A.I.M. Users Bulletin Board

[ls7550]

As part of investing we should consider possible events before they occur rather than trying to react to them as (or after) they have occurred.

If we look at the long term Dow (I used monthly figures here) and use Excel's 'Add Trendline' option then we see something like



Since the mid 1990's it would appear that the Dow's run above trend, but as of more recent has reverted back down towards the trend line.

In some respects the 1990's onwards period is a mirror reflection of the late 1960's onwards period that I've encircled in red.

Ignoring the first decade or so of the graph, and starting in around 1938, you can visualise sequences of prolonged periods of below trend, above trend, below trend, above trend with each lasting around 15 to 20 years.

There is a possibility therefore that we might be entering a repeat of something like the encircled red area, with a cut down below the trendline, then a sustained period of sideways ranging, before perhaps after another ten years or so an upward bias resumes.

I guess what I'm saying here is perhaps not to anticipate a relatively short period of time reversion back to more recent highs as being a foregone conclusion. It could take much longer than you might have thought.

I'm not saying this will happen, just that it could happen.

Under such ranging conditions AIM comes into its own. Capturing volatility gains as prices range whilst buy-and-hold moves nowhere.

So what sort of gains are achievable in such a ranging market?

Well to answer that here's a simple proportional step ladder



where I've set the Top to Dow = 8000 and the bottom to Dow = 3000, so a reasonably deep downside cover before becoming fully loaded into stocks. I chose a 5.85% step size as that is what I've measured as being around 50:50 up down balance levels, so we might anticipate around equal numbers of both up's and down's. Over time across 80 years of the Dow's history there has been around 5 full up/down (or down/up) type 5.85% cycles p.a. (average)

From this particular ladder we see that the level cost is $5882 (opps! - I've uploaded the chart and just noticed I used UK pounds in the chart, so you'll just have to consider the capital value amount and not the currency symbol)

So for each up/down cycle pair we make around $344 gross profit, which after trading costs might decline perhaps $20 down to $324.

With 5 such full cycles p.a. that's a total of $324 * 5 = $1620.

Against the total $100,000 allocated funds that $1620 gain represents just 1.62% p.a. benefit. However when you consider that perhaps the Dow might not fall below perhaps 7000 then we might only actually hold up to around $12,000 worth of stock at any one time, so compared to capital-employed or at-risk that $1620 gain on $12,000 capital-employed equals a 13.5% benefit.

Even if the remaining 88% of funds sat in a cash deposit earning perhaps 5% then in total we could have a 6% total return at year end i.e. ( 0.88 * 5% ) + 1.62%. Alternatively applying those cash reserves to another style, perhaps something like the stop-loss managed futures style I personally use might yield a 7 or 8% benefit for a combined total of ( 0.88 * 7.5 ) + 1.62 = 8.22%.

I believe that this relatively simple example helps demonstrate the D'Alembert betting sequence nature of the Ladder. In this case the D'Alembert unit stake is the Level Cost amount * step size = $344, and after each losing play (downward price move of 5.85%) we increase our stake by one unit, and after each winning play (upward price move of 5.85%) we reduce our stake by one unit. To actually achieve that D'Alembert stake level using stocks we have to invest one level cost amount, around $5882 on a 5.85% price move (5882 * 5.85% = $344).

We have sufficient funds to cover a deep Dow down price and if the price does breach that bottom then we just sit and wait for the price to rebound back into the ladders range. Similarly if the top of the ladder is breached then we're already in 100% cash anyway, so we just start a new ladder with a new higher TOP

A benefit of a D'Alembert betting sequence is that even encountering more losing plays than winning plays on a 50:50 event game can produce overall profit. In effect in the above ladder we are risking around $344 stake upon each play, and even if we encounter 3 sequential losing plays followed by 2 consecutive winning plays then we will have staked units and had Lose/Win outcomes of something like

 
 1 2 3 4 3  
  L L L W W 
 

against a 50:50 like game (even money payout), and achieved a 4*2 + 3*2 total return (14 units) against 1+2+3+4+3 outlay's (13 units) [Overall 1 unit profit].

Which in this particular case amounts to being $320 up whilst the Dow is 5.85% down for that particular price sequence motion.

Whilst we're talking about relatively low investment returns of perhaps around 8%, bear in mind that in comparison buy-and-holders may very well be sitting on dividend income gains alone - with capital values having moved only sideways. These type of returns are just natural under such below-trend moving sideways type periods.

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