Best investment strategies are those backed up by evidence of success

It’s easy for active investors to drown in a sea of misinformation. There’s no shortage of confident commentary telling investors and traders what to do, but what approaches are backed up by evidence? How do we know when markets are capitulating?

What strategies can be used to help investors buy low and sell high? What kind of short-term trading plays have proved profitable? Should investors be looking to buy the “dogs” of an index rather than its darlings?

Buy low, sell high
Dipping in and out of markets is eschewed by most finance gurus, but it seems similarly reckless to have the same equity exposure at, say, the height of the dotcom boom as at the bottom of the global financial crash in 2009. To many, using cyclically adjusted price-earnings ratios (Cape), as popularised by recent Nobel economist Robert Shiller, is the best answer.

Stocks may look cheap on a one-year price-earnings ratio but if earnings are unsustainable, the picture given is misleading. Cape solves the problem of cyclical highs and lows by averaging earnings over a 10-year period. In 2000, Cape was at all-time highs, even above 1929 levels, correctly indicating a lost decade was in store. At the market bottom in 2009, it hit its lowest point in decades.

This isn't cherry-picking. Studies confirm Cape has been one of the best predictors of long-term stock returns over the last century. London-based strategist Niels Jensen of Absolute Return Partners, bearish for most of the last decade, was pounding the table for European stocks in late 2011 due to low Cape readings. Twenty-year returns average 13.4 per cent when Cape readings are at their lowest, he noted, compared to 3.2 per cent when at their highest.

Some argue American accounting changes mean Cape is no longer reliable in the US. True or not, its global value is undimmed.

Investment manager Mebane Faber found countries with the lowest Cape readings average almost double the returns of the priciest indices over the next decade. He says investors should invest in indices with the lowest ratios, rebalancing annually. Studies also confirm the value of rotating out of sectors according to their Cape ratios.

Cape readings are not simple buy/sell signals. Instead, they indicate if investors should overweight or limit exposure to various assets or sectors.

Buy when there's blood in the streets
It's not easy to buy into investor panics, but it tends to be profitable, as various indicators confirm.

Rory Gillen, founder of Merrion Capital and currently running GillenMarkets.com, was bullish on European equities at the height of the debt crisis. In August 2011, the Euro Stoxx 50 declined by more than 20 per cent relative to its 30-week moving average. Such capitulation occurred on just nine occasions since 1970, with average returns of 17 per cent one year later, and 53 per cent within five years (the Euro Stoxx is up almost 50 per cent since its 2011 low). Returns are strongest when markets are not overvalued, Gillen adds in his book, 3 Steps to Investment Success.

Another sign of market panic is indiscriminate selling. Quantitative blog Woodshedder tested for market returns when the percentage of S&P 500 stocks trading above their 20-day average is less than 15 per cent, and when less than 20 per cent of stocks are above their 50-day average. Over the past two decades, such cases have been followed with 50-day returns more than double that seen in an average 50-day period.

Perhaps the most well-known measure of market panic is the Vix, or fear index.

High Vix readings tend to occur when markets are plunging, and when nervy traders are buying options to guard against further losses. Vix readings above 30 indicate elevated fear; over 40 represents outright panic.

Market bottoms following the Asian financial crisis in 1997, the collapse of Long-Term Capital Management in 1998, the September 11th, 2001, attacks, WorldCom’s 2002 bankruptcy and the euro debt crisis of 2011 were all marked by Vix readings in the high 40s.

The one exception – a big one – was in October 2008, with unprecedented market panic resulting in a Vix reading of 89. Markets continued to tumble in the coming months.

On average, however, the S&P 500 has enjoyed 12-month gains of 19.4 per cent when the Vix was between 35 and 40, Citigroup noted recently. Average annual gains of 30.9 per cent and 32.6 per cent have followed readings in the 40-45 and 45-50 group.

Buy pullbacks,
not breakouts
Some short-term traders like to buy when stocks break out to new highs; others buy during the dips. In recent decades, pullback strategies have proved more profitable, as the so-called "Double Seven" strategy shows.

Developed by Larry Connors of TradingMarkets.com, this simple mechanical strategy recommends buying into the S&P 500 when the index (which must be above its 200-day moving average) hits a seven-day low, and selling when it hits a seven-day high.

Between 1993 and 2009, says Connors, the strategy easily beat the S&P 500, despite being in the market only 25 per cent of the time. It triggered 153 trades, 80 per cent of them winners. Similar stats apply to the Nasdaq.

The strategy was retested this year by the System Trader Success website, which described it as “very promising” and not optimised – that is, it worked similarly well for five-, six-, eight- and nine-day lows.

Potential drawbacks? The strategy does not use stop-loss orders, so a major market collapse could trigger big losses. Secondly, pullback strategies were not nearly as profitable prior to the last 20 years – markets change, and the strategy may not work forever. Finally, with an average profit per trade of just 0.85 per cent, a deep-discount online broker like Interactive Brokers is essential.

Buying market 'dogs'
Buying beaten-up stocks with large dividends can be profitable. The most famous version is the Dogs of the Dow strategy, which buys the 10 highest-yielding stocks in the Dow Jones Industrial Average at the start of the year, with those stocks replaced 12 months later by the next highest yielders. Backtesting shows the approach trounced the market for most of the 20th century.

After being popularised in 1991, returns dropped off over the following decade, although the dogs again handsomely outperformed in the noughties.

The approach also works in international markets. Studies have found it outperformed in Finland, China, Thailand, and especially so on Japan's Nikkei – returns averaged 13.6 per cent between 1981 and 2010, compared to just 3.97 per cent for the index.

Rory Gillen, noting renowned contrarian fund manager David Dreman’s work on US dividend strategies, has tested for UK dividend plays. Since 1995, he found, picking the 15 highest-yielding stocks in the FTSE 100 returned 11 to 12 per cent annually, compared to just 7.4 per cent for the FTSE 100.

Greedy
Many argue against active investing strategies, of course, but Warren Buffett puts it well: "If they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."