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Understanding And Acting On Tops And Bottoms

The stock market offers us many ways to make money. The most common one is buy and hold, although many would like to buy low and sell high. Many investors feel the buy and hold strategy doesn’t work anymore but few know how to buy low and sell high. To do that, we likely need to be a bit of a contrarian. It gets easier to buy low and sell high if we can understand how our stocks move and why.

We’ve made a lot of money with stocks since 2006 even though stocks went through the worst bear market in many years. While investing still is only a part-time thing in my life, I have been about as close to the market as a cattle producer might be to his herd or a grain farmer to his crops.

Most cow-calf producers and grain farmers harvest one crop a year. If that doesn’t come or if the price is poor, they are out of luck and profits. Yes, grain producers can buy crop insurance, but they still have only one crop a year.

I can make money many times a year. A reader of my newsletter once said that my cows (stocks) can have 12 calves a year. That is true, yes, but with a little knowledge and some work I can make my cows give us 15, 20 maybe even 25 “calves” a year. Plus, my strategy is reversible so if I don’t like something I can always change my mind. Try changing your mind after you seed a crop — you can’t. You are committed.

MY STRATEGY

I use a strategy called selling covered calls to bring in what I would call a main line of cash flow. We can do this on our stocks eight, 10 or 12 times a year and stocks don’t have to go up or down to make money for us.

Then I try to manage our stocks according to how they behave during the year. We call this seasonality. Many stocks move down three times a year, and then move up three times a year. This lets us buy stocks at a good price if we are patient. With a little knowledge and some work we can make money as stocks go up and as stocks go down and if they stay flat. More and more I see capital gain as a bonus more than the main line of income from my stocks. Plus, we keep the dividends.

I might miss out on the occasional big capital gain, but as far as I’m concerned if we can make 15 to 22 per cent a year on most of our money, we will do just fine. Most of our money has made 15 to 22 per cent has doubled in a year. Some of our Tax Free Savings Accounts (TFSAs) have doubled in a year using this strategy.

WAITING FOR THE TOPS AND BOTTOMS

While many investors say we can’t time the market, I have proven to myself that we can. There is lots of data to prove this so it’s not just me talking. For example, most precious metal stocks move down ahead of February, in April and again in the summer/fall. Energy stocks have a season, too. Many industrial stocks make most of their gains from the lows in October to the highs in April. If we pick them right they do go up year over year, but they swing a lot during each year. If we want to learn how to manage those swings we can make some very good money.

Plus, we keep the dividend which is the main reason some investors buy good stocks. We sell calls to bring in extra cash and now these two streams of income build our main line cash flow. Often capital gain is just a bonus that we don’t count on much.

A lot of stocks have moved in a trading range for the past few years and the way it looks to me many stocks might stay in a trading range. For example most Canadian bank stocks are not much higher that they were in October, 2007. Actually on August 2, shares of Bank of Nova Scotia were $52, $2 below the price on October, 2007 before the bear market started. Some energy stocks have come up a long ways off lows but have traded up and down a lot more than up.

I don’t write much about mutual funds (from my past job) because I only own $36,000 worth and they don’t get any attention from me. They peaked in 2007 dropped by a third and now are back to 90 per cent of the old peak. Meanwhile the fee is two per cent a year. I’m moving them to a self-administered account where I can buy stocks, collect dividends and sell calls and pay no admin fee.

OWNING STOCKS IN VOLATILE TIMES

What do I see ahead? First, we have to understand that this (past) recession was caused by deleveraging of economies around the world and not because of monetary policies. This is contrary to past recession. In the bookThis time is different: Eight centuries of financial folly,authors Carmen Rheinhart and Kenneth Rogoff show that based on 800 years of data, recessions caused by monetary policies last 18 months or so. Recessions caused by deleveraging last six to eight years. If that holds true then many countries face a recession until 2017 or 2018. But some say it could take a generation (33)

years to rebuild countries hit by deleveraging.

As a point of interest as Germany and France created a deal to bail out Greece, they converted bonds to 15 — and 30 — year terms. To me that suggests they hope the economies revive inside 15 years, but they don’t count on it.

Does that mean businesses are suffering? Well some are and will get bought out or go broke. These days many companies have a lot of money on their balance sheet and they are very slow to spend it so they are not hiring new workers. Upgrading technology improves productivity enough for them to survive in a recession economy. So over nine per cent of the U.S. workforce is officially unemployed but many say it is twice that.

That many people unemployed or underemployed cuts demand for stuff. And high oil and gas prices cuts demand for other stuff. Technology can only improve productivity two to three per cent per year. So why hire new people? In fact I suspect many companies are hoping more and more of their baby boomers will just retire and go away. Of course since the baby boomers fear their financial future, they are not in a rush to leave a job, even if it’s not perfect.

All of this leads me to believe the recovery in the stock market will be a V where the right-hand side of the V is a little lower than the left side which was October 2007. I can’t draw that on my computer but I think the market has come up the right -hand side of its V and from here on it could be in a trading range for years.

In the meantime, since good companies keep getting better, earnings will improve and since stock prices could be flat their price earnings ratios (P/E) will keep improving until 2017 when that P/E would reach a low of around seven at which point value investors will buy. My guess is that could be 2017.

THE 80-20 RULE AND OPTIONS

Over the years I have seen the 80-20 rule work in many areas, and I think it works with stocks. In bullish markets, often 80 per cent of stocks go up; in bearish markets often 20 per cent go up. If we are in an era of flat prices then I would speculate 80 per cent of stocks could be flat. But if the ratio works like I think it does, 20 per cent of stocks could or would still go up. We just have to find those stocks.

In my opinion stocks related to gold, silver, coal, iron ore, copper, oil and such and stocks that service these industries, have been part of the 20 per cent rule for several years and have several years to go. Most of my money is invested in companies working in those commodities.

The prices do go up and down three times a year. This scares some investors but I like them because the premium from selling calls is quite high on volatile stocks. We just have to figure out how to dance with them. As this picture became clearer to me I decided to try to figure out how to work with volatile stocks.

PUTS AND CALLS

While I might lose some readers with my next discussion I have to go directly to the concept of dealing with options. There are two main categories: puts and calls. We can buy or we can sell them. We just have to figure out when to use each one. So here goes.

We can do four things when stocks peak: 1) sell the shares and hope to buy them back at a lower price; 2) buy a put as insurance since puts go up as the price of a stock goes down; 3) sell a call when the stock is high and hope to buy the call back for less after the stock drops; and 4) sell a covered call well below the price of the day which would bring in cash that would offset the drop in the price of the shares.

We can do four things at bottoms: 1) buy shares when prices are low; 2) buy long calls; 3) sell puts; and 4) sell covered calls quite a bit above the price of the day.

Yes, this is more complicated than buy low and sell high or buy and hold, but this is a learnable, teachable skill. I learned it. I teach it. Most people can learn it. And we don’t have to do this with all of our money — just enough to make some good, comfortable cash. We will have to believe and understand that many stocks drop three times a year and then go up again.

Since all stocks might not work with this strategy I checked the history of a bunch of stocks until I found many that go up and down several times a year; go up and down with the seasons; have options attached to them; and, have high premiums on their calls and puts. I share this stuff with readers of my newsletter StocksTalk.

A WORD OF CAUTION

Dealing with stocks is risky. Selling covered calls on good stocks is a very conservative strategy but it can limit gains. Buying puts can be an insurance policy against falling stocks. Calls we buy can go to zero, much like a cow can die. Selling naked puts and naked calls is risky, takes knowledge and is not a buy and ignore strategy. I started this strategy by selling covered calls on stocks we own. Over time I have learned how to manage the other parts of this strategy. It takes time to learn a new skill — be careful.

Andyismostlyretired.Hetravelswithhis wife,playswithgrandchildren,fixeshiscars, gardensabitandmanageshisinvestments. Andyalsopublishesanewsletterwherehe tellswhathedidwithhisinvestmentsalmost daybyday.Ifyouwanttoreaditfreefora monthgotoGoogle,typein StocksTalk.net, clickonfreemonth,clickonform,typeinfour linesandclicksend

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In bullish markets, often 80 per cent

of stocks go up; in bearish markets,

often 20 per cent go up

About the author

Freelance Writer

Andy was a former Grainews editor and long-time Grainews columnist. He passed away in February 2017.

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