April 2, 2012
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Buy-and-hold advocates cite two reasons why tactical investing should fail. It violates the efficient market hypothesis (EMH), they say, and it is nothing more than market-timing in disguise.
But they are wrong. Rather than endure losses in bear markets – as passive investors must – I have shown that a simple trend-following model dramatically improves results, most recently in an Advisor Perspectives article last month. Now it’s time to extend my approach by showing how this methodology can be applied to fundamental indicators to further improve performance.
The EMH does not automatically endorse buy-and-hold, nor does it compel investors to endure losses in bear markets. Financial analysts forecast earnings and economists make recession calls routinely, yet academics ridicule market timers as fortunetellers, and market timers resort to labeling themselves as tactical investors to avoid the stigma. Why?
Perhaps what sparks resentment toward market timers is not their predictions, but how they make their predictions. Reading tea leaves is acceptable as long as the tea has a "fundamental analysis" label, but market timing is treated as voodoo because it offends the academic elite, whose devotion to the notion of random walk is almost religious.
I am not a market timer, because I can't foretell the future. But neither do I buy the random-walk theory, because my Holy Grail verifies the existence of trends. Timing is everything. When your religion commands you to hold stocks even when the market is behaving self-destructively, it's time to find a new faith.
Timing models that follow price trends are technical timing models. "The Holy Grail" is an example of a technical timing model. Timing models that monitor the investment climate are fundamental timing models. My Super Macro model is a prime example of a fundamental timing model that works. Before presenting my Super Macro, I will first disclose the details of my earning-growth (EG) model. As one of the 18 components of Super Macro, the EG model illustrates my methodology in model design.
But first let’s look at the engineering science that makes these models possible.
Macroeconomics, an engineering perspective
Engineers assess all systems by their input, output, feedbacks, and controls. From an engineering perspective, the economy is like an engine. It has input (the labor market and housing) and output (earnings and production). The engine analogy and the economic terms in the parenthetical are presented in Table 1. At equilibrium, the engine runs at a steady state, with balanced input and output. When aggregate demand exceeds aggregate supply, the engine speeds up to rebalance. This leads to economic expansions that drive cyclical bull markets. When output outpaces input, the engine slows down. This causes the economy to contract, leading to cyclical bear markets.
The economic engine has multiple feedback loops linking its output to input. Feedback loops can amplify small input changes to produce massive output differentials. Financial leverage is a positive feedback to the economy like a turbocharger is to a car engine. Strong economic growth entices leverage expansions (credit demands), which in turn accelerates economic growth. This self-feeding frenzy can shift the engine into overdrive.
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