Successful investing requires risk management

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In football, baseball and investing, winning is a basic matter. This is especially important when the game is not going your way.

In fact, there’s an old adage that sums up the best way to pull yourself together: when you’re on a losing streak, go back to basics.

In football, it’s all about blocking and tackling.

In baseball, it all comes down to throwing and keeping your eye on the ball when you get up to bat.

And when it comes to investing, it’s about anticipating the future while managing risk in the present.

the past is gone

The COVID pandemic and subsequent war in Ukraine changed everything, at least what most of us took for reality.

The story is far from over, so a lot can still happen as the ripples from the “Pond of Chaos” continue to spill across the global landscape. But those of us still hoping to trade stocks in the next few years have to start somewhere.

The principles of a good investment

There are three important principles for staying in the investment business:

  • Don’t fight interest rate trends. Many find this one the hard way in this market. But never forget that rising interest rates cause stock prices to fall. This is especially true when central banks tell you that more rate hikes are coming.
  • Don’t fight the prevailing market trend. Buying low and selling high is easy to remember, but woefully insufficient. A better mantra is not to fight market momentum.
  • Recognize that the economy is a reflection of the stock market, not the other way around. Indeed, a large portion of the population bases their long-term financial decisions on the status of their Individual Retirement Accounts (IRAs), 401k plans, crypto, and stock trading accounts. I call this the MELA effect, where M is for markets, E for economics, L for life decisions, and A for artificial intelligence and its role in communications and the financial system.

The unique price chart that tells the story

If I was on a desert island with an internet connection and had a choice of price chart to examine, I would choose the New York Stock Exchange (NYAD) advanced decline line.

This is because this indicator offers the most reliable possibility, in my opinion, to assess the state of the stock market.

When evaluating the trend, consider the following points:

  • The general trend of the graph. If NYAD is up, the general trend is up. If NYAD is falling, you are in a downtrend.
  • The 200-day moving average (red line). If the NYAD is above this line, it is considered to be in a bull market. A drop below this line often precedes entry into a downtrend.
  • The 50-day moving average (blue line). When NYAD is above this line, the medium term (weeks to months) trend is up. The opposite is true.
  • The volatility bands (green lines above and below NYAD). These are also known as Bollinger Bands. When they get close to prices, they signal that a big move is coming.

Note that the NYAD broke below its 50-day moving average at the end of 2021, a sign that the medium-term trend was weakening. This was followed by a break below the 200-day moving average which correctly predicted the current bear market.

Also note that the NYAD slumped after the Federal Reserve began forecasting its next cycle of higher rates in late 2021-early 2022.

Reality and anticipation

The stock market is a tough place. Yet, when this bear market is over, the new bull market will justify patience in these trying times. If you anticipate the future and manage risk, of course.

Indeed, higher interest rates may slow, but cannot stop the macrotrends that were in place before the rate hikes began and they certainly cannot stop the rebound once rates reverse.

The housing sector creates a windfall

Current housing data is horrendous. Mortgage rates are rising. Housing starts, sales of new homes and existing homes are collapsing. And sentiment among builders and homebuyers is plummeting.

But the fact remains that inflation and the current post-COVID reality are increasing the number of people migrating from high-tax, high-gas, high-rent states to the Sunbelt. Meanwhile, the lack of housing supply that began in 2008 and spread due to relocation rejected by COVID has not drastically changed.

Experts tell us that the housing sector will eventually collapse. And they could certainly be right. It’s already arrived. And in the present, housing inventories look dismal.

Yet, time and time again, we receive reports of homebuilder earnings exceeding estimates. And while companies are clearly growing more cautious, they are still running their business.

Maybe they’re whistling past the cemetery. But perhaps they are betting on major macro-demographic changes. Maybe they trade on what they see.

For example, in my neighborhood, a new row of townhouses is coming up and the builder is putting up his next block, next to those where the framing is nearly complete. A few kilometers away, I see a similar development.

I realize this may be a regional phenomenon and just like in the past, home builders are notorious for overbuilding and eventually going bankrupt.

And certainly, there is no guarantee that everyone who wants a better place to live will be able to get one. But from a supply and demand perspective, homebuilders and homeowners (those who survive Fed rate hikes) will be in a good position once things stabilize.

Dismal price charts

Technical analysts, those who make buy and sell decisions based on price charts, are likely spooked when looking at homebuilder stock charts.

The ETF S&P SPDR Home Builders (XHB) certainly tells a story of misery. It features a litany of negatives including:

  • Lower high prices combined with lower low prices – the mark of an established downtrend;
  • Failed assembly attempts – February, March, April, May 2002;
  • Strong hit for short sellers based on falling Accumulation Distribution Indicator (ADI) line; and
  • A lack of conviction from long-term investors (smaller volume bars per price – large bars to the left of the chart) as price falls to new lows.

In other words, sellers and short sellers are overwhelming buyers in this sector.

Cheap basement prices abound

The graphics are horrible. But homebuilder stocks are very cheap.

I randomly picked five homebuilder stocks and looked at their current valuation metrics based on their price-to-earnings (P/E) ratios and compared them to the S&P 500.

Manufacturer and P/E reports:

  • DR Horton (NYSE: DHI) – 39
  • Lennar (NYSE:LEN) – 48
  • KB Houses (NYSE: KBH) – 96
  • Pulte Group (NYSE:PHM) – 56
  • Green Brick Partners (NYSE: GRBK) – 26
  • S&P500 (SPX) – 21

What the numbers clearly show is that homebuilders are currently classic value stocks. Indeed, they are selling for around one-fifth of the value of the stock market as measured by the S&P 500.

Conclusion

There’s a lot of hand manipulation going on right now. This is certainly warranted, at least to some extent given the current state of financial markets.

Still, as homebuilder data shows, there are bargains to be had that will, at some point, attract value investors.

Given the messages from the Fed about its continued rate hikes and the negative effect this has had on the stock market, it may not be time to jump into real estate stocks with both hands. But this is also the time to become fully aware of the value created in this market.

After all, the fundamentals of successful investing are managing risk in the present while anticipating the future.

I own shares in DHI, LEN and GBRK in my private investment account.

PS: Dr. Joe Duarte has identified a small, unknown company that has developed revolutionary “black box” technology. You need to get on the ground floor of this game-changing opportunity before the investment herd finds out and drives the stock price higher. Click here for more details.

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