Investing in, not Trading, the Price Cycle: an Overlay Strategy

Here’s the reason market timers lose money: They are traders instead of investors, and as discussed in a previous article traders are time sensitive as their main dependence is on price movement. Therefore they need to invest as close to the upturn in price as possible and they need to hold on and exit only when the price stops appreciating.

Investors, though, can trade the cycle to their profit as an overlay strategy. What is an overlay strategy? It is an extension of an existing strategy. An enhancement. It makes sense only if the underlying strategy makes sense.

So if the cycle trading overlay is dependent on a core investment strategy, what is that investment strategy? In the article linked above I made a case for the best investment strategies being those that provide a yield, free cash flow regardless of whether or not it is paid out to shareholders.

With a yield an investor can acquire and hold an underpriced investment at the bottom, or close to the bottom, of the asset price cycle. In simple terms, the trader who buys company XYZ which has no yield will be upset if the price does not immediately appreciate. On the other hand, an investor who buys a yielding asset is not going to be worried about the price appreciating immediately. Even if the yield is not paid out in the form of a dividend or coupon, the free cash flow automatically creates value, in the most basic sense as cash, or as new opportunities created when said cash is deployed.

This explains why the trader gets burned by trying to time the market. He is too scared to buy before the price starts going up, ends up buying after the price goes up and because he is too scared to sell before the top of the market, he doesn’t sell until the price drops, which is usually a collapse.

The investor on the other hand is in a completely different position. At the bottom of the cycle the yielding assets that he is seeking will have a higher yield due to the lower price of the asset. Whereas the trader is scared to buy at a bottom in case the price falls further, the investor loves the bottom of the cycle as he is acquiring wonderful yields!

Here’s the magic. As the market heats up, prices go up and asset yields go down. Additionally, market dynamics dictate that cash yields go up to compensate for the flight to the asset bubble. If the neighborhood central bank seeks to suppress the asset price bubble, they will further raise rates even more and create a bigger gap between cash yields and asset price yields.

Whilst the trader hangs on to his assets trying to squeeze the only return he knows out of them, the investor is calmly comparing his asset yields to cash yields and deciding when to switch. If the asset cannot pay for the price volatility it gets sold for cash, well before the bubble is pricked. But even if the investor doesn’t sell at the top, he is happy: he has a yielding asset.

Investing in the price cycle is bad for traders but natural for investors. The astute investor will overload yielding investments at the bottom of the cycle, confident in receiving the benefit of free cash flow. He can then offload any surplus investment once cash yields approach or surpass asset yields.

Benefitting from asset price cycles is not impossible. It just requires an effective yield based investment program as its base.