When These 3 Indicators Are ‘Green’ It’s Time to Buy Stocks

Contrarian Profits — Tue, 14 Jul 2009 11:00:19 +0000

We stayed up late last night reading Dr Van K Tharp’s Safe Strategies for Financial Freedom. It’s a great primer on how attain financial freedom without busting a gut. And we thoroughly recommend it to anyone hoping to free up more time for themselves and live off their investments.

Included in the book is a great strategy for determining stock market performance, which Tharp calls the “1-2-3 model.” It takes its name from the three factors that Tharp believes affect the market most: the valuation of the market, the interest rate climate as determined by the Fed, and the price of the market.

The model is very simple to follow. If all three factors are in your favor, it’s time to buy. If only two factors are in your favor, it’s time to hold. If two out of the three factors are against you, it’s time to sell. Think of it like a basic traffic light system:

Green light – buy

Yellow light – hold

Red light – sell

According to Tharp, under green light conditions (going back to 1927) stocks have risen on average 19.5% a year; under yellow light conditions stocks have risen on average 10.7% a year; and under red light conditions stocks have lost 9.7% a year.
To put it another way, the three most important questions to answer about the stock market are:

Is the stock market too expensive?
Are the Feds in the way?
Is the market going up?

The answer to the first question is easy. The best way to measure whether stocks are cheap or not is the price-earnings (P/E) ratio. For Tharp, expensive is defined as the average P/E over the last 75 years, 17.0. Anything under that is considered cheap.

You can tell if the Fed is in the way by an equally simple rule of thumb. Just look at the six-month period following a hike in the Fed funds rate. The Fed is out of the way either after the six-month period has ended or if the Fed cuts rates before the six-month period has ended.

The last question is possibly the easiest to answer. The market is going up when it’s above its 45-week moving average. It’s weak when it’s below this momentum indicator.According to Tharp, the market has been strong 67% of the time between 1927 and 2004. When the market is strong, stocks have returned 12.7% a year during this period.

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When These 3 Indicators Are ‘Green’ It’s Time to Buy Stocks