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Library of Congress Cataloging-in-Publication Data:

Davis, Ned (Nathan E.)
Being right or making money/Ned Davis. — Third edition.
pages cm
Includes index.
ISBN 978-1-118-99206-7 (hardback)—ISBN 978-1-118-99656-0 (ePDF)—
ISBN 978-1-118-99659-1 (ePub) 1. Investments—United States. 2. Investment analysis. I. Title.
HG4910.D394 2015
332.6—dc23

2014023440

Disclaimer

The data and analysis contained herein are provided as is and without warranty of any kind, either expressed or implied. Ned Davis Research, Inc. (NDR), d.b.a. Ned Davis Research Group (NDRG), any NDRG affiliates or employees, or any third-party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any NDRG publication. NDRG disclaims any and all express or implied warranties, including, but not limited to, any warranties of merchantability, suitability, or fitness for a particular purpose or use.

NDRG's past recommendations and model results are not a guarantee of future results. Using any graph, chart, formula, or other device to assist in deciding which securities to trade or when to trade them presents many difficulties and their effectiveness has significant limitations, including that prior patterns may not repeat themselves continuously or on any particular occasion. In addition, market participants using such devices can impact the market in a way that changes the effectiveness of such device.

S&P 500 index is proprietary to and is calculated, distributed, and marketed by S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC), its affiliates and/or its licensors and has been licensed for use. S&P^® and S&P 500^® are registered trademarks of Standard & Poor's inancial Services LLC, and Dow Jones^® is a registered trademark of Dow Jones Trademark Holdings LLC. © 2014 S&P Dow Jones Indices LLC, its affiliates and/or its licensors. All rights reserved.

For important additional disclaimers, refer to www.ndr.com/invest/public/copyright.html.

CONTENTS

Foreword

Preface

Acknowledgments

Chapter 1: Being Right or Making Money

Bad News about Forecasting (Being Right)
Good News about Making Money
Being Right and Other Investment Techniques Are Overrated and Are Not the Keys to Success
The Four Real Keys to Making Money
The Battle for Investment Survival and Handling Mistakes
Stories of Five Successful Winners
Making Our Own Reality
The Ned Davis Research Response to All This
Timing Models
What Is Contrary Opinion and How to Use It
History and Risk Management
The Rest of the Book
Notes

Chapter 2: The Model-Building Process

The Model-Building Process
Where to Start: Model Inputs
Sentiment and Valuation Indicators
Monetary Indicators
Economic Indicators
Internal Indicators
Moving Averages
Crossings and Slopes
Momentum
Putting Indicators Together
Conclusion

Chapter 3: A Stock Market Model

A Stock Market Model
Overview of the Fab Five
Tape Component
The Final Tape Component
The Sentiment Component
Sentiment Summary
The Monetary Component
Monetary Component Summary
Fab Five Combo Component
Combo Model Summary
Summing Up the Fab Five
How We Use the Fab Five

Chapter 4: A Simple Model for Bonds

A Slight Modification
Summary

Chapter 5: Potential Bear Market in 2014; Bearish Secular Residue and Then Buying Opportunity

Preparing for a (Say, 20 Percent) Bear Market
Sentiment and Valuation Indicators, If One Wanted to Be Bearish
Other Sentiment Indicators
Valuation Problems
Trend Indicators to Plan for a Potential Pullback—Follow the Leaders
More Leading Indicators of Market Peaks
Four-Year Presidential Cycle Risks
Macro Backdrop: Debt Bubble Update
Watching Fed Policy to Prepare for a Major Pullback in 2014
What Do Demographics Say?

Chapter 6: The Aging World: Economic and Market Implications

Global Population View
Why Is the Population Getting Older?
Demographic Developments
Implications of Aging Populations
Ways to Offset a Declining Workforce
Conclusion

Chapter 7: United States Energy Independence—A Game-Changer

What the United States Consumes
The Thorn in the Side of Energy Independence—Oil and Transportation
Choosing the Right Fuel
Why Electric Could Be a Game-Changer
Why Electric Has Yet to Take Off
How Far Ned Could Go
Nat Gas—An Indirect Play on Electric
The Immediate Impact of Abundant U.S. Energy Resources
A Potential Headache for the U.S. Manufacturing Resurgence
Conclusion

About the Author

About the Contributors

Index

End User License Agreement

List of Illustrations

Chapter 1

Figure 1.1 Real GDP Growth versus Survey of Professional Forecasters
Figure 1.2 Real Year-to-Year Percentage Change in U.S. GDP versus Federal Reserve Projections
Figure 1.3 S&P 500 Index versus Consumer Price Index
Figure 1.4 DJIA and DJTA Above/Below Their 200-Day Moving Averages
Figure 1.5 TOP, S&P 500 Index; Bottom, Yield Curve (Long-Term Treasury Bond Yield minus Three-Month T-Bill Yield Spread)
Figure 1.6 Top, S&P 500 Index; Bottom, Real Monetary Base: Annualized Six-Month Rate of Change (Moved Forward Two Months)
Figure 1.7 Top, S&P 500 Composite Index; Bottom, Crowd Sentiment Poll (2002–2014)
Figure 1.8 Top, S&P 500 Composite Index; Bottom, Crowd Sentiment Poll (1995–2002)

Chapter 2

Figure 2.1 Top, S&P 500 Index; Bottom, American Association of Individual Investors: Bulls/(Bulls + Bears)
Figure 2.2 Top, S&P 500 Index; Bottom, S&P 500 Price/Operating Earnings Ratio (Historical Estimates)
Figure 2.3 Fed Watch I (Money Supply Growth): Top, DJIA; Bottom, Year-to-Year Change in Real M2 (Constant Dollars)
Figure 2.4 Top, S&P 500 Index; Bottom, Moody's Year-to-Year Change in Baa Bond Yield
Figure 2.5 Top, DJIA with Buy/Sell Signals; Bottom, Annual Rate of Inflation
Figure 2.6 Top, DJIA 2004–2014; Bottom, 50-Day versus 200-Day Moving Averages
Figure 2.7 NASDAQ Composite versus 200-Day Moving Average
Figure 2.8 NASDAQ NDX 100 Index
Figure 2.9 Top, S&P 500 Index with Buy/Sell Signals; Bottom, Long-Term Treasury Bond Yield (Three-Week Smoothing)
Figure 2.10 Top, S&P 500 Index; Bottom, Multi-Cap Institutional Equity Series Percentage of Stocks above Their 50-Day Moving Averages
Figure 2.11 Top, S&P 500 Index; Bottom, NYSE 52-Week New Lows/Issues Traded
Figure 2.12 NASDAQ Composite vs. 200-Day Moving Average

Chapter 3

Figure 3.1 Top, S&P 500 Index and Model Allocation Line; Bottom, Fab Five Composite Model
Figure 3.2 Top, S&P 500 Index; Bottom, 50-Day versus 200-Day S&P 500 MA
Figure 3.3 Top, S&P 500 Index with Stochastic Indicators; Bottom, 85-Period Stochastic NDR Equal-Dollar-Weighted Equity Series (Five-Day Smoothing)
Figure 3.4 S&P 500 Index versus NDR Supply and Demand
Figure 3.5 S&P 500 Index with Advance/Decline Breadth Thrust
Figure 3.6 Top, S&P 500 Index; Bottom, NDR Combination High-Low Logic Index
Figure 3.7 Top, NDR All-Cap Equal-Dollar Weighted U.S. Equity Series; Bottom, Percentage of 46 World Markets above Their 50-Day Smoothings
Figure 3.8 Top, S&P 500 Index; Bottom, Big Mo Multi-Cap Tape Composite (Directional Mode Basis)
Figure 3.9 Top, S&P 500 Index; Bottom, Fab Five Tape Component
Figure 3.10 Top, DJIA with Buy/Sell Signals; Bottom, Bulls/(Bulls + Bears) with 10-Week Smoothing
Figure 3.11 Top, NDR Multi-Cap Equal-Dollar Weighted Institutional Equity Series; Bottom, NDR Multi-Cap Institutional Equity Series Median P/E Ratio
Figure 3.12 Top, S&P 500 Index; Bottom, S&P 500 Stock Earnings Yield (GAAP) Compared to Interest Rate Composite Ratio
Figure 3.13 Top, DJIA with Buy/Sell Signals; Bottom, Big Block Index
Figure 3.14 S&P 500 Index versus Open 10 and Open 30 Trading Indices
Figure 3.15 Top, S&P 500 Index with Buy/Sell Indicators; Bottom, Value Line Median Appreciation Potential (VLMAP) with SD Brackets (Six-Week Moving Average)
Figure 3.16 Top, S&P 500 Index; Bottom, NDR Daily Sentiment Composite
Figure 3.17 S&P 500 Index versus the Hulbert Newsletter Stock Sentiment Index
Figure 3.18 S&P 500 Index versus Multi-Cap Institutional Equity Series Advancing/(Advancing + Declining) Volume
Figure 3.19 S&P 500 Index versus CBOE VIX (Inverted)
Figure 3.20 Top, S&P 500 Index and Model Allocation Line; Bottom, Fab Five Sentiment Component
Figure 3.21 Top, NDR Multi-Cap Geometric Total Return Index; Bottom, Moody's Baa Bond Yield (26-Week Change)
Figure 3.22 Top, S&P 500 Index with Liquidity Signals; Bottom, M2 Money Supply—(Industrial Production x PPI Commodities)
Figure 3.23 S&P 500 Index versus 10-Year Yield Deviation-from-Trend
Figure 3.24 Top, DJIA; Bottom, Reuters CCI (Year-to-Year Change)
Figure 3.25 S&P 500 Index versus AMEX Securities Broker/Dealer Index
Figure 3.26 Top, S&P 500 Index with Buy/Sell Signals; Bottom, Free Reserves (3-Week minus 52-Week Smoothings)
Figure 3.27 S&P 500 Index versus M1 Annualized 13-Week Rate of Change
Figure 3.28 Top, S&P 500 Index and Model Allocation Line; Bottom, Fab Five Monetary Component
Figure 3.29 Top, S&P 500 Total Return with Model Allocation Line; Bottom, Three-Month Financial Commercial Paper (with 10-Month Smoothing)
Figure 3.30 Top, S&P 500 Index and NDR Multi-Cap Index (Geometric TR); Bottom, Eight-Indicator Model
Figure 3.31 Top, S&P 500 Index; Bottom, Environmental Risk Index
Figure 3.32 Top, MSCI Europe ex UK Index in Local Currency; Bottom, Europe ex U.K. Internal Composite
Figure 3.33 Top, S&P 500 Index; Bottom, Big Mo External Composite
Figure 3.34 S&P 500 Index versus the Adaptive Trading Model
Figure 3.35 Top, S&P 500 Index and Model Allocation Line; Bottom, Fab Five Combo Component

Chapter 4

Figure 4.1 Zweig Bond Model When Constructed (1966–1986)
Figure 4.2 Zweig Bond Model Real-Time (1986–2014)
Figure 4.3 Zweig Bond Model Full History (1966–2014)
Figure 4.4 Modified Zweig Bond Model (1966–1986)
Figure 4.5 Modified Zweig Bond Model (1986–2014)
Figure 4.6 Modified Zweig Bond Model Full History (1966–2014)
Figure 4.7 Modified Zweig Bond Model with FBNDX
Figure 4.8 Modified Zweig Bond Model with JNK

Chapter 5

Figure 5.1 Top, Dow Jones Industrial Average; Bottom, Margin Debt (in Billions)
Figure 5.2 Top, S&P 500 Index; Bottom, Investor Credit Balance/Margin Debt
Figure 5.3 Top, MSCI World Index Total Return (USD); Bottom, NDR Global Consumer Sentiment Composite
Figure 5.4 Top, DJIA with Buy/Sell Signals; Bottom, Bulls/(Bulls + Bears) (10-Week Smoothing)
Figure 5.5 Top, S&P 500 Index; Bottom, Stock Mutual Funds' Cash/Assets Ratio
Figure 5.6 S&P 500 versus Stock Fund Inflows/(Stock Fund Inflows + Bond Fund Inflows)
Figure 5.7 Equity and Bond Flows Including ETFs (Exchange Traded Funds)
Figure 5.8 Asset Allocation for All Mutual Funds and ETFs
Figure 5.9 NDR Total Market Value versus Money Market Fund Assets/NDR Total Market Value
Figure 5.10 Top, S&P 500 Index; Bottom, NAAIM Survey Average
Figure 5.11 U.S. Household Asset Allocation
Figure 5.12 Top, Dow Jones Industrial Average; Bottom, Consumer Confidence (Conference Board)
Figure 5.13 Top, S&P 500 Index versus “Normal” Valuation; Bottom, S&P 500 Index, Percentage Over- and Undervalued
Figure 5.14 Top, S&P 500 Index; Bottom, S&P 500 Median Price/Sales Ratio
Figure 5.15 NDR Multi-Cap Institutional Equal-Weighted Equity Series with Large and Small Cap P/E Valuation Methods
Figure 5.16 Top, Value Line Geometric Index; Bottom, Value Line Median Appreciation Potential (Percentage)
Figure 5.17 S&P 500 Price/Earnings Ratio (Normalized Earnings)
Figure 5.18 Top, DJIA; Bottom, DJIA Price/Book Value Ratio
Figure 5.19 Top, S&P 500 Index; Bottom, S&P 500 Price/Cash Flow Ratio Using NIPA Profits for Nonfinancial Corporations
Figure 5.20 Top, S&P 500 Stock Index; Bottom, Tobin's Q (Market Value/Net Worth)
Figure 5.21 Top, S&P 500 Index; Bottom, S&P 500 Price/Dividend Ratio
Figure 5.22 Top, S&P 500 Index; Bottom, Real Dividend Yield
Figure 5.23 Top, S&P 500 Index with Buy/Sell signals; Bottom, Leading Indicator Diffusion Index
Figure 5.24 Top, S&P 500 Index with New 52-Week Highs; Bottom, Percentage of NYSE New 52-Week Highs & New Lows to Issues Traded
Figure 5.25 S&P 500 Index versus Volume Supply and Demand with Spread
Figure 5.26 Top, S&P 500 Index with Buy/Sell Signals; Bottom, Big Mo Multi-Cap Tape Composite (Signal Basis)
Figure 5.27 Dow Jones Industrial Average and NYSE Breadth Indicators
Figure 5.28 Financial and Utilities Relative Strength versus Bear Markets
Figure 5.29 S&P 500 and S&P 500 Financials Divergences
Figure 5.30 S&P 500 Index versus AMEX Securities Broker/Dealer Index
Figure 5.31 S&P 500 Index over the FOUR-YEAR Presidential Cycle (1929–2013)
Figure 5.32 Potential Impact on Growth from Total Credit Market Debts (All Sectors, as a Percentage of GDP)
Figure 5.33 Potential Impact on Growth from Net National Savings (as a Percentage of GDP)
Figure 5.34 Household Balance Sheet Items as a Percentage of Disposable Personal Income
Figure 5.35 Stock Market Capitalization as a Percentage of Gross Domestic Income
Figure 5.36 Nonfinancial Corporate Debt as a Percentage of GDP
Figure 5.37 Government Debt (Federal, State, Local) plus GSE Debt as a Percentage of GDP
Figure 5.38 Government Debt: Its Growth Rate and the Cost of Servicing It
Figure 5.39 Potential Impact on Growth from Household Debt Service Ratios
Figure 5.40 Total NOTIONAL Derivatives
Figure 5.41 Commodity Indices
Figure 5.42 Top, Consumer Price Index (Year-to-Year Change); Bottom, ISM Supplier Deliveries Index
Figure 5.43 Top, Consumer Price Index (Year-to-Year Change); Bottom, Average Hourly Earnings of Production and Nonsupervisory Workers (Year-to-Year Change)
Figure 5.44 Top, DJIA with Buy/Sell Signals; Bottom, Real Money Supply (M2) minus Industrial Production (Year-to-Year Changes)
Figure 5.45 Top, S&P 500 Index; Bottom, National Financial Conditions Index (NFCI)
Figure 5.46 10-Year Constant Maturity Treasury Note Yields (since 2007)
Figure 5.47 The Birthrate versus Real Stock Prices

Chapter 6

Figure 6.1 Total Population Growth by Country between 2013 and 2050
Figure 6.2 Median Age by Country
Figure 6.3 World Population By Age (as a Percentage of Total Population)
Figure 6.4 2013 Fertility Rates by Country
Figure 6.5 World Population Growth by Age Group, 2013–2033
Figure 6.6 U.S. Population by Age Group, 1980 versus 2016
Figure 6.7 The U.S. Stock Market and a Maturing Population
Figure 6.8 Financial Assets of Households by Type of Asset

Chapter 7

Figure 7.1 U.S. Energy—Production versus Consumption
Figure 7.2 U.S. Energy Production by Fuel
Figure 7.3 U.S. Energy Consumption by Fuel
Figure 7.4 U.S. Petroleum Consumption versus Production
Figure 7.5 U.S. Energy Consumption by Sector
Figure 7.6 U.S. Transportation by Energy Source
Figure 7.7 U.S. Oil Resources
Figure 7.8 North American Shale Plays, May 2011
Figure 7.9 U.S. Crude Oil Production, Onshore versus Offshore
Figure 7.10 U.S. Shale Gas Production
Figure 7.11 U.S. Corn Production Devoted to Ethanol
Figure 7.12 Standards for Volume of Renewable Fuel, 2008–2022
Figure 7.13 U.S. Gasoline Stations
Figure 7.14 U.S. Fueling Stations by Type of Fuel Sold
Figure 7.15 State-by-State Maps of Electric, LNG, CNG, and Ethanol Fueling Stations
Figure 7.16 U.S. Alternative Fuel Consumption
Figure 7.17 Energy Density Comparison of Various Transportation Fuels (Gasoline = 1)
Figure 7.18 U.S. Average Retail Fuel Prices
Figure 7.19 Moving 12-Month Count of U.S. Vehicle-Miles Traveled
Figure 7.20 Driving from Ned's House to Savannah, Georgia: Lexus versus Tesla
Figure 7.21 Driving from Ned's House to Orlando Magic Game: Tesla Model S versus the Fit and the Leaf
Figure 7.22 Natural Gas Consumption by Sector
Figure 7.23 Natural Gas Consumption in the Transportation Sector
Figure 7.24 Electric Power Net Generation by Energy Source (as a Percentage of Total)
Figure 7.25 Coal/Natural Gas Ratio versus Natural Gas Utility Usage
Figure 7.26 Electric Utilities Capacity Utilization, Capacity Growth, and Real GDP Growth
Figure 7.27 Saudi Arabian Oil Reserves
Figure 7.28 U.S. Natural Gas Resources
Figure 7.29 Map of Basins with Assessed Shale Oil and Shale Gas Formations, May 2013
Figure 7.30 U.S. Petroleum and China Goods Deficits
Figure 7.31 Federal Government Budget
Figure 7.32 Top, Trade-Weighted U.S. Dollar; Bottom, U.S. Federal Government Budget
Figure 7.33 GDP by Industry as a Percentage of Total GDP
Figure 7.34 Composition of U.S. Manufacturing Activity, 2013
Figure 7.35 World LNG Estimated November 2013 Landed Prices
Figure 7.36 U.S. Natural Gas Production versus Natural Gas Rig Count

Foreword

TIM HAYES, CMT
JOE KALISH
LANCE STONECYPHER, CFA

We knew nothing about sleepy Venice, Florida, and only one of us knew about the investment research company that Ned Davis started in 1980. Tucked away on a quiet street near a tired strip mall that had been ravaged by a tornado a year earlier, NDR's two small houses appeared sparsely occupied when we started in 1986. The company employed about 15 people.

As we gradually learned about computer-threatening lightning strikes and other surprises of working in southwest Florida, we also started to learn more about the founder's philosophy and approach to investing. Knowing little about market behavior, we listened to Ned carefully as he pored through his chart pile at weekly research meetings, anxious about the inevitable market questions that he would fire our way.

It wasn't long before our minds started filling with phrases that to this day remain crucial to successful investing: Don't fight the tape, don't fight the Fed, and beware of the crowd at extremes. We learned about behavioral finance long before it became a common term in the investment world.

While Ned would employ his red pen to raise questions about our research, he would also use it to circle data points in the past with similarities to market conditions of the present, in the process demonstrating the importance of understanding history. Along with his emphasis on clean data and historical analysis, Ned stressed reliance on indicators and composite models to support an investment approach that's objective, flexible, disciplined, and risk aware. His tenets would come to be known as Ned's Nine Rules of Research, which he discusses in the first two chapters of this book.

Ned has always encouraged independent thinking. Even early on he was open to whatever market calls we wanted to make as long as they were supported by the objective weight of the evidence. As the firm expanded, Ned encouraged and enabled us to expand our respective research areas and develop our strategy teams, all the while producing commentary and research tools based on his research guidelines. These guidelines helped us navigate through three decades of bull and bear markets, economic expansions and recessions, peacetime and war, euphoria and panic, and bubbles and crashes. We learned that market survival requires humility and respect for an entity—the market—that demonstrates an amazing ability to surprise, time and time again. Ned has often called investing “a game of making mistakes,” adding that “the difference between the winners and the losers is that the losers make the big mistakes while the winners cut their losses short.”

In terms of size and global recognition, the NDR of today bears little resemblance to the NDR of 1986. Now in a bigger facility, the Venice office employs more than 100 people, with nearly half in research. Sales offices can now be found in Boston, San Francisco, Atlanta, and London, and service a client base of more than 1,200 client firms in 43 countries around the world. From the early days when the product consisted of a printed chart book and Ned's comments on a recorded call, it has expanded to include a custom research team that builds indicators and models for clients, plus nearly 20 different authors covering macro and market conditions, commodities and currencies, sectors and sub-industries, ETFs, and individual stocks in countries around the world.

The breadth of topics and depth of coverage are exemplified by the last two chapters of the book, in which Alejandra Grindal discusses the implications of demographic changes and John LaForge focuses on prospects for U.S. energy independence. Loren Flath, who joined NDR even earlier than we did, explains in Chapters 3 and 4 how NDR's technology developments have supported the evolution of our modeling and research efforts.

Certainly a lot has changed since we started in 1986, such as the proliferation of data available over the Internet. But what hasn't changed is the time-tested research philosophy that Ned discusses in the pages that follow. It has continued to underpin the product development and analysis that has kept us on the right side of major market moves and investment themes.

Preface

Why write a new edition of Being Right or Making Money?

The short answer is that I always feel that I can improve my work. However, though I have updated the philosophy chapter from the previous editions with some new facts and quotes, the only major change is the evolution of my belief that the most successful money managers are risk averse. While it might seem that many of the big winners since 2000 have been risk takers, I still contend that those who consistently succeeded were successful risk managers.

This book is mostly about making money, but that is not my only focus. I try to understand the world and educate myself about the issues affecting it. I have thought about a quote from Eleanor Roosevelt many, many times. She said, “Great minds discuss ideas, average minds discuss events, small minds discuss people.” In that spirit, I spend much of my time researching and learning about ideas. Among my current passions: new research data, techniques and indicators, energy fracking, health care and biotech, demographics, the Middle East and other areas of geopolitical conflict, the implications of fascinating new technology in cars and electronics, secular trends, the European Union, debt problems, and domestic politics. So many factors can impact the economy and investments.

I'm fortunate that I no longer need to work to make a living, but I still find it exhilarating to be paid to continue my education and stimulate my mind. I am so grateful. This is a fascinating business! My hope is that this book will inspire discussion about important issues, such as demographics, the energy revolution, and potential investment risks.

Acknowledgments

While the 45 years I have dedicated to my work have been very fulfilling, much of my joy comes from my family: Mickey, Evan, Ben, Brody, Dylan, Connor, and Lisey.

I am fortunate to be surrounded by talented and dedicated colleagues at Ned Davis Research, but I want to offer special thanks to my extraordinary team: my executive assistant Leslie Kahoun; my senior research assistant, Loren Flath, who was largely responsible for building the models described in Chapters 3 and 4; my research assistants Stephanie O'Brien and London Stockton; and Julie Meyers, who also helps edit my work.

Thanks to two of our outstanding up-and-coming strategists—senior international economist Alejandra Grindal and commodity strategist John LaForge—for authoring Chapters 6 and 7.

There are now more than 100 employees at Ned Davis Research. We are dedicated to quality products and customer service. I appreciate all their efforts and support.