What Matters Most When Investing – Part I

The stock market is a mysterious beast to those who do not study it. Correlations between stock prices and everything from the economy to lunar cycles are drawn by those wishing to divine some sense of the movement in stock prices. At times there appear to be very clear correlations between the stock market and another asset class, such as the dollar or US treasury securities. However, in the long-term these correlations invariably break down and leave people wondering why.

The market’s behavior is so confounding that many have subscribed to the ‘random walk’ theory of the markets, which states that price movements in stocks have no discernible pattern. The biggest detractor from this hypothesis is the fact that the stock market as a whole does display price patterns and trends that repeat over and over. The random walk theory was devised before ETFs and index funds existed, so it is somewhat forgivable. However, fortunes are made by the best trend-followers, even in years like 2008. In fact, a fund run by consummate trend-follower John Henry, who is also owner of the Boston Red Sox, was up 91% last year.

The problem with trying to determine why the market is moving a particular way is that it is a fool’s endeavor. There are simply too many factors that affect the market for one to accurately evaluate and anticipate in a given week, month, or year, and much less to do so in a repeatable fashion. In very short timeframes, such as a few hours, it is possible to trade profitably based on news and asset correlations. However, even such short-term trading is difficult, as news and events are now reported and disseminated so quickly that anything not anticipated can ruin a week’s worth of profits in a matter of hours.

Instead of asking why the market is moving as it is, consider looking simply at how it is moving. That is, look at the trend of price movement as divorced from all other factors, and you will have a much better understanding of how to profit in the stock market. The underlying trend for the past 200 years is clearly up. However, there have been periods of significant multi-year declines throughout. In the past decade, stocks have produced about a 0% return before dividends, but the S&P500 rose over 100% between late-1996 and 2007, then retreated over 60% by March 2009. There is ample opportunity to profit during such times, and there will be many more such opportunities in the future.

Stay tuned for a primer on technical analysis tools and how to use them at the appropriate time.

The Bears' Dilemma

The S&P500 and NASDAQ have both met the three conditions necessary to confirm a new primary uptrend, as per my last post. The intense rally from early March to early May had the appearance of a bear market rally, as it was sharp, volatility remained high, and there was very little backing and filling. However, two months of consolidation led to a resurgence of buying in mid July, and the indices confirmed their new primary uptrends by breaching their prior highs and rallying so hard that their 200-day moving averages began to slope upward.

The upslope of the 200DMA is key, as it had been in decline for 18.5 consecutive months until mid July. This shows a major long-term shift in buying patterns from market participants. As the primary uptrend matures, very likely there will be periods of sideways movement and intermediate-term downtrends. However, most of the time the market is likely to be in rally mode, as long as it remains above its 200DMA.

There are headwinds aplenty that will constantly challenge the uptrend. A major shift, and new trading challenge, that has taken place in the market since last Fall is the speed with which the market moves. Timeframes, which had already been shrinking before the Crash of ’08, have since become so short that moves that would previously take a year or longer are now happening in a matter of weeks. The March-June period produced the largest rally for such a short timeframe since the 1930s. The more recent rally from the July low to the August high in the S&P added 17% to the index. For some perspective, the entire range of trading for all of 2007 was only 15.5%.

With such extreme moves in such a short amount of time it is understandable that investors do not feel comfortable putting money to work in the market. Such sharp moves indicate an underlying instability in the market, which likely means that, at least in the next few months, the market may continue to move in fits and starts. The days of clean, non-volatile uptrends are not likely to return for some time.

Another ‘headwind’ to the market rally is the fundamental picture. This is not a true headwind, however, as the fundamentals are already known to be generally bad, which has already been priced into the market. As a very intelligent and insightful market commentator writes, “Technically, all my charts are damn Bullish! But for reasons I’ve been noting for years, I just can’t believe what I’m seeing is real.” This commentator is expressing the precise emotional state that occurs when a primary trend has changed direction: disbelief. The commentator goes on to declare himself a “big bad Bear.” This self-identification is pointless and quite damaging, as it fails to account for the fact that equity markets are smarter than individuals in the realm of discounting future economic conditions. When will such a person shed himself of his bearskin? Most likely when every piece of the economic puzzle is perfectly in place, and the market has been making new highs for years.

The Bears’ dilemma right now is understandable. The fundamentals have been frighteningly negative until recently, and there are huge problems, such as commercial real estate refinancing and a ballooning balance sheet at the US Treasury, that leave one wondering if the US economy will be able to right itself sustainably any time in the next few years. However, the stock market rallied over 50% from its lows in the face of these and other troubling fundamentals. How is this possible? Answer: these bad fundamentals are YESTERDAY’S NEWS. The market cares not about what has already happened to the economy, but rather what lies ahead. What is difficult for many to swallow, especially those with the burden of knowledge about the economy and financial markets, is the fact that the market is smarter than any given individual, as it represents the aggregate of all market participants’ analysis of where the underlying fundamentals will be within six months or so.

It is true that banks are failing on a weekly basis. It is true that home foreclosures are at historically high levels. It is true that the US government has borrowed a frighteningly large amount of money from foreigners in order to save its banking system. However, the stock market sees something in the future that has it excited. It could be the fact that short-term interest rates remain at record lows and the yield curve is the steepest it has been since the beginning of the last economic expansion in 2003. Perhaps it sees the government bailout of the banking system as an impetus for lenders to take on additional risk and make new loans. Maybe it is the combination of all of the Fed’s liquidity programs that has the buyers back in control. Or it could be the replenishment of company inventories that the market is anticipating.

The end result is that it matters very little what the causes are for a market to shift long-term primary trend direction. What is important is the fact that it does so at all. Indeed, the market is already looking past the coming improvement in fundamentals to the next stage of the economic recovery, the stage where the economy either takes off in a ‘V’-shape, flattens at a low level of growth, or retracts again creating a double-dip recession. It is a distinct possibility that the market may even sell off on the coming good news if it is not good enough. On August 18th, for example, when Japan reported that its GDP grew 0.9% in the second quarter versus the first quarter, the NIKKEI spent half the day in negative territory and finished with only a mild gain of 0.15% for the day. After four straight quarters of GDP contraction, one would think that the report of growth would have produced a fantastic rally. However, this news was already discounted by the market, as the growth rate was in line with consensus expectations. So, even if US GDP advances in the third quarter, a sell-off in the market would be likely if the advance were significantly lower than anticipated.

Price trends defy human logic, as they at times persist despite currently known data at odds with the trend. This is because market participants buy and sell with the intent of correctly determining where the economy and financial markets will be at a certain point in the future. However, such information about the future is always incomplete in a free and open market, and therefore, as price trends are self-reinforcing due to humans’ herd mentality, markets almost always overshoot to the extremes in shorter timeframes. Therefore, it is likely that the market’s advance over the next few months will be characterized by intermediate sell-offs, improving fundamentals, and plenty of bearishness among market commentators.

How Bear Markets End

It is significant that just about anyone can spot a bear market after it has happened, but few have a methodology for defining what a bear market is, when it has begun, and when it has ended. Given the duration and severity of the declines in the current bear market, it is appropriate to analyze methodologies to determine when the bear market has ended and a new bull market has begun. You can find some of my material on the subject of bear market completions at Stockbee.blogspot.com – just do a search for my name in the ‘Search Blog’ field.

A successful methodology must simply catch the long-term shift from primary selling to primary buying by market participants. Because historic average volatility remained much lower than current levels for many years, the old definition of the start of a new bull market, any increase of 20% or more in a market, is not appropriate in the current high-volatility environment. Under the old definition, there have been three new bull markets since last October – clearly another methodology must be used in order to be useful in the real world.

So what is a good indication that the pendulum of the market has swung from down to up? First we must define the timeframe of the trend on which we wish to focus. Are we talking about a daily timeframe? Weekly? Yearly? To talk of trends at all is without meaning unless a timeframe is specified. We will focus here on the long-term timeframe, which covers the one- to two-year period. In analyzing the major bear markets since 1929 – the 1929-1932 Great Depression bear market, the 1973-1974 Vietnam War/Watergate bear market, and the 2000-2002 Tech Bubble Bursting bear market – several key factors have defined the end of long-term bear markets.

The first element is the market trading above a long-term moving average: the 200-day moving average. There is nothing inherently magical about the 200 DMA, but it does represent the average price of a relatively long timeframe (about 10 months of trading), and has proven to be a reliable tool in defining whether the market is trending up, down, or sideways. When using the 200 DMA, two things are important: the market price relative to the 200 DMA, and the slope of the 200 DMA. The market may break above the 200 DMA and remain above the moving average for days, or even weeks, as happened from August-October 1932, October 1973, and March 2002, while not changing the downward direction of the long-term bear market. However, once the slope of the 200 DMA has turned up and the market has crossed above the 200 DMA, each time, among the bear markets mentioned, the market has seen subsequent significant gains over the following months and years, and the bear market lows were not breached thereafter*.

The second element to define the end of a bear market is the ability of the market to breach the high point of the previous significant rally. This can only be accomplished when there is greater pressure from buyers versus sellers in a sustained trend. Clearing a prior high also means that everyone who bought and held since the prior high has made money – this tends to give market participants more confidence, so they continue to allocate more money to the market, thus reinforcing the new uptrend. Until the market successfully breaches a prior high, there is no way to know if the upward momentum is likely to continue, as the market’s strength has not yet been tested. Therefore, a new bull market, by definition, cannot take place without the market first trading above a prior rally high.

So, armed with this knowledge of bear markets, where does the current market stand in the long-term trend? Well, the S&P500 cleared the 200 DMA on June 1st by a margin of several percent, but the 200 DMA remains in a downward slope – strike one. In June, the S&P500 also tested its prior rally high made in January. However, after failing to close above the January high by more than a couple of points, the index then dropped 9% over the next few weeks – strike two. No new bull market there.

And how about the NASDAQ? In late-April, the NASDAQ breached its prior rally high made in January, and has remained well above the prior high ever since – first test passed with flying colors. In late-May it then breached its 200 DMA and has also remained well above the moving average ever since. However, the slope of its 200 DMA, like that of the S&P, is still pointing down – the bull market has not yet been confirmed.

So the US equity markets remain in long-term bear trends. Although the groundwork has been laid for the next bull market, it will likely take at least several months before a successful attempt at breaking the bear trend will occur. Currently at 883, even if the S&P500 stays in a range between 850-1000 for the next two months, the 200 DMA will only begin sloping up sometime in September at the earliest. Therefore, although it has had a run for its money, the bear market remains alive and is likely to remain the primary long-term trend for the foreseeable future.

*The 2002 lows were in fact breached in the current bear market, but not before the market rallied 70% after the 200 DMA began sloping upward.

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.