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2011 / Strategy Article
Investing To Beat The Smart Money
Part 1 - Smart Money Versus Retail Investor Psyche
Most people know
what makes up a defensive stock, but for those who don't
know, here is a definition. A defensive stock is a stock
that pays a dividend and keeps increasing their dividend
despite the economic circumstances. They have stable
earnings because their products are needed and in demand at
all times of the year and as such economic problems do not
They are normally
found in the energy sector (have to heat our homes, drive
our cars, keep the lights on), food (always have to eat),
drug and health care (because health never takes a holiday) and consumer
staples (always need Kleenex, toilet paper, soaps)
Defensive Stocks - When Are They
defensive stock investing was always recommended for long
term buy and hold investors and "widows and orphans". This
was for obvious reasons. These types of investors want
security and need a stable income (widows and orphans). The
strategy was sound and worked. Throughout the 20th century
defensive stock investing paid the dividends many
conservative investors needed and often there was capital
That began to change in the 1980's as inflation reached
lofty levels of over 10% eroding the dividends being paid by
these "defensive stocks". As well there was a sudden growth
of mutual fund companies who plied widely diversified and varied funds
which seemed to cover every imaginable invest-able product.
The next change came with the arrival of "financial
planners" rather than simply brokers. These "financial
planners" were suppose to be educated individuals who could
take capital from investors and turn it into a nest egg for
The Google S&P 500 chart below shows the S&P 500 index from
May 1971 to Mar 1984 often looked upon as the "hay day" of
defensive stocks. From May 1971 to Mar 1984 the S&P 500
returned 51% or about 3.92% a year. Dividends paying
defensive stocks obviously made a lot of sense.
This was typical of the S&P500 and a major component of the
reason for defensive stock investing. The belief was always
that stocks will recover and move to higher highs. However
the believe was that this could take years to occur and so
buying and holding defensive stocks for their dividends made
a lot of sense. Midway through the 1980's though inflation
reared and suddenly those dividend payments were miniscule
in relation to what long term bonds and even bank
certificates (Guaranteed Investment Certificates) were
This was the catalyst that changed the concept of buy and hold for defensive
stocks. Over the next 20 years, the concept of defensive
investing changed from buy and hold for the dividend, to buy
defensive when the market looks to be at lofty levels. This
made sense as the defensive stocks supposedly would, A)
survive through a market downturn and B) paid the investor
to "wait" out the downturn.
This next chart from Google Finance shows the S&P 500 from
Sep 1986 to the May 13 2011. Looking at these two charts an
investor is struck by the enormous amount of volatility,
spikes, market downturns, uptrends and return. It is the
return that captures most investors attention. From Sep 1986
to May 2011 the S&P 500 has returned about 480% or 19.2% a
year. That returns makes dividends look pretty poor.
The amount of wealth which the baby boom generation has
accumulated is staggering and actually only a small portion
of it is invested in stocks. The stock market itself pales
in comparison to the amount of money in fixed income. Yet
even the small amount of capital in stocks, has pushed up stock
valuations and indeed increased the balance sheet of
thousands of companies. Brokers, hedge fund managers, mutual
fund managers and financial planners have seized upon these
returns and have convinced the majority of investors that
they should expect returns of 10% or greater in a year -
every year. But in order to make those kinds of consistent
gains, investments have to be actively managed. It is
impossible to consistently make 10% a year, every year through simply
buying and holding defensive stocks. Investors will jump
from among mutual fund companies and ETFs monthly and
quarterly based on historic returns. Many investors today
invest based on historic returns in the belief that they can
indeed earn 10% a year on their capital.
Today then, investing means chasing the latest "hot stock"
or "sector" as investors tune into "Mad Money" on MSNBC and
watch dozens of YouTube videos about how to invest and
listen to planners talk endlessly using terms like
"investment vehicle"; "commodity index"; "exchange traded
funds". But by and large investors do not actually
understand the various products, terms or strategies being
bantered about. What they do understand is making 10% a year
on their money and being upset when their financial
statement arrives in the mail and shows loss of capital.
The whole concept of defensive investing has almost
collapsed. It is paid lip service by everyone selling a
financial product, but it is deeply misunderstood in today's
complex investment world where the concept is to generate as
large a profit as possible and get in and out of an
Understanding Smart Money and the Retail
Smart Money is a term used to describe the hundreds
of large pensions, hedge funds, mutual funds managers and
large institutional investors who are considered
sophisticated investors with a strong understanding of the
financial markets in general and can judge or spot the
latest trend in investing. They know when to get into a
trade and when to get out of a trade. They are dealing in
billions of dollars.
The Retail Investor is for want of a better phrase
"the little guy" or the smaller investor who has a few
thousand to a few million dollars. The retail investor is
considered less knowledgeable and is usually late to any
Since stock markets in general have far less capital
involved than the fixed income market, stocks work in favor
of smart money. This investing atmosphere serves the "smart
money" managers extremely well. Historically, smart money
can move into almost any sector and due to the billions of
dollars involved and the float limit of stock shares for
various companies, smart money can push shares up quickly
and down quickly. The smart money traditionally purchases
shares of stocks in sectors that they believe will have the
next move up. Through their sheer buying power they
carefully acquire shares, supporting share prices as they
accumulate shares and then push the stock higher as they
purchase the remaining shares they want to acquire. This
final push up is often referred to as "window dressing".
By this mid to final stage the retail investor and media
have become alerted to the buying by the smart money
managers. It is obvous because the stock is moving higher
daily. The retail investor does not have enough capital to
move the shares but they can purchase them and most do in
the belief that the smart money managers will keep pushing
the shares higher and the retail investor believes they can
sell for a profit and get out before the "other retail
But the smart money managers have already made their
purchases and are just doing some last minute "window
dressing". This window dressing is designed to catch the
attention of the retail investor as the smart money pushes
the stock up a little more enticing the retail investor to
purchase shares. The retail investor in almost every case
will buy the shares at the top of a trend, hold these shares
too long in the belief they will move higher, may even
accumulate more shares as the stock pulls back in the belief
that they are averaging down into just "weakness", only in
the end to find out that they are holding shares for months
and often years before the cycle is repeated and they have a
chance to get out.
Defensive stocks work very well for smart money managers.
First, defensive stocks are always referred to as "safe",
they often have "low profit to earnings" ratios, pay a
"stable dividend" and are even referred to as "attractive".
Many financial planners will even tell investors that in a
bear market "defensive stocks will not fall as far" as the
rest of the market. This is small consolation when the
market falls 40% and their defensive stock portfolio falls
25% or 30%. The incredibly sad truth about bear markets is
that retail investors often sell out their defensive stock
near or at the bottom, which is exactly when they should be
adding to their defensive portfolio for a recovery higher.
Financial planners in general do not work to ensure that
clients understand the incredible risk taken with stocks and
the fact that at some point in time their portfolio
will fall by more than 25%. The day will come when
the small investor will open their investment statement and
see an enormous drop in capital as stock shares have fallen.
Instead before this even occurs financial planners should
advise clients that this will IN FACT HAPPEN, and
they should keep some cash aside to take advantage of the
fire sale prices on their "defensive stocks".
I am sure you have heard all these terms before. But in
today's fast paced investing world, where computers reap
millions of dollars with even ten or twenty cent moves,
there really isn't anything "defensive" about these stocks.
Instead many retail investors end up owning defensive stock
which they have bought at high or over valued levels, sucked
into the myth of defensive stock investing. In the end the
smart money manager walks away from the stock with a very
handsome profit. Looking at the chart of stocks like Johnson
and Johnson below you can see how this stock has had no real
capital appreciation for 10 years. Yet during this time
period smart money has pushed this stock above $65.00, seven
times. Every time someone ends up owning this stock above
$65.00 and it is the retail investor.
When the latest hot sector, such as recently (as of May 13
commodities have cooled off, analysts everywhere bring out
the buzz word "defensive stock" and incredibly it is
actually acted upon, by not just the small retail investor,
but the so called "smart money" as well.
It has been smart money that has pushed up commodities and
now smart money is back pushing up defensive stocks. Stocks
such as PepsiCo, Johnson and Johnson, Clorox, Coca Cola are
all back setting 52 week highs. The chart of JNJ above shows
the dramatic move up yet again for JNJ. Incredibly as it may
sound, I have a lot of investor friends who over the course
of the past 10 years have bought JNJ above $65.00 on every
move higher. So rather than buying the stock on the
collapses, they have ended up supposedly "averaging down" by
buying on the upswing always hoping they will "this time get
out". Instead they end up owning even more shares than
So what can you do to not end up being the little guy stuck
holding shares at lofty heights? Over 20 years ago I worked
to develop a simple strategy for mapping out on charts over
valuation and under valuation as well as a RETURN POINT or
mid-way point on defensive stocks. That's what the rest of
this article will discuss.
PART 2 - Beating The Smart Money - Look To The Charts
PART 3 - Applying The Strategy To Stocks In Long Term
How To Invest In Defensive Stocks and Beat
The Smart Money - Study The Charts
What should a small investor do when it comes to defensive
stock investing? What can the retail investor do to beat the
smart money at their own game. As anyone who frequents my
site knows, I believe in staying within large cap, blue chip
dividend payers. My strategy is
To understand defensive stocks you must understand that in
any downturn ALL stocks will fall including the DEFENSIVE
STOCKS. In bear markets every stock sinks. It is a rare
bear, when certain sectors do not fall.
Let's take a look at Johnson and Johnson, one of the
pre-imminent Defensive Stocks and how it fared in the
various bear collapses over the past 10 years:
In 2000 JNJ lost 38.1%: If an investor had 10,000 in JNJ
during this period and had bought at the high, it would be
worth $6190.00 without taking any dividends into account.
In 2001 JNJ lost 24%: If an investor had 10,000 in JNJ
during this period and had bought at the high, it would be
worth $7600.00 without taking any dividends into account.
In 2002 JNJ lost 36.9%: If an investor had 10,000 in JNJ
during this period and had bought at the high, it would be
worth $6310.00 without taking any dividends into account.
In 2003 JNJ lost 18.6%: If an investor had 10,000 in JNJ
during this period and had bought at the high, it would be
worth $8140.00 without taking any dividends into account.
In the bear market of 2008 - 2009 JNJ lost 36.4%: If
an investor had 10,000 in JNJ during this period and had
bought at the high, it would be worth $6360.00 without
taking any dividends into account.
In between these bear market collapses, Johnson and Johnson
stock also saw a variety of declines with some being as high
as 11%. But then that's the nature of investing in risky
The last chart (below) shows Johnson and Johnson over the
last 10 years from 1999 to 2011. Looking back this far,
gives a much clearer picture of Johnson and Johnson stock.
By dividing the stock into three sections - OVER VALUED,
RETURN POINT and UNDER VALUED we get an even better picture
to help decide how and when to invest.
The RETURN POINT shows that in general, an investor could
expect that over the course of several years, JNJ should be
able to recover to around the $57.50 to $59.50 value. The
over valued prices are easy to spot since the stock
constantly falls back to the return point. The under valued
prices are also easy to spot, again based on the return
Using Charts To Beat The Smart Money
An individual investor needs to understand that chasing
stocks is in the end a losing strategy. The smart money can
push stocks up and down in very short order. Getting in and
out of stocks profitably that smart money is in, is
difficult to do in a consistent fashion. The moves can be
sudden and strong both up and down. As of writing this
article, the smart money has been leaving commodities for a
few weeks now, YET the analysts are just now suddenly
talking up defensive stocks.
Look at the chart below. Since mid April the big buyers or
big money have been moving out of commodities and at the
same time moving into defensive stocks that just a few weeks
ago were perceived as undervalued or fairly valued. But
looking at the chart on JNJ it is obvous the sudden move
higher. This is not just related to JNJ, but a host of
defensive stocks. Yet analysts are discussing this
"phenomena" like it is just happening, when in actual fact
the bigger moves are already underway.
But it is easy to beat smart money if an investor takes the
time to understand the stock and studies all of the above
charts. Consider these points as you review the above
1) JNJ even though a "defensive stock" will collapse just
like all stocks in any bear market. Therefore as an
investor, I know that Johnson and Johnson stock will fall
dramatically should selling commence.
2) Looking at the charts I can see over valuation in JNJ.
Right now the stock is being pushed higher. I have to ask
myself if there is any point in buying the stock when the
smart money is buying in and pushing it into over valued
territory. The answer is simple - NO.
By answering NO, I have ended forever the retail investor's
biggest problem - buying stocks too high.
3) During market contractions, I now know that I can pick a
RETURN POINT. This can give me as an investor a great deal
of confidence to step in and buy some shares when the stock
goes into under-valued territory.
NOW I AM BUYING STOCKS UNDERVALUED! I have beaten the second
worst problem of retail investors - NOT BUYING LOW.
4) I also know from the above charts that JNJ may fall
further than I imagine. Therefore the best way to handle
this is to buy in small lots and NOT USE UP ALL MY CAPITAL
IN A PURCHASE, but to TAKE MY TIME buying stock. Forget
worrying about commission rates. With today's discount
brokers I can buy 100 shares at a time and average my way
into the stock all the way down, because I know when it
recovers that I will make such a large profit that
commissions will be unimportant.
5) I know from the above charts that every collapse in JNJ
has been followed by a recovery. Therefore I can buy with
the confidence of knowing that at some point the stock
should move back to the RETURN POINT.
6) I now know that buy and hold for this stock is probably
no longer feasible unless I am content to see the stock move
up and down and perhaps never actually have a decent capital
gain at the end. Therefore I know that after buying the
stock in UNDER VALUED territory, I will hold the stock,
collect the dividend and then once it recovers above the
RETURN POINT, wait for it to move into OVER VALUED territory
and sell the stock.
7) I know from the above charts that there is no need to
ALWAYS BE INVESTED. That if I buy the stock in the UNDER
VALUED territory and sell it when it is OVER VALUED that I
can get a very good return which will more than compensate
me for those times when I am in cash waiting for the stock
to pull back so I can buy JNJ stock in UNDER VALUED
8) I KNOW THAT THE STOCK WILL END UP IN UNDER VALUED
TERRITORY SOME TIME - THEREFORE THERE IS NO REASON
EVER TO CHASE THIS STOCK HIGHER.
9) By buying this stock in UNDER VALUED territory I will be
selling it to the smart money, when they push it into OVER
VALUED territory which is exactly OPPOSITE to what the smart
money wants me to do as a small investor.
In the final chart below, is the past 12 months in Johnson
and Johnson stock. It shows 4 opportunities during the year
when an investor following the chart above which showed over
valuation, under valuation and return point could have
made trades based on those valuations. A conservative
approach would have returned 11.8%. However those who use
stop losses could have made considerably more. In all 4
cases an investor would have been in the stock at the low
and sold at the high. This shows that it is not necessary to
always be invested but instead keep capital aside because
opportunities will always present themselves throughout the
This type of study is very simple to do and does not require
a degree in rocket science, let alone a degree in economics.
For those not interested in buy and selling defensive
stocks, the above charts are an easy way to pick option
strike prices to buy and then sell or for those investors
interested in selling put options, an investor could pick
the appropriate strike price based on the above charts. As
well, if assigned shares an investor can take great
confidence that the stock will, even in a collapse,
eventually move back up to the RETURN POINT, allowing the
investor to consider covered calls as a strategy.
This is a straight forward approach to investing in
defensive stocks and a winning approach that allows the
small retail investor to beat the smart money managers at
their own game..