by Martin Zweig
Although I have pointed out the market pitfalls, there is always a good time to invest in stocks. Over the long run, stocks have achieved greater returns than bonds, Treasury bills, or other financial instruments. But stocks run hot and cold. Paradoxically, opportunities are greatest when the market is terrible. Using my indicators, you can position yourself on the sidelines when conditions are unfavorable. Thus you can come through relatively unscathed and have the resources to profit when the bear market is over.
In the next chapter, I present an actual case study of how my indicators and investment models allowed me to foresee the rising market risk in late 1987 and why the value of my Zweig Forecast portfolio climbed 9% on “Black Monday” when the market plunged 22.6%.
INTRODUCTION
How I Foresaw the Rising Risk—and Profited on the Day of the Crash
On that fateful day of October 19, 1987, the Dow plunged 22.6%. Using my time-tested indicators and strategies described in this book, I had taken certain fail-safe steps before the crash. As a result, the value of my Zweig Forecast portfolio climbed 9% on “Black Monday”! In this chapter I’ll share with you the background and the basis for these investment decisions.
When I was a kid in the 1940s, the normal conversation at dinner invariably turned to the Depression of the prior decade. That dreadful period and its great bear markets are always on my mind whenever I deal with stocks. But I learned long ago that if you holler and scream that “1929 is coming,” you’ll probably be wrong several times before you are eventually right, and by then you’ll have shouted “wolf” so often that no one will believe you … and not without good reason. Moreover, 1929 and the subsequent Depression created psychological havoc for most people. At the least, the devastating events of the 1987 crash have brought 1929 out of the closet.
Excluding the period before Black Monday, the last time I thought it was ’29 was back in September 1978. I was convinced the market was about to collapse and I was not at all shy about writing on page one of my Zweig Forecast, “Expect a Crash.” I went on to compare that situation with ’29. Well, the market did fall apart right after that in the “October Massacre.” But the damage was contained to a 13.5% loss on the Dow and to 21.7% for the average stock (Zweig Unweighted Price Index).
That’s not exactly chopped liver, but it’s not 1929 either. So, I learned from that experience (plus times when I was just plain wrong) not to scream about ’29. Instead, my plan was that if and when a ’29 type possibility cropped up, I would speak quietly but adopt a strategy to protect portfolios.
I had fretted all during 1987 about the market’s gross overvaluation, but it wasn’t until Labor Day or so that I really began to concentrate on that year’s similarities to 1929, 1946, and 1962. All wound up with crashes, but ’29 was still the case most similar to ours before the break. That brings me to what I wrote in the two issues of The Zweig Forecast that preceded the crash.
In the September 18, 1987, Forecast, I talked about the discount rate hike and how just one such increase had led to wicked selloffs in 1946 and 1968 (later, there was another hike in 1969) and how the 1973 bear market got started on the heels of the first such hike. Most of Wall Street had been insisting that we needed at least 3 hikes before there would be danger. I also ran graphs of the market’s P/E ratio, dividend yield, and book value to show how absurdly overvalued stocks had gotten.
The next issue on October 9, 1987, was headlined, “Risk Is Rising.” Right there in the first paragraph I said, “The overall pattern of recent weeks is not unlike that of 1929, 1946, or 1962, just before stocks crashed.… I cannot escape the fact that risk is easily the greatest since the last bear market in 1981.” I deliberately avoided going into the gory details of 1929, 1946, or 1962. It wasn’t necessary, nor was I absolutely, positively 100% convinced that ’29 was here. I merely thought there was a darn good chance we were there, but I was also concerned that the speculative mania of preceding months might continue. Heck, if I had been 100% certain, I would have shorted every stock on the board … but no one other than a fool can be that sure. I deal in probabilities, not certainties. So, the key was strategy, not preaching.
In that vein, on September 25, I advised everyone on my Zweig Forecast telephone hotline to place 1% of his portfolio in November put options. (Put options give their owner the right to sell a specified number of shares at a specified price during a certain time period.) At that time the November puts were roughly 8% out of the money. In other words, even if the market had gone down by 8%, the puts still would have been worthless. Moreover, if the market had gone down big, but not by November, the puts would also have been worthless. Those puts made sense if and only if the market collapsed by mid-November.
I figured that if a break of the magnitude of 1946 or 1962 evolved, the puts would have climbed sufficiently to protect the 40% or so long positions we held (whose risk was also limited by stops) and would have even provided a moderate profit. If I were wrong, the puts would have produced a mere 1% loss for the portfolio, which might have been offset by gains on the stocks if the market had risen. Remember, I was not positive, I was only dealing in probabilities.
The upshot is that the market walked right into the buzz saw of 1929. From the August 1987 high of 2722, the Dow collapsed to a closing climax low of 1738 on October 19, a plunge of 36.1%. That nearly equalled the 39.6% wipeout in 1929 down to the October 29 climax low. As a result, the puts, which were bought at 2 3/8; in late September, soared in price (this was only the second time in sixteen years that I had bought puts in the Forecast and the first time in two years).
I began selling them in pieces as the market crashed. Beginning on October 15, we sold in 5 bunches over the next several days at prices of 9.25, 19.25, 54, 86.50, and finally on October 20, we sold the last at 130. The weighted average profit on the puts was 2075%, which added about 20.8% of value to our overall portfolio, and more than offset losses of about 7% on our remaining stocks, which were stopped out. (By the close of October 16, the portfolio was down to just 8% invested in stocks.) As a result, our portfolio gained 9% on Black Monday.
If I were a genius—and there aren’t any in this business—I would have sold everything before the break, bought even more puts, held them all right up to the bottom day and made zillions. But that’s not reality. Reality is cutting risk to the bone when the indicators weaken, hoping that you can make a few bucks when conditions are good, and praying that you’ll survive crashes, plagues, and earthquakes long enough so that someday you’ll see the pleasant light of another bull market and have some money left to play it.
Why was I so concerned about a collapse, yet far from being cocksure about one? First, my regular indicators which measure monetary, sentiment, and tape conditions, were only moderately bearish before the break. I’ve taken all of these models back a few decades and with the aid of computers, I can classify the overall composite of the models into “deciles,” that is, the top 10% of all readings in the past, the next 10%, and so on.
Before prices broke a few weeks before the October 19 crash, the composite of the models was down to only the fourth decile. Granted that was the worst reading since 1984, but, to put it into perspective, the bear market of 1973–74 consistently had readings in the first and second deciles. The fourth decile is only moderately below average. Of course, we had been in the eighth through the tenth deciles most of the time since late 1984.
The fourth decile has historically led to declines on the S&P Index of only some 3.4% annualized whereas the first decile has produced losses of more than 28% a year. Monetary conditions were only moderately bearish because there was no credit crunch (the yield curve has been positive … and that was the main difference between 1987 and 1929). Sentiment indicators were about neutral (although they were rotten earlier that year … and traditionally they improve somewhat off their worst readings before markets make their final top). The tape, of course, had been bearish.
So, my regular indicators, those which
I can quantify and back-test, were negative, but not exceptionally so. What bothered me were the similarities to 1929, 1946, and 1962. The familiar pattern was gross overvaluation in P/E’s and yields along with straight-up price movement which lacked a major correction for years and which had produced doubles or a lot more in the Dow. When these conditions had existed, I found that, late in the bull markets, there was a major rally lasting several months which evolved out of a minor correction (the one which started in the fall of 1986 at 1755), another minor correction (spring 1987 from 2404 to 2216), then a narrow smaller blowoff rally to the final high lasting 2–3 months (which peaked this time in August at 2722).
Those earlier markets then began what looked like “normal” corrections, but which soon cascaded into breaks. The key, and what upset me in September, was that as the smaller correction unfurled, the sentiment in Wall Street was “buy ’em.” Everyone had learned not to fear the dips, and that scared me into buying the puts.
I’ve found over the years that it’s best simply to get bullish or bearish as the case may be, adopt the appropriate strategy, and stay with it until the indicators turn; then shift the strategy. To get ready—and stay ready—for any climactic change, it is urgently important to have constant access to reliable market indicators. And when they tell you to do something, do it! The costliest mistakes I’ve ever made came from ignoring—or, worse yet, distrusting—my own indicators … like a pilot second-guessing his compass. I’ve spent some 35 years testing and improving my key stock market indicators detailed in this book. They’re not perfect, but they’re by far the most reliable I know of anywhere.
Patience is one of the most valuable attributes in investing. I liken it to a great baseball hitter such as Wade Boggs nowadays or Ted Williams in my youth. The key to their success is to wait for the fat pitch to hit and not to swing from the heels at just anything. The idea is to work the pitcher into a hole and get the count to 2-and-0 or to 3-and-l. That forces the pitcher to throw strikes … often fastballs. In other words, if the hitter is patient, he tries to work the odds into his favor. Then, and only then, does he take a real rip at the ball.
It’s about the same in the stock market. I try to “work the count” in my favor by waiting for the indicators to get very one-sided before “swinging from the heels” with an aggressive strategy. If I don’t find the indicators producing very good odds in one direction or the other, I’m content to play defensively and just bide my time. In the following pages, I describe and document how you can profit from this investment philosophy.
CHAPTER 1
How This Book Is Different from All Other Books on the Stock Market and What It Can Do for You
If you are looking for a simple, reliable, and workable system for playing—and beating—the stock market, this book was written for you. I will show you how to avoid the most common investment errors, preserve your capital, and make a good deal of money as well. All you need is a willingness to spend half an hour or so a week keeping up with the market indicators that I will describe, and a commitment to maintain a discipline.
Let’s face it. No one is smarter than the market all the time. If market forecasting were easy, everyone would be rich. Even Bernard Baruch, the legendary Wall Street financier, went broke early in his career. I don’t have a crystal ball—and wouldn’t want one. I’ve found that investors who rely on crystal balls frequently wind up with crushed glass. I’m satisfied if I can predict a market trend, get in tune with it, and stay with that trend as long as it lasts.
Since becoming an investment advisor, I have read most of the books on the stock market—not that I buy them; publishers send them to me hoping I’ll promote them in my market letter. Sad to say, most of them are not very helpful.
Some books dangle the get-rich-quick bait. How I made $1,000,000 overnight without trying. These are just plain hype. What they’re selling is the end of the rainbow. Greed is a very powerful emotion, and a lot of people buy these books hoping that, by following an offbeat formula, they will immediately find that elusive pot of gold. Of course that’s impossible. The world just doesn’t work that way.
Other books may not make extravagant promises but offer systems—simple or complicated—for playing the market or picking stocks. A system is not necessarily a bad tool, but many of these are ineffective or worse. It is said that no girl was ever ruined by a book, but I suspect some would-be market plungers would come pretty close to ruining themselves if they tried to implement these schemes.
Then there are the virtual encyclopedias on investments, books that span the spectrum from options to precious metals, from Ginnie Maes to Freddie Macs, from commodities to collectibles. They describe every vehicle comprehensively, but I don’t think such overwhelming detail equips you very well for the nitty-gritty of investment decisions.
I should also mention books like those by Adam Smith and Andrew Tobias. They entertain with great anecdotes, humor, and bits of wisdom. And that’s fine; they serve a purpose and the general reader will get useful advice from these books. But they don’t offer a system for making money in the market.
However, don’t despair. There is valid academic work that proves conclusively that a few methods do exist for “beating the market.” I have incorporated these tools into my stock selection techniques and have junked those methods that are popular but, unfortunately, futile. With this book, you can find the proverbial “edge” in playing the market.
I am proud of my winning Wall Street track record. Since the mid-1980s when the independent Hulbert Financial Digest began rating advisory services, through 1995, my Zweig Forecast showed a total return of 898.9% which, on a compounded basis, equalled a 16% annual gain for the period. I was the number-one stock picker for two years straight and Hulbert ranked The Zweig Forecast number-one for risk-adjusted performance for the fifteen years through 1995.
The job of selecting stocks should never be taken lightly. It’s tough to be a consistent winner. Although Wall Street spends millions each year analyzing stocks, the best available research indicates (1) that analysts cannot consistently predict earnings—which makes such strategies as buying growth stocks at any price multiple rather risky (as many institutions have found in recent years); (2) that mutual funds and other institutions as a group have failed to beat the broad market averages over the years regardless of their methods; (3) that such technical tools as charting and relative strength don’t predict any better than pure chance; and (4) that expensive and lengthy research reports from brokerage houses generally fail to pinpoint stocks that outperform the broad market.
My proven methods for market forecasting and stock selection, painstakingly developed through trial and error over the years, are suitable for both conservative investors and those who wish to trade more actively. My principles have been extensively tested and are all verifiable and thoroughly documented in this book. They work!
I can’t possibly include all the variables I track on market activity because it would get hopelessly complicated. So I have simplified my approach to make it understandable and workable for the nonprofessional reader. In this regard, I have tried to follow Albert Einstein’s dictum: “Don’t make things simple. Make them simpler.”
THE FUNDAMENTAL INDICATORS
First I would like to tell you about my basic approach to investment decisions. Most people think of me as a technician, but actually, I use anything that works. If they worked, I’d track the planets or sunspots, or even use a Ouija board. Instead, I rely heavily on a group of fundamental indicators.
The major direction of the market is dominated by monetary considerations, primarily Federal Reserve policy and the movement of interest rates. To monitor these and other vital trends, I have devised several simple indicators, described fully later in the book, that I have found very reliable.
My guidelines include purely technical indicators. I refer to this factor as the tape action, or momentum, in the market. Here I combine various price and volume indicators
to measure the actual behavior of an individual stock or the overall market. To appreciate the role of momentum, think about a rocket ship being launched to the moon. If it takes off with a lot of thrust, it has a chance of making it out of the earth’s atmosphere. If it doesn’t, it will turn around and flop back. Broadly speaking, the market behaves in a similar fashion. To me, the “tape “ is the final arbiter of any investment decision. I have a cardinal rule: “Never fight the tape.”
If you buy aggressively into a bear market or into individual stocks that are performing badly, it is akin to trying to catch a falling safe. Investors are sometimes so eager for its valuable contents that they will ignore the laws of physics and attempt to snatch the safe from the air as if it were a pop fly. You can get hurt doing this: witness the records of the bottom pickers on the Street. Not only is this game dangerous, it is pointless as well. It is easier, safer, and, in almost all cases, just as rewarding to wait for the safe to hit the pavement and take a little bounce before grabbing the contents.
I also follow closely the degree of optimism and pessimism in the marketplace and will share with you my key sentiment indicators, which provide an early-warning system to detect market trends. I believe you’ll be surprised at how wrong so-called expert opinion can be.
Last but not least, I monitor what I call the fundamentals—the actual value of a particular stock. That includes analyzing earnings, dividends, and balance sheets. Fundamental analysis doesn’t do much for forecasting the broad market direction but is very important for individual stocks. I use fundamentals for probably 90 percent of my input on stock selection but for not more than 10 percent of the weight in predicting the market as a whole.
Big money is made in the stock market by being on the right side of the major moves. I don’t believe in swimming against the tide. It’s rare for me to recommend stock purchases when my market-timing models are bearish, or a short sale when the reverse is true. I would like to be fully invested when the market goes up and fully in cash when it goes down. But the market couldn’t care less about what I like. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.