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What Are the Current Odds for the Stock Market?

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Many investors believe that this rally is artificially induced and will lead to a market crash. Not to be overlooked, however: Earnings for the S&P 500 have doubled over the past four years.

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I reflected on mathematics, probabilities, and odds over the weekend after again reading the book Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone. The book centers on Claude Shannon, who in the late 1940s had the idea that computers should compute using the now familiar binary digits 0s and 1s such that 1 means "on" and 0 means "off." Shannon's information theory is what lies behind computers, the Internet, and all digital media. As the book notes, when asked to characterize Shannon's achievement, USC's Solomon Golomb said, "It's like saying how much influence the inventor of the alphabet has had on literature."

In 1956, Claude Shannon and John L. Kelly turned their skills to how to mathematically "win" at the casinos and eventually on how to "win" in the stock market. Those mathematical insights were subsequently employed by the phenomenally successful hedge fund Princeton-Newport Partners. While there were many formulas for their success (edge/odds; Gmax = R; etc.), the manner in which Shannon rebalanced portfolios was elegantly simple. To reprise some lines from the book:

Consider a stock whose price jitters up and down randomly, with no overall upward or downward trend. Put half of your capital into the stock and half into a "cash" account. Each day, the price of the stock changes. At noon each day, you "rebalance" the portfolio.... To make this clear: Imagine you start with $1000, $500 in stock and $500 in cash. Suppose the stock halves in price the first day. This gives you a $750 portfolio with $250 in stock and $500 in cash. That is now lopsided in favor of cash. You rebalance by withdrawing $125 from the cash account to buy stock. This leaves you with a newly balanced mix of $375 in stock and $375 in cash. The next day, let's say the stock doubles in price. The $375 in stock jumps to $750. With the $375 in the cash account, you have $1,125. Look at what Shannon's scheme has achieved so far. After a dramatic plunge, the stock's price is back to where it began. A buy-and-hold investor would have no profit at all. Shannon's investor has made $125.

I have often written about portfolio rebalancing as one of the keys to successful investing. And, while Shannon's simplistic example is too short-term oriented for me, I am intrigued by it. For example, say you put $100,000 into a cash account and $100,000 into Raymond James' "Analysts' Best Picks" (ABPs) and then rebalanced the portfolio every other month, or at the end each quarter, using Shannon's methodology. The results might just be eye-popping. As a sidebar, Shannon's rebalancing methodology could likewise be employed with this scale-in buying approach. I think these types of strategies can improve the odds of success for most investors. And for much of this year, I have suggested another investment strategy for those investors that are... well, not invested. The strategy was first proffered by my friends at the Riverfront organization, but has been repeatedly scribed in these missives. To wit:

First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and fourth segments if market pullbacks occur – example: invest the remaining 10% of the cash on market pullbacks. And sixth, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into three to four parts and follow a strategy similar to the one utilized for investing the first 10%.

Hereto, I think this approach can improve the odds of success for most investors. Speaking of odds, what are the current "odds" for the stock market? Last week, I gave 10 presentations to groups of 100 to 400 individual investors and found it surprising that most believed this current rally is artificially induced and will lead to a market "crash." While it is true the Federal Reserve has flooded the system with money, which is clearly part of the equation for higher stocks, it should not be overlooked that earnings for the S&P 500 (INDEXSP:.INX) have doubled over the past four years.

Also not to be overlooked is the fact that the Fed is likely to continue its quantitative easing for the foreseeable future and therefore stocks can continue to elevate. And that's just what the SPX did again last week, sporting a 2.29% gain as it traded to a new all-time intraday high of 1593.37 before falling back on Friday to close at 1588.85. The early morning Friday fade was triggered by weak revenue-growth numbers from some of the large cap banks, worse than expected retail sales, and surprisingly poor consumer sentiment data. Also surprising was Thursday's release of the sentiment survey by the American Association of Individual Investors, which showed a 45% drop (35.5% down to 19.3%), despite the fact the SPX was making new all-time highs (see chart below).


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No positions in stocks mentioned.
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