When the stock market moves in any one direction, either generally up (remember the late-1990s tech rally) or generally down (think the bear market of early 2000s), it is easier to make an investment decision and ride it up or down. But when the market moves sideways, or non-directionally, investment decision-making is markedly more difficult. During trendless markets, investors tend to be paralyzed with inaction. However, there are opportunities to cash in on the uncertainty and continue to profit from the market. Understanding what trends look like and the investing mentality that generally works in different market environments can assist investors in making profitable investments. (Learn about some of the indicators that traders can use to determine the direction and strength of the market's present trend in our Market Strength Tutorial.)
Capitalizing on an Uptrend
It is significantly easier to make money when you can invest in a definitive and recognizable market trend, but identifying what the trend looks like while it is happening is the key aspect to taking advantage of the opportunity. With a trend, you don't need to determine exact timing because it will carry you into profits. An uptrend, as depicted in Figure 1, is characterized by a steady movement up and to the right of the chart.
Between January 1996 and September 2000, the S&P 500 had a total return of 130.8% and an annualized return of 25%; there were 29 positive months and 16 negative months. The market was benefiting from an unprecedented technology boom as the personal computer began penetrating most households and the corporate world was benefiting from productivity gains and gearing up for the turn of the century. During such a tremendous bull market, investors basically needed to invest in, or be long, a technology company associated with the computing industry and let the momentum of the market propel stock gains. Similarly, during a downtrend, as depicted in Figure 2, picking the industry or sector that is the subject of the negative momentum and short selling stocks in that industry generally results in positive returns. (Buy high and sell higher, short low, and cover lower; find out if you can surf these risky waters in Riding The Momentum Investing Wave.)
Profiting From a Downtrend
Between September 2001 and October 2002, the total return of the S&P 500 was -26.9%, or an annualized -25.2% with eight negative months and five positive months.
After the technology boom of the late 1990s, the market came to a screeching halt, led by many factors such as oversaturation of new technology and unsubstantiated business models. During such a bear-like market, choosing a technology company that did not have a proven business and short selling the shares should have produced positive returns. (For more insight, read Understanding Cycles - The Key To Market Timing.)
A Trendless Market - Now What?
The previous two scenarios showed trends that were easily identifiable. However, when the market is not showing any trend - either it's sideways or it's volatile with huge swings up and down in a short time period, investing becomes much more onerous and disproportionately less predictable.
As depicted in Figure 3, between September 2006 and June 2008, the S&P 500 had a total return of 10.5% and an annualized return of 5.9% with 13 positive months and eight negative months. Similarly, between March 2004 and October 2005, as depicted in Figure 4, the S&P 500 had a total return of 7.5% and an annualized return of 4.4% with 12 positive months and eight negative months. During these time periods, different macro trends characterized the market, but similarities do exist with sectors that tend to outperform or underperform during trendless markets.
There are industry groups that tend to outperform in trendless markets and those that tend to underperform given the nature of their businesses. Think of the things in life that are necessary and compare them to those that are luxuries. Healthcare services, healthcare facilities, utilities - to name of few - tend to be steady, slow growers; they rarely have a surprise hiccup and are able to pay dividends. Companies that pay dividends tend to hold up well in directionless markets, given there are no negative fundamental or macro trends, because investors get paid while waiting for the market to settle out. (For further reading, be sure to check out The Importance Of Dividends.)
Industries and companies that are subject to earnings surprises tend to be extremely volatile during trendless markets - investors are cautious and timid and tend not to grant any leeway or give any benefit of the doubt. Thus you can see some extreme volatility during these times. Conversely, many stocks tend to trade within a range as investors fail to see trends and put additional money to work. Because there are very few indications that point investors in one direction or another, it is more important to understand macro themes and fundamentals to find undervalued investments than try to find sectors that may fare better or worse. (Learn to identify the things that may impact your investments down the road in Taking Global Macro Trends To The Bank.)
Out of Trend … What to do?
Trendless markets generally require investors to become intimately involved with macro themes - to understand what is driving the global economy and what will persist in the long term. They must also look at company fundamentals, especially the drivers of growth. With non-directional markets, timing becomes much more important, but historically, it is a very difficult concept to execute. Short-run profits are difficult in trendless markets, but finding companies that are undervalued with growth drivers that will continue to spur global or local economic growth should produce profits in the long run. (To learn more, read Investing During Uncertainty and A Top-Down Approach To Investing.)
For example, the time period depicted in Figure 3 was characterized by a strong global infrastructure build, especially in China and India, necessitating a greater supply of materials and energy to meet the increased level of demand. As a result, agriculture and chemicals also experienced higher demand. Thus, the best performing industry groups were fertilized and agricultural chemicals (+164%) and diversified metals and mining (+130%). In addition, various energy industries comprised three of the top 10 best performing industries.
Knowing the macro trends driving global growth and anticipating whether these trends will continue in the future is the most important aspect to choosing investments in this environment. Getting these investments at a discount is the key to returning profits to the investor.
If the market could present a definable trend at all times, investing would be simple, but market efficiencies should take away profits in the long run. Opportunities exist when investors are able to take advantage of favorable fundamentals while they are undervalued and before the market recognizes them. Trendless markets present those opportunities, but generally require a longer term investment horizon.