Rearview Mirror Investiing

Overly bearish investors are focusing too much on what was wrong with the economy, and are failing to look ahead. Economic data have been getting worse for eight, nine months, even years by some measures, like housing data. This is not news.

What is news is the fact that the stock market has had one of its biggest three-month rallies of all time since the March lows, and there are tons of people who almost blindly assume that the market now has to go lower. This is a common reaction to rising stock prices after a major bear market. But such persistent bearishness in the face of rising stock prices is an emotional response, not an entirely rational one. The emotional wounds inflicted by last year's vicious market declines will be slow to heal. Such declines have only been seen or approached three other times since 1929, and each time the market rebounded, it took many years to get back to the previous highs. In fact, some investors exited stocks during these bear markets never to return. We've probably all heard the stories of people who, in the 1950's, proudly boasted having significant amounts of their net worth in cash in order to avoid another impending crash. By the mid-1950's, after 25 years since the crash of 1929, the market had still not reached its old highs...yet it had rallied seven-fold from its lows reached in 1932. An historic opportunity, missed by those who were looking in the rearview mirror.

By no means is the economy in great shape right now. All the talk of "green shoots" is about enough to make one sick. However, the market has risen over 40% from its March low for some reason, and those reasons were by no means apparent when the market was selling off to its lows the first two months of the year. Likewise, now it is not apparent what catalysts will drive the market lower or continue to push it higher in the months ahead. Investing is a game of allocating money with incomplete information, and once we admit that we do not know how the market will react to future data, or even what that data will be, then we can get down to making money.

What matters right now is that the market is going up. There are still problems in the economy that may come home to roost later this year and next (consumer credit, commercial real estate, future inflation), so we must avoid becoming pollyannas. However, it is irrelevant whether I or you or any individual thinks the market will go up, down, or sideways, because the market itself is much more powerful than any of us individually. So we must understand what the market is saying. We may conjecture that the reasons for the rally are increased liquidity, attractive valuations, performance chasing, a bottoming in the economy, growth in the emerging markets, or whatever other "glass-half-full” arguments we can come up with. What we cannot argue about, however, is the price itself.

The current uptrend from the March lows is likely to continue, and all dips are likely to be bought. Once the uptrend is broken, and in time it will be broken, the pundits can dust off those bearish arguments once again. For now, the market continues to rally and the trend remains up.

Cognitive Dissonance vs. The Trend

You want to make money trading stocks. You have a decent system that makes money if you stick with your plan. Great. But sometimes you get that feeling of not being anchored, like you are just wandering in the woods. You are not necessarily lost – it’s just that the path has become a tad overgrown, covered with leaves, a bit more difficult to discern than before. Suddenly your trading begins to suffer, you take some losses, and, because you are a wise manager of risk who’s in it for the long haul, you realize that you are out of your element, so you exit all of your positions and take stock of what’s going on.

So what happened? Once you are out of all of your positions and you are back safely in the bunker, you take a look at your trades and have that inevitable ‘Aha! …duh’ moment. What you find is that you were trading your plan nicely in the beginning of the trend, but as the trend became further entrenched, the momentum got the better of you and you really didn’t stick to your strategy at all those last few trades. In fact, at the very end there you were trading like a complete amateur, you now see. “How could I be so stupid! Am I just an amateur,” you ask yourself. Now you’re in a bad place, questioning your abilities. Your confidence is shot.

Relax. Take a deep breath, do a few Stuart Smalley affirmations, and shake it off. Take another look at what went wrong. It was not your core strategy that was the problem – what screwed you up was your failure to stick with the plan. “If I had only” is all-too-common a refrain in discussions about investing. So why do we sometimes stray? The reason is that a person’s identity tends to become defined by their philosophies and actions – we therefore rationalize in order to maintain our view of ourselves if our ideas and actions are no longer functional in reality. I apologize for getting all Psych 101, but this is important stuff. This phenomenon is called cognitive dissonance, and it is crucial that all investors and traders understand its influence in order to succeed.

In no uncertain terms, cognitive dissonance can destroy your portfolio. You can rationalize your trades until your account is at zero. Take the example of big holders of GM. Let’s take the man who is 65 years old, bought GM in 1969 when he got his first real paycheck at age 25, and added to his shares every year until he was 60, reinvesting the dividends in new shares of the stock all along the way. He picked up a few other household names along the way, but GM would always be his first, his true love, his one and only. His GM position is now part of who he is – he’s had the stock for two-thirds of his life, longer than his kids have been alive. He has been married twice, has seen his four children grow up, get married, and have children of their own. He has seen the world change in ways he could hardly imagine in the last 40 years: he has seen three hot wars and one cold war in his country, he has witnessed the frightening and murderous consequences of the convergence of technology and terrorism, and he has seen the amazing advent of internet technology bring people together from across the globe who may never meet in person. And through it all, his GM stock has been there by his side. True, the stock has vastly underperformed the S&P and the Dow since he has owned it, but after the dividends he’s done okay. He has amassed 43,892 shares over the years. GM is part of who he is. So how does he react when the stock plummets 70% from 1999 to 2003? “Oh, well, I’m not worried,” he says. “It did the same thing in ’74 and was back near its highs in two years.” What about when the stock drops another 50% in 2008? “Buying opportunity of a lifetime, if you ask me.” And when it’s down another 50% and the company goes hat in hand to the government for a bailout? “They certainly can’t go bankrupt – it’d destroy the economy. And people still buy cars, anyhow – I see ‘em on the road every day. Don’t you? I’m sticking to my guns.” And on June 1, 2009, when…well, you know what happened last Monday.

…Painful, sad, and completely avoidable.

For some real-world examples of cognitive dissonance in action, let’s take a look at a few during the emerging bull market in 2003. The market had just suffered two years of declines after the biggest bubble in two generations burst into flames, sending the NASDAQ down nearly 80% from its highs. By May 2003, the market was trading in a wide 10-month range but had recently rallied over 15% since making a higher low eight weeks before. All of the major market indices had crossed above their 200-day moving averages by mid-April with the NASDAQ leading the advance. A Business Week interview with Comstock Capital Value Fund’s manager, Charles Minter, from May 7, 2003 reveals a disbelief and rejection of the emerging rally. Since Minter’s fund operated much like a hedge fund, so he was not forced to be a perma-bull, as he could short or buy puts as well as go long – he willfully chose to be in the bear camp at that time. Minter cites a bunch of fundamental reasons why the market should go lower (p/e multiples, job losses, low capacity utilization rates), never mentioning the super-bullish technicals that had recently emerged. He actually was right on his view of technology stocks, which he said would offer the best opportunities once the bear market was over. …And yet he proudly proclaims being short CSCO, IBM, INTC, KLAC, LLTC, and BRCM right in the middle of super-strong uptrends. Clearly Minter lacked the necessary tools to determine when the bear market had in fact ended. Regardless of this fact, he knew that these stocks had risen dramatically from their lows and that the broader market had resumed rallying after it failed to break down in early-March when it neared its bear market lows. And he knew that tech stocks – the very sector he was short – were outperforming the market since the lows. So the reality on the ground, by which I mean the prices of his stocks, was telling him that he was wrong, but he identified so strongly as being bearish that he was unable to adapt to the new reality, and rationalized away using flawed analysis of how the market would react to certain fundamentals. This is cognitive dissonance at its worst.

For full disclosure, having been in the financial business for a whopping two whole years at the time of the Minter interview, I was in the bearish camp too. “Every significant rally has been sold for the past two years, so why should this one be any different?,” I thought. I was short into June 2003 after the S&P had rallied 30% off its bear market low – that was the first time I learned about cognitive dissonance firsthand in the market, and I will never forget it.

Another example of cognitive dissonance can be found here in a newsletter by CPA Tim Wood, of FinancialSense.com, found later that same year. The piece was written on November 14, 2003, after 13 months of rallying and a 35% gain off the bear market low in the S&P500. In the newsletter, Wood talks at length about cycles, Dow Theory, market cycles, etc., and gives a brief summary of some historic trends going back to the 1920’s. Although lacking focus, there is some useful stuff in his comments. However, after carefully reporting what happened in the past, his argument boils down to an emotional response to the prior bull market and subsequent collapse, as he declares, and this is verbatim, “There is simply no way that a bull market advance of 2,061% that took some 26 years to complete was corrected in 3 short years. NO WAY!” …Who were you trying to convince, Mr. Wood – your readers, or yourself? The S&P then rallied another 10% in the following weeks, and never saw the November 14, 2003 level again until after it rallied a full 50% from the time of the newsletter piece. Cognitive dissonance strikes again.

The good news is you know how powerful, and dangerous, cognitive dissonance can be. You can now spot it in yourself and step away from the market when you recognize it. So when the current bear market is over, don’t fight it. Whether you use the 200-day moving average, the level of the prior bear market rally high, a weekly moving average, or whatever, to determine that the bear market is over, do yourself a favor and respect the new long-term uptrend. Same thing goes on the downside. If this market slices below the 50-day moving average after a false breakout above the 200-day, respect that emerging intermediate downtrend. Remember that the market does not have to do anything. It does not have to go down because the economy still sucks. It does not have to go up because the government is expanding the money supply. All the market has to do is open at 9:30 in the morning and close at 4 in the afternoon Monday through Friday. The market is the aggregate vote of all market participants averaged into one neat closing price each day, and unless you can personally affect where the market goes, you must respect the trend in order to trade successfully.

The Solution to All of Your Investing Troubles

Want a quick answer to solve all of your investing troubles? Know your frame of reference. That's it.

No matter what you are doing you must always operate within a frame of reference, a system, in order to succeed. Investing in stocks is no different. However, since there are so many moving parts that affect the stock market, it can seem futile to discern how to invest for absolute return. With the advent of ETFs, it is no longer necessary to wring your hands trying to find an adviser who will perform in line with the overall market or the sector of your choice. You want exposure to the overall US equity market? Buy SPY -- end of story. You want exposure to big cap technology stocks? Buy QQQQ -- no questions asked. You want exposure to solar stocks? Buy TAN.

However, if you want to achieve positive annual returns regardless of how the overall market performs, buying and holding ETFs won't cut it. What you need is a system, a methodology for allocating your money. Investing based on fundamentals is an attractive proposition at first, as it feels like the right thing to do. You do your 'homework' on a stock, check the recent 10-K filings, read a few analyst reports. That way, when you've lost 40% on your investment you can safely tell yourself, "Well at least I bought the company with the lowest P/E." Let's face it: most of us are not accountants, financial analysts, or Warren Buffett. Unless you fall into one of these categories, leave fundamental analysis for the pros.

Technical analysis, which is simply the study of the movement of price, offers both a simpler and more effective solution to the investing puzzle. After all, you invest, not to look smart or feel good about yourself, but because you want to make money, right? Right. So, in order to benefit from the movement of the price of a stock, you must study the movement of its price. There are various ways to accomplish this, but inherent in all successful investing is an understanding of price trends.

All stock market players are trend-followers in on way or another. The day-trader may 'tape-read' and try to jump ahead of a perceived large buyer in hopes of exiting after the price has trended up a few ticks. The hedge fund manager may short the housing stocks because he believes they are still fundamentally overvalued -- his hope is to cover his short positions after the sector has trended down 15%. And the long-term value investor may buy Chinese stocks even while they are declining, because he hopes to profit from a multi-year uptrend in the stocks that may not have even started yet. The distinction among investing strategies lies in the timeframe traded and the phase of the trend which each strategy targets.

So what timeframe should you trade? What part of the trend should you focus on? The answers to these questions depend on your personality, level of commitment and amount of time you can devote to investing, how much risk capital you can use, and what your goals are in life. If you are an owner of a small business and work 14 hours a day, have three young kids, hate risk-taking, and want to buy that dream house that you and your wife have had your eye on for the past 15 years, day-trading penny stocks is not the best use of your time...but perhaps investing in the S&P500 using month-long trends would suit you. If you are 65 years old, retired, living on a fixed income, and want to travel the world, buying and holding Indian stocks for their 20-year growth prospects makes little sense for you...but trading several-day cycles a few times a month may be a great match for you. If you are 29 years old, aggressive, and cannot stick with a trade for more than a few days, stop investing in utility stocks for the dividends -- day-trading could be your calling.

Because you are human (with the exception of the internet bots reading this), you must understand that your humanness is a liability when it comes to making money investing in stocks. Our emotions control much more of our decision-making than any of us would like to admit. You must therefore set yourself up to win by putting yourself in situations where you are in your element and have confidence. This is why it is crucial to know yourself and know your life goals. Once you understand these things about yourself, your humanness becomes an asset when investing.