BUY, SELL, OR HOLD?
by Dr. Steve Sjuggerud

September 12, 2002

In just a few short months, chances are the stock market will do something it hasn't done in the post-World War II era - it will have fallen for three consecutive years.

This has prompted many to claim we're headed for a major bear market in stocks that could last up to a decade. On the flip side, pundits like Abby Cohen of Goldman Sachs tell us that stocks are undervalued and we may never see a better time to buy.

Who's right?

With all due respect to my friends here at the Daily Reckoning, the answer never seems clear. There are certainly good arguments (on both sides). And regardless which pundit you choose to believe, you still have to decide on the big question regarding your financial assets - how much should you have in the stock market? After all, you don't want to miss out. But you don't want to get clobbered either.

Today, my aim is to help you solve this dilemma. I call my solution the "1-2-3 Model." And it couldn't be simpler.

Green light - buy. Red light - sell. Yellow light - hold.

If you can understand traffic signals, you can invest with this model. Let's begin... Using 75 years of weekly data, I crunched numbers until my fingers ached as if besought by arthritic fatigue. Now the signals are clear. The method for determining your stock allocation is simple. And it isn't at all subjective...it doesn't depend on any overpaid "analyst" forecasts. All you need to know is whether three core features of the market are working for you - or against you.

From there, the rest is easy. If all three features are in your favor, these are "GREEN LIGHT" conditions and stocks are a "strong buy." Under green light conditions, which have occurred 26% of the time since 1927, stocks have risen 19.5% a year.

If two out of the three factors are in your favor, well, that's a YELLOW LIGHT. These are "buy and hold" conditions and they have occurred 50% of the time since 1927. Stocks under yellow light conditions have returned 10.7% a year.

If two or more out of the three factors are against you, hold your hat, because that's a RED LIGHT. Time to sell. For most of the 20th Century stocks lost 9.7% a year under red light conditions.

Armed with this knowledge, you'd have known that we dropped into red light conditions in late 1999. You'd have adjusted your portfolio ahead of the collapse, and the stock market crash of 2000-2002 would have come as no surprise. You would know, too, that we're still under red light conditions now. So...it's not time to buy yet.

Back-tested for 75 years, the '1-2-3 Model' has proven to work in all market conditions: depressions, wars, booms, you name it. I even checked each decade individually, and the results were always about the same - green light led to big gains, and red light mode was a portfolio killer.

What are the three market factors that make up the model? It's best to phrase them in the form of questions:

1. Is the stock market expensive? 2. Are the Feds in the way? 3. Is the market acting badly?

Let's look at each question closely: First, is the market too expensive? The clearest, time-tested measure of whether stocks are cheap or expensive, is the price- to-earnings (P/E) ratio. From 1927 until mid 2002, if you'd bought stocks when the P/E was above 17.0 (when stocks were expensive), you would have made only 0.3% a year.

During the test period, the P/E was above 17.0 about 36% of the time.

However if you'd bought when the P/E was below 17.0, which occurred 64% of the time, you would have made 12.4% a year in stocks. Right now, the P/E is significantly above 17.0 - therefore, the market is expensive.

That's one strike...one out of the three criteria is already against us.

Second...are the Feds in the way? Interest rates are probably the biggest factor affecting stock prices. To understand it, simply consider this: If the bank starts paying 12% interest, what would people do? Well, if they're smart they'll probably move money out of the stock market and into the bank. It only makes sense that as interest rates rise, people sell stocks.

The interest rate movements that have historically had the most dramatic effects on the market have been changes in the interest rates set by the Federal Reserve - in particular, the Fed Funds rate. When the Fed is raising interest rates - look out!

When the Feds stay out of that way - that is, when they're not raising rates - we earn, on average, 10.9% per year on stocks. This situation has occurred 71% of the time since the 1920s. However, for the 29% of the time the Feds are in the way, it pays to be cautious. Since '27, stocks returned only 1.0% a year with the Feds in the way.

How do we define the 29% of the time the Feds are in the way? It's simple. We look to see whether or not there's been a rate hike over the previous six months. The Feds are out of the way either 1) after the six-month period has ended or 2) if the Fed cuts rates before the six- month period has ended. Right now, as I write, the Feds are emphatically NOT in the way.

So this factor is not against us. At least not right now. (But we'll be watching events closely... this is one of the few times in history when the Fed has cut rates so dramatically and the market has failed to rally.)

Let's take a look at the third component of the model: is the market going up? Market action is critical. No market model is complete without some indicator of market action. The market knows more than any "expert" can predict. Market action helps to account for the "human" element in the markets.

The Nasdaq didn't rise from 1,500 to 5000 in two years on earnings or interest rates alone. Likewise, it didn't fall from 5,000 back to 1,500 in two years on earnings or interest rates either. Human emotions are a very real part of the market. We need a simple, yet effective, tool to account for market action. And we've got one...

The market momentum indicator is simple. It's the 45- week average of stock prices. If the market is above its 45-week average, stock prices are strong. If the market is below its 45-week average, stock prices are weak.

Sixty-seven percent of the time, according to our market action indicator, the market is strengthening. If you are in the market when this indicator says the market is strong, stocks return 12.6% a year. The market is weakening 33% of the time, based on this indicator. During this period, stocks have lost 1.6% a year. Right now, the market is weak. The index is below its 45-week average.

That's two of three negatives...meaning we're in red light mode.

In my view, these three indicators are the only things you need to know to decide when to put your money in the stock market. All the rest is just noise. You can ignore it. If you use the three indicators above, you will know whether you should buy, sell, or hold.

And what's best about the model is, these indicators don't change very often, so you don't have to check the papers every day. Check in a few times a year. (I'm serious!) Stocks have been expensive for years. The Fed has been cutting rates for years. And the market has been acting badly for years. Had you been aware of the model you wouldn't have had to spend any time stressing over the last two years - we've been in red light mode since late 1999.

Okay...so now that you've got a reliable stock market indicator, what do you do with this information? That's fairly simple, too.

As a simple rule of thumb, subtract your age from 100. That's how much you should have in stocks under "normal" conditions. I consider yellow light conditions normal. Under red light conditions - like now - you should cut that number in half.

For example, a 60-year-old man should have 40% in stocks under "normal" conditions (that's 100 minus 60). But since we're in red light mode, the rule is to cut that number in half, to 20%. It's a simple rule of thumb, but a good starting point for most people, most of the time.

You can follow this model on your own. The P/E numbers appear in Barron's every week, and on the S&P website. For interest rates, its all over the news if the Fed does something, which isn't that often. And for market action, you can go to www.bigcharts.com to do the 45- week moving average. I also follow the model in my monthly advisory, called True Wealth. Once a month my readers check in to see exactly where we stand.

The solution has led readers of my newsletter to many great winners this year, with hardly any losers - in a terrible bear market. It also led my readers to lower their exposure to the stock market in plenty of time, as I'll show. And best of all, regardless of what market situation we're in, my readers know that we'll make money in all market conditions.

And beyond solving one of your most important financial questions, by following this technique, you won't be concerned about what they're talking about on CNBC, what your friends are saying, and all the other things that ultimately have no positive impact on your investment success.

Instead, you'll know what really matters. And you'll be able to sleep comfortably at night, knowing that you'll never miss out, and that you'll always be positioned correctly. What more could you want than that?

Good investing,

Steve Sjuggerud,
for The Daily Reckoning

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