The Boom & Bust Investment Strategy

The Market Cycle & Human Psychology

If our strategy is for the most part about avoiding the big draw downs then we keep an eye on where we are in the current investment cycle. Financial markets are run by humans and as we see time and time again, human psychology is big factor driving markets.

The market cycle chart below shows the general pattern that plays out in markets. There is usually a story/narrative drivng the main boom phase that end with "Euphoria". So for example the previous 2 big booms in recent history were the DotCom boom (2000) and the GFC boom (2008). The story driving the DotCom boom was the advent of internet stocks. With the GFC it was real estate. After an initial drop we see "Complacency". This is the last call for avoiding the big drop. 

With this strategy, the we are always monitoring the price action to determine of we are in a Complacency phase and what signs do we have the the Complacency is failing.

If we apply this thinking to the current SP500, there is a string case to be made the current bull market has as it's main story/driver the Magnificent 7 stocks and A.I, but also on the liquidity side, a very long run in very low central bank interest rates which has inflated asset prices.

The current boom then is comparable to the DotCom boom and GFC boom, but with central bank interest rates now set to remain "higher for longer", we have the conditions for a large reversal and have therefore entered a Complacency phase where "it's different this time", because you know... it's A.I. ... it's just going to keep going up... the hype is real this time... right? ...

Long Term Risk - Are We In A Bubble?

The SP500 is in bubble territory driven by the "Mag 7" stocks - the biggest 7 stocks in the US stock market. A historical measure of this "concentration risk" can be traced in the top 10 stocks which has been tracked since the 1920's. Its clear to see that we are in dangerous waters and therefore we can only logically conclude that the market is at risk here. We are at 'Great Depression' levels of concentration as you can see in the chart below... 

Generally speaking, global financial markets have two 'modes': -

• "Risk-on"  (a.k.a or "bull market" or "boom") when the markets are going up. 

• "Risk-off" (a.k.a "bear market" or "bust") when the markets are going down.  

This investment strategy is a 'secular' (long term) asset allocation strategy which aims to reduce or avoid the major downturns, when the markets really are 'Risk-off', such as in the DotCom crash in 2001 and the Great Financial Crisis in 2008 by dialling up 'Capital Preservation' assets (such as bonds) and 'dialling down' Growth assets (mainly stocks/equities). 

Other than that the markets are in Risk-on mode, so we are invested in equities (growth) to capitalise on long-term gains in the stock market. For well over a century, the stock market has delivered long term growth to investors. It's called 'market drift' as the stock market drifts up over the longer term. In general then, 'Capital Preservation' assets are dialled down. So, the strategy is to 'react' and 'position' to prevailing market conditions rather than predict them. 

My Core Growth portfolio is a globally diversified stock market fund (ETF) that delivers long term growth. This core portfolio is supplemented by two 'satellite portfolios' which are increased or decreased based on the extent of the Risk-on or Risk-ff sentiment prevailing in financial markets: -

• A Capital Preservation (Risk-off) satellite portfolio focusses on assets such as bonds and bond-like assets designed to shield capital in a downturn.

• A Growth/Factor (Risk-on) satellite focusses on riskier sectors such as 'tech', or on funds designed to beat the core globally diversified stock market.

Bogel's Wisdom

Vanguards' Jack Bogle popularised the concept of globally diversified Index investing which is still the mainstream investing methodology of choice and one in which I actively participate... for the most part.

Bogles legendary investment wisdom and guiding principles below are the foundation on which I build. If you are keeping things simple in your quest for financial independence then it's perfectly acceptable to own one globally diversified fund, and then ‘set and forget’...

1. Develop a workable plan e.g. a household budget, live below your means.

2. Invest early and often. Compound interest will work its magic long-term.

3. Never bear too much or too little risk. The primary driver of risk is the amount of equity in your portfolio and Jack Bogle’s guideline is your age in bonds (age 20 means 20% bonds, 80% equity, age 40 mean 40% in bonds, 60% in equity) so you gradually reduce risk as you get older.

4. Diversify. Don’t put all your eggs in one geographic, sector, or asset class basket. This reduces your risk because it is unlikely all markets will crash simultaneously.

5. Never try to time the market. Don’t hold back cash in the expectation of a crash or put in extra cash in the expectation of a rally as these are unpredictable.

6. Use index funds when possible. These track an index, usually cheaply.

7. Keep costs low. Fees compound over time as well as returns. The difference between 1% per year and 0.1% per year over a lifetime can be staggering.

8. Minimise taxes. In the UK and the world over, there are tax-efficient wrappers such as ISAs, IRSs (US), Pensions and SIPPs.

9. Invest with simplicity. Keep the number of funds you own to a minimum, Bogle suggests just two are sufficient for many investors. One equity fund and a bond fund.

10. Stay the course! Don’t tinker with your portfolio. Once you have settled on a risk profile stick with it. During rallies don’t be tempted to increase your risk by selling bonds and buying more shares. During selloffs don’t be tempted to sell shares and move into bonds.

The realities of protecting financial independence and retirement funds in this day and age means points 5, 9, and 10 are open to some degree of active management...

Market Timing?

• "Time in the market beats ‘timing’ the market"?

Other wise known as 'buy and hold' (or HODL 'Hold On for Dear Life). This is where you don't increase or decrease 'asset allocation' (E.g. stocks vs bonds) in your portfolio, but just hold onto the investments over the longer term. By and large you will see your portfolio drift up and this is sometimes called "market drift". Stock markets so far, in recorded history have always recovered from market crashes and resumed growth over the longer term although sometimes this can take a painfully long time. Regardless, if you 'buy and hold' you will see big drawdowns (declines) in your portfolio along the way, and if you are following this advice then the trick is to hold your nerve and await the market upturn.

The image below shows the biggest stock market in the world, the US stock market taking about 14 years to reach break-even from the start of this century to 2013/14. If you were a US investor who retired in 2000 you would have felt the pain (and risk) of "buy and hold". Japan in the 90's was even worse with investors retiring in Japan at that time... STILL not breaking even until sometime in 2023. However, Japan was such a basket case back then that we can probably discount that ever happening again.

The two big 'secular' declines in recent history in the US S&P500 Index were -50% (DotCom crash 2000/02) and -57% (GFC 2008/09), so for investors only invested in the US stock market they would have had to stomach watching their entire portfolio coming down that much over the space of a year or two. And, a 50% decline means you need to rise by 100% from that point to get back to break even...

So, whilst Bogles' wisdom might ring true across the board for investors in their accumulation phase when they are building up their portfolio over the long term, it didn't ring true for US investors at the end of their accumulation phase at the turn of the century and it certainly didn't ring true for Japanese investors in the 1990's. There are other examples of these big drawdowns happening in other stock markets across the world.

For investors aiming to live off their portfolio for the rest of their lives, the reality of achieving that goal in these boom and bust financial markets presents, in my opinion, makes it a necessity to at least attempt to mitigate the type of secular bear markets you see in the images below.

A poignant illustration of the current risk in over-valued equity markets is shown below in the inflation adjusted SP500 going back to 1913 no less! The 60% peak to trough inflation adjusted drawdown occurred after the price action breached the long term upper trendline, which as you can see is the current position as of the begining of 2025 ...

ASSET ALLOCATION... THE US vs THE WORLD

The US Stock market (SP500) is by far the biggest in the world and is the Index by which all others are measured. Most standard globally diversified internationally diversified stock market funds and ETF's will be invested in this one stock Index to the tune of around 70 to 75%, reflecting the global market share of the US stock market. 

This standard intrnational stock matket fund/ETF will rebalanve the allocation for each countries stock markey based on the global market share of that country. So this rewards the investor by allocating in the most successful countries in the biggest stock market which makes sense.

For example Emerging Markets (EM) comparison to SP500 chart below shows the relative secular bear market that this asset class was in in the early 2020's. Owning an EM ETF/index fund at this time would have dampened down returns. depending on how much EM you had allocated to your portfolio. (Most standard funds would have a low allocation in any case)

Dollar Cost Averaging, Zone Investing & Market Valuation

Dollar Cost Averaging advocates for investors to invest equal amounts throughout a year and so ensures that the investor achieves the 'market average'. Zonal investing breaks the year into 4 zones and advocates buying more in the 2 lower 'buying zones and even selling in the 2 upper 'selling zones...

The chart above shows a horizontal ranging market, but if the market is trending up then the zones are placed within an upward sloping channel with the peaks and troughs market the upper and lower trendlines within which the 4 zones reside.

The basic strategy is to buy when the price is in the lower half, say Zone 2 and buy even more when it is in Zone 1. As you can see from the diagram above, you have the lower half, which are your Buying Zones, and you have the top half, which are your Selling Zones.

You want to buy in Zone 1 and when the price goes up to Zone 4 you want to sell. In Zone 2 you should think about buying and in Zone 3 you should think about selling. You can get quite creative here. For example, you buy £100 worth of stock when it is in Zone 2 and £200 when it is in Zone 1. You then sell 50% of the stock when it exits Zone 3 and enters into Zone 4 and the rest when it reaches the top of Zone 4.

Market Valuation

From a longer term investment viewpoint, it is better to invest when markets are not overpriced. The median Price to Earnings ratio for the SP500 is 17.9. At the time or writing, it's over 28. Stock Market valuation and performance can factor into a Dollar/Pound cost average strategy by limiting position sizes at high P/E values.

An interesting (or rather... 'telling') metric on stock market valuation is the difference between the sp500 yield (expected total return) and the yield on "cash" (read ... short-term government bonds). When the sp500 yield (expected total return) is less than the yield on 'cash' then allocation to stocks should not be high. At the time of writing in 2024, this ratio is as low as it was in 1999 before the Dotcom crash…  

…. and whenever this line is below zero is when stocks have been less attractive… 

…. Warren Buffet also uses this metric to allocate to cash... which is exactly what he has done with his multi-billion dollar fund. Stocks have done much better when this ratio is higher…

Asset "Revesting" - Chris Vermeulen - The Technical Traders

I have been following Chris Vermeulen at the Technical Traders for some time now and his Asset Revesting strategy of aiming to invest only in rising assets to generate better longer term outcomes for portfolios is worth a read.