"Value investing is all about downside protection – and then trying to make a return on the upside."Â –Â Prem Watsa
I am not predicting a stock market collapse, now or at any time in the future; I know how badly most of my predictions have worked out, but it is time for prudent investors to take stock of their defenses against a big selloff.
I’m biased, of course. Back in the early 2000s, my mutual fund mentor, Dale Rathgeber, introduced his newsletter subscribers (including me) to the idea of selling in late August and buying back in late October. Timing the market; I know. But it also explains why I was fully in cash in late August 2008 and did not lose a cent when the market plummeted a few weeks later. Not something I’ll forget, obviously.
Value investors may find such jumps into and out of the market unpalatable, and they would be right because you can’t compound value by jumping in and out. On the other hand, you also can’t get ahead if you have a big loss perched on your shoulders.
There are defensive measures that can be taken, given that this bull market has been around for a long time now. Geopolitical risks are heightened to new levels, and various political issues could roil investors’ confidence.
In this article, I will recommend a big-picture scanning tool to help defend against potential market collapses. More specifically, we will look at a technical indicator that can provide helpful information.
Simple moving averages
Also known as SMA, Simple Moving Averages are one of the basic tools used by technical analysts. They are a lagging indicator and only inform about past price history. But even that can be helpful in getting the bigger picture.
In the StockCharts’ chart below, we see how two Simple Moving Averages, used together, can give us a hint of what’s ahead. In this case, there is a 200-day moving average in blue and a 50-day moving average in red. When they cross, something significant may be ahead, as this chart of the SPDR S&P 500 (SPY, Financial) ETF shows:
The 200- and 50-day averages cross twice in this chart, which covers the period Jan. 1, 2007 to Dec. 31, 2009. The leftmost cross, circled in green, shows the 200-day crossing above the 50-day, which is a bearish signal, sometimes called a Death Cross. As we can see, that would have been a good time to take defensive measures of some kind.
The second crossover, also circled in green, shows the 50-day crossed above the 200-day average; that’s known as a Golden Cross. It signals potential bullish conditions and perhaps even a bull market.
If you work with individual stocks, rather than ETFs, GuruFocus has several technical indicators that can be added to price charts. Click here to read a brief tutorial on the use of these tools.
Now, look at Apple Inc. (AAPL, Financial) in this GuruFocus chart, again covering the period Jan. 1, 2007 to Dec. 31, 2009:
In this case, the chart is less useful because it shows four crossovers, and the first two meant very little (as we know in hindsight). This happened because Apple is more volatile than the SPY ETF; Apple has a beta of 1.46 while the SPY naturally has a beta of 0 (beta is a measure of how much a stock price varies from the market, and 1.46 indicates Apple varies 46% more than the SPY).
With more volatile stocks we can reduce the sensitivity of the Simple Moving Average. Here’s what happens when the SMAs are changed to 300-day and 100-day:
With the new settings, just the important crossovers are shown. This won’t always happen, of course; sometimes the crosses don’t mean much, and there is no way to know in advance which will be significant and which will not. Still, a look at the charts gives us a view of the bigger picture as well as context for current prices.
In the case of Apple, this chart shows what happened after the bullish crossover shown in the rightmost circle of the previous chart. That same crossover is shown in the black circle of the chart below, which covers Jan. 1, 2007 through Aug. 31, 2017:
Again, these are lagging indicators, but a crossover makes me more confident that something is expected to change one way or the other. I don’t really expect more than that, but most importantly, technical charts provide an overview that pushes me into a longer-term perspective.
If you are not familiar with technical tools, such as SMAs, experiment with them on the GuruFocus Interactive Charts page. Try different tools and try them with different settings to find what’s right for you. Altogether there are more than 100 free technical indicators that some charting services offer, and there are hundreds more proprietary indicators for sale for specific purposes.
Conclusion
The value of technical analysis is not in its ability to forecast the future or to give us special insight. Instead, it will suggest some patterns in past behavior of a stock, ETF or mutual fund.
As noted in my article, “Is Margin of Safety Enough?” many gurus continue to lag the Standard & Poor's 500 benchmark because of serious losses they suffered in the 2008 financial crisis. Were those losses necessary? No, and the three outperforming gurus (average annual returns beating the benchmark over the past 10 years) had one thing in common: They each appeared to have a better view of the unfolding housing bubble and took action.
Their environmental scanning seems to have been more effective than that done by other gurus. When I see a Simple Moving Average take a fairly sharp turn to the north or the south, I sense that something important is happening. Seeing one SMA cross over the other makes those suspicions even stronger.
Technical analysis can help us get to the bigger picture, to get a sense of where a stock or the market is headed. It’s not enough to justify a buy or sell decision but taken along with other scanning information should make us better investors. If we can use all that information to avoid or eliminate big drawdowns, then we will be stronger investors for following Warren Buffett (Trades, Portfolio)’s key rule: Don’t lose money.
Postscript
As I was preparing this article for publication Sept. 7, 2007, the 50-day SMA had just moved above the 20-day SMA, a bearish sign. See the right side of this StockCharts’ chart:
While this is a bearish sign, it is not a trend. The 50/20 is less robust than the 200/50. But, I will be watching.
Disclosure: I do not own either Apple or the SPY and do not intend to buy either in the next 72 hours.
