Investment Strategy: Don't Over-Rely on Stocks!

There are plenty of misconceptions about investment systems. It’s an esoteric field, so those on the outside tend to think of systems as mysterious, robot-driven, “black box” investment advisors.

Really, though, it’s not that complicated (or mysterious).

A systematic investment strategy starts with an idea… which turns into a hypothesis… which is then proven or disproven.

The idea can be as simple as: “I think cheap stocks beat expensive stocks in the long run.” (That’s the basis of value investing, and countless studies have proven it worthwhile.)

Of course, a keen observation about the markets can also be applied on a one-off basis. Take Kyle Bass – founder of Hayman Capital in Dallas – who, in 2006, created a hedge fund to exploit a single hypothesis: that the U.S. subprime mortgage market would implode.

That market did implode. And Kyle Bass was spot on and made a ton of money. But he’ll need to come up with a new great idea for his next fund, or “trade of a lifetime.”

That’s where a systematic investment strategy differs. Unlike Mr. Bass’ exploitation of a rare event, systematic strategies aim to exploit events that occur again and again, with a good deal of regularity.

Cliff Asness of AQR Capital Management (a quantitative/systematic hedge fund) explained the concept quite well when he was interviewed by Steve Forbes. He said (paraphrased):

With systems, you’re leveraging an idea… that cheap always beats expensive, or that low-volatility always beats high-volatility. And you’re applying that idea across hundreds of symbols… so that, in the long run, you’re exploiting the mathematical edge that’s contained in your idea.

To me, that’s the essence of a system. And that’s what I aim to do with Cycle 9 Alert.

The idea behind Cycle 9 Alert is simple: Everything cycles through periods of underperformance and outperformance.

That idea applies to sectors within the stock market… to individual stocks within sectors… and also to asset classes outside equity markets, like commodities, currencies and bonds.

You heard that right. I don’t just focus on stocks. If I did, it would be a surefire way to miss out on great opportunities elsewhere.

The stock market’s not the “be-all and end-all.” Sure, it’s had a great run since early 2009. But the bull market won’t last forever.

At best, the risk-adjusted returns the U.S. equity markets could produce over the next five years are likely to pale in comparison to the last five years. At worst, any number of global risks could trigger a repeat of the 2008 stock market crash.

Either way, looking for Cycle 9-style opportunities outside the stock market is a must.

The good news is: a careful study of historical stock market crashes reveals which asset classes are safe haven plays in times of crisis.

Here’s a sampling of three, non-equity investments that did quite well to cushion the blow of a plummeting stock market in 2008.

First, a currency…

1) Japanese Yen (CurrencyShares Japanese Yen ETF: FXY)

Between September and December 2008, FXY gained 16%, while the S&P 500 (SPY) lost 29%.

That’s due to the fact that the yen, along with the U.S. dollar, is a safe-haven currency that goes up when everything else in the investment world is going down.

Next, a bond fund…

2) 2-Year Treasury Bonds (via ETF: SHY)

My Cycle 9 system generated four buy signals on the Barclays Low Duration Treasury ETF (NYSE: SHY) between July 2007 and January 2009. Each one was profitable… because like with the yen, the dollar is a safe haven currency, so investors tend to clamor for U.S. Treasury bonds when it seems as if the world is ending.

Finally, a basket of commodities…

3) PowerShares DB Commodity Index (NYSE: DBC)

Commodities sold off alongside equities during the second half of 2008. But that doesn’t mean there weren’t any gains to be had buying commodities in the first half of the year. The two trades triggered by my Cycle 9 system between October 2007 and March 2008 netted a combined 22% gain.

The most important point to take away from today is this…

Whenever stocks crash, we’ll be ready!

While today’s note addresses the question – “What do we do when stocks crash?” – it’s important to reiterate: stocks have not crashed yet!

As investors, we’re wise to trade with the trend. And the long-term trend in stock prices is still up (well, except for in China).

Once that trend changes, we’ll adjust – but not before.

For now, I recommend maintaining our long position in the consumer staple ETF, which is now handing us a gain of 57%.

The Consumer Staples sector has beaten every other market sector since my June 17 buy recommendation.

I think more gains are to come on this one. Stay the course for now.