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Anantha-Nageswaran

"Stocks are still priced as though we were at the top of a bubble market. The dollar is still regarded as though it would last forever. And Americans still spend money as if they had some."

— www.dailyreckoning.com

THIS witty yet valid observation was the basis of my last column when I had argued that it would be difficult to ride the bull wave in the US equities as most investors did in the last two decades. Such bull markets make most investors feel good about their investment acumen; analysts look smarter and venture capitalists are praised for their encouragement to the culture of innovation and enterprise. In a bear market, investment mettle, patience and discipline are sorely tested. The real winners are sorted out from the losers.

Despite all the hoopla about the US economic recovery, it is clear that the Dow Jones has languished for three years since it first crested 11,000 in 1999. We are already in a period of adjustment and consolidation that economists Robert Shiller and Campbell wrote about. They simply said that, having seen prices run too far ahead of earnings, the adjustment has to come from stock prices for them to come back in line with discounted future earnings.

One has to adopt trading strategies. That is, one plays for small gains and protects against big losses. Investors rely on trading signals from technical analyses and sell quickly if the trend starts to run counter to expectation.

What is the contrarian approach?

The other alternative is to wade against the crowd judgment. It is called the contrarian approach. The approach is to sell when the crowd sentiment is too optimistic and buy when the crowd sentiment is too pessimistic. There are two issues involved here. One is to find measures of optimism and pessimism and the other is to decide on what is `too optimistic' and what is `too pessimistic'.

One could turn to investor sentiment surveys. The American Association of Individual Investors (AAII) conducts a survey of such nature, every week on its website. The problem with such surveys is that participation is voluntary and sample sizes could be too small to be considered representative of investor sentiment.

If such sentiment can be, and are, captured in market data, so much the better. We have such indicators available for New York Stock Exchange and the Nasdaq Composite indices.

New highs and lows indicator capture sentiment

Chart 1 is the sentiment index for Nasdaq and Chart 2 is from the NYSE. (The chart is a measure of stocks making new highs divided by the sum of stocks making new highs and new lows over the previous 99 days.) One can quickly figure out that the maximum value this index can take is one (if there is not a single stock making a new low) and the minimum value is zero (if there is not a single stock making a new high). The data is available only for the last four years. Chart 1 appears more volatile than the Chart 2. This is not surprising. Technology investors have gone through a bigger rollercoaster ride both in terms of prices and sentiment than non-technology investors. That is what Chart 1 captures.

How can we make use of this information to trade in equity? The sentiment was at its worst around September 11, after the attacks on the World Trade Centre. Subsequently, central bankers flooded the global markets with liquidity leading to the typical fourth quarter rally. Nasdaq climbed nearly 50 per cent by end-December from its lows of September.

Investment behaviour test signal reliability

We decided to examine this more formally. We devised a trading rule whereby the investor sells the index when the Nasdaq sentiment indicator reaches 0.7 and buys it when it reaches 0.1. We ignored transaction costs and taxes for this exercise. We also assumed that investors had the ability to sell short. Let me make this clearer.

Let us assume that you have now read this article and want to try this out. On Monday night, you find that the SENINASD indicator was above 0.7, as it would be. One would normally not be able to sell the index unless one had bought it earlier. We relaxed that constraint. We assumed that the investor was in a position to `borrow' the index from some one who owned it and sell short. The `borrower' (short-seller) then squares the position as soon as he/she sees a `buy' signal, that is, when the indicator reaches 0.1. Why did we assume something that not all investors would be able to do?

The objective of this exercise is to find the reliability of the trading or contrarian signal that this indicator generates rather than being able to mimic the actual behaviour of the average investor. Second, given that Nasdaq and technology stocks had actually heavily ensnared most investors over the years leading up to 2000, they would be mostly `long' in technology stocks. This signal tells them to reduce their holdings in the short-term and encourages them to buy back at cheaper prices, thus reducing the losses that they have accumulated on their current holdings. That is, if the signal works.

Results of investing by the signal

Let us verify the results. For the period from January 1998 until mid-February 2002, the returns are as follows:

-3.0 per cent when investor sells every time the signal tells her to do so and the positions are squared at the first opportunity, as described earlier;

3.6 per cent when investors sell at a signal only after they had bought earlier at a 'buy' signal

This contrasts with the actual return of 15.6 per cent (including dividends) one would have earned in Nasdaq had the investor remained invested throughout the observation period. Remaining fully invested in the index appears to be a better alternative than to adopt active strategies such as the above. Why? The observation period includes the extraordinary bull years of 1998 and 1999. When equities are in a bullish phase, the most profitable investment approach is to buy the index and just enjoy the ride.

Let us reduce the observation period to March 24, 2000 until mid-February this year. It was in late March 2000 that Nasdaq peaked. What are the returns then?

As per (a) and (b) above, the returns are 14.3 per cent and 2.4 per cent respectively. This contrasts with the - 64 per cent return that staying invested in Nasdaq would have fetched. No ambiguity. Following the contrarian strategy would have earned a positive absolute return even in the worst bear market that Nasdaq had witnessed. By the way, the latest reading for the indicator is 0.865 as of March 14 — still a `SELL'.

What is the key ingredient of success?

What it takes for some one to take advantage of this strategy? It can be captured in three words — discipline, discipline and discipline. Once some one is convinced of a trading rule such as this, they should resist the temptation to second-guess it. The temptation would be high to ride a momentum even when the indicator gives a signal to sell. It might well be possible that for a few days the index continues to rally even after a sell-signal is emitted. One should not lose heart. The reverse applies for `buy' signals as well. Mr Bill Gross, the famous fund manager of Pacific Investment Management (PIMCO), a bond fund house, attributes his success to discipline and the ability to avoid being swayed by emotions or momentum. What is his success? With bonds as the only asset class, his core portfolios have returned annually, on average, 10.6 per cent since 1973, compared to 13 per cent a year for S&P 500 equities. Impressive performance for a `bond-only' portfolio.

Of course, besides being a disciplined investor, he should also believe the underlying hypothesis that the broader indices are still vulnerable to sideways to downward moves, rather than a steadily upward trajectory. I, for one, think so.

(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. His views are personal. Please address feedback to nageswar@singnet.com.sg)

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