How to implement the Free Investment Strategy

The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock market companies; the NYSE Euronext and the NASDAQ OMX.

After the Dow Jones Industrial Average, the S&P 500 is the most widely followed index of large-cap American stocks. It is considered a bellwether for the American economy, and is included in the Index of Leading Indicators. Some mutual funds, exchange traded funds, and other funds such as pension funds, are designed to track the performance of the S&P 500 index. Hundreds of billions of US dollars have been invested in this fashion.

An easy and cost effcient way to invest in the S&P 500 is an ETF that tracks this index, such as iShares S&P 500 Index (symbol: IVV). ETFs can be bought and sold just like stocks of individual companies.

In order to improve results, the model's SELL signal can be used to short stocks with an inverse ETF, such as ProShares Short S&P 500 index (symbol: SH). When you buy the SH, you profit when the market falls. This is why it is called an inverse ETF.

BUY / SELL / CASH signals

Rules for the signals are:

• BUY = close above 50 week MA and confirmation through MACD and RSI
• CASH = break of trendline or close below 50 week MA
• SELL = close below 50 week MA and confirmation through MACD and RSI
  

New signals for the strategy are issued on each Saturday morning. What happens then?

• BUY signal = buy IVV at open of markets on the Monday after the signal
  
• CASH signal for BUY = sell IVV at open of markets on the Monday after the signal
• SELL signal = buy SH at open of markets on the Monday after the signal
• CASH signal for SELL = sell SH at open of markets on the Monday after the signal

That's it! This is a very efficient and easy to implement strategy.

What kind of results can I expect using this strategy?

S&P 500 Index weekly

Chart courtesy of StockCharts, StockCharts.com

Current Signal: CASH

Analysis: This week a new CASH signal was issued. The latest move from the August 2009 BUY signal to this week produced a safe 6% profit.

This week volatility rose and we can now expect a consolidation phase with at least a mild correction. Currently I don't see a market crash, though this could happen a bit later. The rise in stocks and also the end of the recession (the economy grew by 3.5% in Q3) have been caused by government stimulus and very low interest rates increasing liquidity in the financial system.

For a sustainable recovery there will have to be investment and employment. I expect this to happen in the green energy/technology sector, but for now it is better to be on the sidelines with stocks.

If you want to learn more about green energy/technology issues, Wikipedia has a good overview of smart grids. Smart grids are the technology platform where development will take place. New services are also explained on the wikipedia site.

Have a great weekend,
Tom

Weekly financial media scan

Here are the most interesting financial market articles, comments and videos for the week.

We'll start with some negatives:

The guru outlook: George Soros says market at risk of downturn

October 28, 2009 by TPC

Although Soros has turned more bullish over the course of the last 6 months he has not lost sight of the forest for the trees. Much like Jeremy Grantham, Soros believes we are confronted with massive structural long-term problems – particularly in the United States. He believes U.S. consumers are in the middle of a long-term deleveraging process and earlier this month he described the U.S. banking system as “bankrupt”. He sees very weak consumer spending and a drag from the banking sector holding down global growth for years to come. Read more...

Roubini: Global Markets Could Crash Soon

By Dan Weil, Oct 28, 2009

The global markets are at risk of crashing when the dollar rebounds, says economist Nouriel Roubini. Roubini, a professor at NYU, is credited with long predicting the financial collapse of 2007 and 2008.

“In the short run what’s happening is there’s a wall of liquidity, not just in the U.S., but around the world, that is chasing assets,” he told CNBC.

“It’s equities, it’s commodities, it’s credit, it’s gold, it’s emerging market asset classes.” Read more...

But it's not that bad:

Ahead of the Bell: Leading economic indicators

(AP), Oct 23

NEW YORK — The Conference Board's index of leading economic indicators likely rose 0.8 percent last month, according to Wall Street economists surveyed by Thomson Reuters. The index, which is meant to project economic activity in the next three to six months, climbed 0.6 percent in August.

The Conference Board forecasts economic activity by measuring current jobless aid claims, stock prices, consumer expectations, building permits for private homes, the money supply and other data. Read more...

Fueled by stimulus, U.S. economy grows

By Jeannine Avers, Associated Press

WASHINGTON - Fueled by government stimulus money, the U.S. economy grew during the summer for the first time in more than a year. The question now is, can the recovery last? Read more...

Then again......

U.S. Economy: Consumer Spending, Confidence Fall on Job Worries

By Timothy R. Homan and Courtney Schlisserman

Oct. 30 (Bloomberg) -- Americans cut spending for the first time in five months and a gauge of confidence weakened, signaling consumers will make a limited contribution to the recovery without government incentives. Read more...

So the negatives do seem to overweigh and the stock market fell accordingly.

Free Investment Strategy Rules

How should I read the chart?

Each bar on the chart represents the price of the S&P500 index for one week. As we update the chart on weekends, the most recent bar is for the past week. The bars are also called candle sticks. Basically when the week closes on Friday at a higher price than it opened on Monday, the candle stick will have a white body. A week where the Friday closing price is lower than the Monday open has a red body. Go here to see a further explanation for candle sticks.

The blue line on the chart is the 50 week moving average, which indicates the trend. When price is above the blue line and the line is rising, stocks are in an uptrend. The red line represents the 200 week moving average. A strong uptrend is in place when:

• 50 week MA is above 200 week MA and both lines are rising

A strong downtrend is in place when:

• 50 week MA is below 200 week MA and both lines are falling

There are 3 signals:

• Green arrow = BUY
  
• Yellow arrow = CASH
• Red arrow = SELL

Additional confirmation is provided by the relative strength indicator (RSI) above the chart and the moving average convergence divergence indicator (MACD) below the chart.

When the RSI is above 50, it confirms a BUY signal. Below 50 confirms a SELL signal.

The MACD indicator shows patterns of the moving averages.

When the black line is above the red line, the MACD confirms a BUY signal. When the black line is below the red line, a SELL signal is confirmed. Additional strength is shown when both lines are above 0 for a BUY and below 0 for a SELL signal.

To learn more about RSI and MACD or other technical analysis indicators, go here.

Want to learn how to implement the strategy? Go here.

What are investment risks?

When investing, risk is considered the amount of money you can potentially lose by investing in a specific asset class. The loss is, of course, realized only when selling the asset, but if asset prices take a long time to rebound, you incur a loss no matter what the portfolio theorists will tell you.

It is important to identify possible risks to your portfolio. The following issues are the main sources of risk to your portfolio:

• market risk: valuation of stocks measured by the price earnings ratio (P/E). When the economy takes a downturn earnings decrease, so stock prices come down to reflect a fair value of the earnings

• inflation risk: rising inflation is generally not good for either bonds or stocks. Bond yields rise and corporate earnings suffer

• currency risk: currencies have long term trends that influence the value of foreign assets. For example the dollar declined significantly during 2003-2008. This made foreign holdings for US investors more interesting, while non-US investors should have avoided USD holdings.

• systemic risk: market bubbles in general always contain systemic risk. At the end, the bubble always bursts. Specifically the banking crisis is a good example, where contagion caused the near collapse of the entire financial system.

• geopolitical risk: wars and regional conflicts can effect oil prices among others. For example, in the 1970's there was a global oil crisis after OPEC hiked prices through export restrictions.

These risks are fundamental risks, which you can evaluate by following the news or market commentary. If you combine fundamental issues with the technical analysis provided in the Free Investment Strategy, you will get a good picture of what is going on with your portfolio.

What is the right asset allocation?

Academic studies have also shown that about 90% or more of portfolio returns are generated by asset class selection and weights. Only about 10% or less of a long-term return is generated by security selection, i.e. purchasing individual stocks.

An aggressive investor will choose a higher weighting for stocks than an investor seeking capital preservation and secure returns.

A popular rule is:

100 – your age = percentage of stocks in portfolio

Rebalancing of your portfolio on a yearly basis to correspond with this allocation will place a smaller weighting on stocks when you grow older and preserve capital for your retirement.

Long term portfolio returns

The returns of different asset classes after inflation from 1926 to 2000 reveal the long-term average returns. In the long run, small stocks have returned on average 13.8% and large stocks 9.7%. The volatility for small stocks has been very high with a 32.8% standard deviation (a measurement of volatility), which is not necessarily desirable for the average portfolio. Large stocks on the other hand have the risk/return parameters an average investor expects. Bonds have provided less than 3.0% on average, which proves the benefit of stock investing in creating wealth.

Source: Ibbotson Associates

It is clear why stocks are considered the best way to build wealth.