycle, and that this is especially true for emerging economies. I think the global economy has made the transition from early to late-stage recovery. That means that for foreign stock holdings (and for U.S. companies that rely on sales in the developing world for growth), you should be overweighting those sectors that do best in the late stage of the recovery cycle. Energy typically does well in this stage, and, near the end of the stage, consumer staples and services also tend to prosper.

Confused yet? Let me explain now in more depth and lay out a way for you to position your portfolio for this unique moment in the global economic cycle. I'll end by suggesting a few stocks that I think fit our rather complicated picture.
A primer on the economic cycle

The best work on this subject comes from Sam Stovall, the chief investment strategist for Standard & Poor's Equity Research. His 1996 book, "Sector Investing," is still the best resource on the subject.

Stovall divides the economic cycle into four stages:

Early recession. You should remember this stage vividly. Consumer sentiment ranges from fear to terror. Industrial production plunges, interest rates peak and then start to fall, and unemployment begins to rise rapidly. Sectors that have done well -- relatively, at least -- during this stage include services (near the beginning), utilities, and (near the end of the stage) cyclicals and transportation stocks.
Full recession. Gross domestic product tumbles, interest rates keep falling, and unemployment rises. Sectors that do best during this stage historically have been cyclicals and transportation. Technology performs well at the beginning of the stage; industrials benefit near the end.
Early recovery. Consumer sentiment improves, industrial production turns up, interest rates hit bottom, and unemployment peaks and starts to move lower. Sectors that do best are usually industrials (near the beginning of this stage), basic materials and energy (near the end).
Late recovery. Interest rates rise as the central bank tries to control inflation, consumer sentiment heads down, and industrial production is flat. Sectors that have done well in this stage include energy and, (near the end of the stage) consumer staples and services.
Is the recovery real?

In 2009, it seemed we were well along the path to recovery. The economy had bottomed in the second quarter with U.S. GDP contracting by 0.7%. The economy then grew by 1.6% in the third quarter and by a huge 5% in the fourth quarter.

The recovery was off and running. In January 2010, I wrote that we were in the early recovery stage of the economic cycle.

And then the economy double-crossed us. In 2010, GDP growth dropped to 3.7% in the first quarter and to 1.7% in the second quarter.

1.7%? Wasn't that just about the 1.6% growth investors had seen back in the third quarter of 2009?

No wonder lots of economists and investors started to worry that we were headed to a double-dip recession -- and that the next quarter would show a drop back to something like the negative 0.7% growth of the second quarter of 2009. But luckily, the economy decided that it had at least one more zigzag up its sleeve. Economic growth accelerated to 2.6% in the third quarter of 2010 and now economists are expecting 3.5% growth for the fourth quarter of 2010.

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Wednesday 7 March 2012

10 rules for novice traders

If you are going to day trade, it's essential to have a set of rules to manage any possible scenario. Even more important, you must have the discipline to follow the rules.

Sometimes, in the heat of battle, traders will throw out their rules and play it by ear -- usually with disastrous results.

Although there are many rules, the following are the 10 most important:
1. Know your 3 E's: enter, exit, escape

This is the first rule for a reason. Before you press the "enter" key to execute a trade, you must know at what price to get in, when to get out and what to do if the trade doesn't work out as expected.

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Escaping a trade -- also known as using a stop price -- is essential if you want to minimize losses. Knowing when to get in or out will help you to lock in profits, as well as save you from potential disasters.
2. Refrain from trading until 15 minutes after the market opens

Those first 15 minutes of market action are often a time of panic trades or market orders placed the night before. Novice day traders should avoid making moves during this time, while looking for reversals. If you're looking to make quick profits, it's best to wait until you're able to spot rewarding opportunities. Even many pros avoid the market open.

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3. Use limit orders, not market orders

A market order simply tells your broker to buy or sell at the best available price. Unfortunately, best price doesn't necessarily mean the trade will be profitable.

The drawback to market orders was revealed during the May 2010 "flash crash." When market orders were triggered on that day, many sell orders were filled at 10, 15 or 20 points lower than anticipated.

A limit order, however, lets you control the maximum price you'll pay or the minimum price at which you'll sell. You set the parameters.
4. Avoid using margin

When you use margin, you are borrowing money from your brokerage to finance all or part of a trade. Full-time day traders (i.e. pattern day traders) are usually allowed 4:1 intraday margin. That means a trader with a $30,000 trading account will be given enough buying power to purchase $120,000 worth of securities. Overnight, however, the margin requirement is still 2:1.

When used properly, margin can leverage, or increase, potential returns. The problem is that if a trade goes against you, margin will increase losses.

One of the reasons that day trading got a bad name a decade ago was because of margin. Some people cashed in their 401k's or borrowed bundles of money to finance their trades. When a major bull market ended in 2000, many of those traders' accounts were devastated. The bottom line for novice traders: Learn how to day trade stocks without using margin.
5. Have a selling plan

Many rookies spend most of their time thinking about stocks they want to buy without considering when to sell. Before you enter the market, you need to know in advance when to exit, hopefully with a profit.

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Thursday 1 March 2012

When investing, it’s all right to be wrong

In 1973, the Kreditbanken (bank) at Norrmalmstorg in Stockholm was attacked by robbers, who held bank employees hostage for five days. After the drama, it was evident that the hostages sympathized with their captors, even though they were held against their will. The situation is now considered an academic study — the Stockholm Syndrome — where people get emotionally attached to people who obviously try to do them harm.

More apparent, perhaps was the case of Jaycee Lee Dugard, who was held for 18 long years — from 1991 to 2009 — but got so emotionally attached to her abductor that she even helped him in his business and met customers. Being an unwilling hostage, or in other cases, just being in an unwelcome situation with no way out, makes us rationalize in favor of our position.

Less dramatically, we become hostage to our own opinion. We simply can't let go of what we believe is "normal", even in the face of facts. If your blood tests show you have a high cholesterol level, your immediate reaction is to hope the problem will go away on its own, or imagine that the tests were incorrect. A person abused at work — sometimes with lewd suggestions — will initially justify it as harmless workplace banter. The victims of a drunken driving accident will side with the driver saying how good a driver he "usually" is. We simply don't want to see it, even if we know it.

In the financial world, our beliefs are tested often. In 2011, the markets fell over 24%, with the situation in December as dire as it could be; the government was running out of money, industry was slowing down, inflation was high and everything looked bleak. In January 2012, we saw the Nifty and Sensex rise 12%, with no apparent improvement in any of the other pieces of data. This rise has bewildered most analysts, who continue to believe, at every stage, that the market will reverse back down. Consistently, nearly every day, the market sees a rise, but the sage opinion is that this is a fake rally, and that this will come down like a ton of bricks.

It might. The analysis may be spot on, that the Indian story has hit a pause button and not worthy of very high valuations. But at some point, we need to admit that the tide has turned, and prices keep moving north. Our conviction is worth the paper it was never written on — but we carry the weight of it on our shoulders altogether too long. Such irrationality can cost money —a trader that stays short despite a stop loss being broken, almost in anger against such a furiously rising market, continues to lose until eventually giving up. An investor who decides a stock is great and watches it fall, keeps buying until the stock becomes an abnormally large investment, and later feels serious regret when other stocks do better.

If you strongly believed in the Indian telecom story, it was lost on the stocks. From Bharti Airtel to Reliance Communications, the stock prices are way lower than their highs in 2007. We have more air travel than ever before, but airline stocks are in the doldrums. India is spending an enormous amount of money on infrastructure, but the road-builders and power-plant-owners are scraping the bottom of the barrel in the markets. Yet, the question I first get when I say all this is: "Good time to buy?"

The correct way to deal with markets is to expect to be wrong. You have to consciously look for information that counters your thought process. If banks are supposed to be in trouble, then look at their positive results, and look at how strongly the RBI is supporting the system. If buying IT companies on a falling rupee sounds exciting, consider reports that customers are quite aware of the fall and demand corresponding concessions, which they don't reverse easily as the rupee recovers. If you like to buy stocks when they make a new one-year-low, test out how many times you would have made money investing in a broad array of such stocks in the past. (I have checked, and results are horrendously negative at a portfolio level though there are a few that will shine)

It's not easy to stay fluid and keep switching sides as the tide turns — society values loyalty much more than rationality. Being wrong is okay, but staying wrong is evil; in the markets, we can't get married to our opinion.

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