by Martin Zweig
If the Super Model were on a buy signal, launched at 6 points or greater, but had deteriorated later down to 4 or 5 points, the buy signal would still be in effect, but the risk-averse investor might feel a bit queasy about remaining 100% invested when the model was in neutral territory and falling. If so, that investor ought to do a bit of selling. There’s an old saying that one should “sell down to the sleeping point.” That’s not a bad idea in a situation like this.
On the other hand, say that the Super Model had previously given a sell signal at 3 points, but over some period there had been some improvement in the model up to the 4- or 5-point region. Some investors at that time might feel uneasy about being 100% invested in Treasury bills and might rationally want to own a stake in the stock market. I wouldn’t advise, of course, going 100% invested, but going one-third or one-half into stocks at that point might be sensible. Again, choose the alternative that makes you comfortable, as long as it makes sense according to the Super Model.
CHAPTER 7
Fighting the Tape—An Invitation to Disaster
Ican’t overemphasize the importance of staying with the trend in the market, being in gear with the tape, and not fighting the major movements. Fighting the tape is an open invitation to disaster. Let me give you an example. As an investment advisor I live in a glass house, so I’m not about to throw stones at any of my competitors. Therefore, I’d rather not mention this other advisor’s name: We’ll just call him Sam. Sam writes a market letter and, on a few occasions in the 1960s and early 1970s, had gone haywire by fighting both major bull and bear markets. But like many of us, he has had his share of successes and, beginning in 1975, got on a hot streak. For several years Sam called numerous market turns correctly, most of them intermediate swings. He picked up a large following and his business boomed.
During the early eighties Sam turned bearish. In the summer of 1981 the Dow fell about 200 points and Sam looked like a genius. As prices fell, Sam grew ever more bearish. In an interview in a major financial publication in early 1982 he predicted vastly lower prices for the Dow Industrials and for the market. A reporter asked Sam how he would know if he had been wrong in his prediction. Sam answered, “If the Dow were to rally one hundred points I would be wrong and I would change my prediction.”
Sam’s thinking was actually pretty good at that time. A 100-point Dow advance then would have been roughly 12%. That’s much higher than our 4% rule, but Sam was looking for the major trends, and giving up that much in a possible forthcoming bull market wouldn’t have been bad at all. Sam could have turned bullish just 100 points from the bottom and would have gotten back in gear with the tape, even though he would not have called the precise low. A noted trend follower, Sam had said on many occasions, “The market is like a train and I am the caboose: I simply follow the train.” Again, excellent advice.
In August 1982 interest rates fell sharply and suddenly the market bolted ahead, rising some 38 points on August 17. In just six market days, from its low of 777 on August 12, 1982, the Dow had surged to 891, a whopping 114-point advance. That was the sign for Sam to follow his own advice. Had he done so, he could have told the world later that he turned bullish just six days after the bear market bottom. True, he would have missed the first 100 or so points, but that was small potatoes compared to what followed.
By October 1983, less than fourteen months later, the Dow hit a temporary top of 1285. By following the trend, as Sam had once planned to do, he would have made about 400 Dow points. Moreover, the average stock during that period went up far more than the Dow. In fact, in the year or so that followed August 1982, stock prices had their greatest percentage advance in a relatively short period since the twin bottoms of the worst bear market, way back in 1932 and 1933. But Sam did not follow his own sound advice. As prices soared, Sam stayed bearish. He fought the tape and failed to remember that he was the caboose and the market was the train. Sam ran off the tracks.
Sam’s fatal flaw in this case is that he had a preconceived idea of where the market would go, and for a time he was right. When conditions changed—and they changed quickly—Sam refused to accept the new evidence and to alter his outlook accordingly. Instead, Sam began to search for shreds of evidence to support his bearish case. This is a very common trait of stock market investors. Psychologists would call it “selective perception.” One sees only what one wants to see.
Unfortunately, in the stock market, there is always some bearish evidence and some bullish evidence. You never have difficulties in unearthing clues to back your viewpoint. If there were a hundred stock market indicators out there, it would be highly unusual to have even eighty of them bullish at one time. In fact, if 80% of all the indicators were bullish at once, it would be an overwhelmingly bullish case. But a bear could hang his hat on any or all of the twenty indicators still giving negative signs. Sam chose the latter and made a mistake that just about every stock market player makes once or more in his lifetime.
It’s the kind of mistake that you should never make more than once. I’ve been there, too, having made the opposite error back in the bear market of 1974.I had turned bearish in the spring of 1972, virtually at the top of the bull market for most stocks. For two years I remained bearish most of the time, going bullish only on a short-term basis here and there and catching a few rallies. But in June 1974, for whatever the reason, I turned all-out bullish and had my head handed to me over the next three months.
I could argue that a year after I had turned bullish the market was higher. I could argue that I was not wrong, just “early.” I could stubbornly insist that I was right and the market was wrong. These are all common rationalizations among those who err. The fact is, I was just plain wrong. In the weeks that followed I sensed that I was wrong, I knew deep in my bones I was wrong, but my ego got the best of me and I was convinced that the bottom was close at hand anyhow. Instead of staying in gear with the tape and flipping back to the bearish side, I searched out indicators that backed my bullish stance. There were many of them at that time, and I was hooked on them. But the weight of the evidence was still bearish and I blew it.
My main mistake then was in ignoring the very bearish monetary conditions that prevailed. Determined not to go that route again, I then constructed several new monetary indicators that have since served me well. Even so, I made one more major mistake a year and a half later, in January 1976. This time I fought the tape on the upside, staying neutral and in a 100% cash position while the market rallied smartly for a couple of months. My mistake here was ignoring the powerful momentum of the market, and soon I did something about it. After in-depth research, I developed improved momentum and tape-following indicators, first using them individually and then, by 1978, putting them together into a model.
Since those days I absolutely and utterly refuse to fight a major trend in the market. I’ll simply move with the tape even if it means being whipsawed every now and then. As a result, I have not missed a major move since that time. Mind you, I’m not bragging, because I know I’m going to be wrong at times, but by following the tape I know I will not blow a major move. So, I’ve been there before, and I’ve learned from my lessons the value of staying in gear with the tape.
By contrast, Sam—and probably millions of other investors—had made those mistakes more than once and yet continued to fall into the same trap of fighting the trend. The market just doesn’t allow you that many mistakes before it brutalizes your pocketbook. Ignorance (yes, I plead ignorance for my earlier mistakes) can cause you to fight the trend the first time and perhaps the second, but to do so a third or fourth or fifth time is no longer ignorance when you have already suffered the consequences.
What causes the subsequent failures is ego. When you take the attitude that you’re right and the market is wrong or that your preconceived idea must be right no matter what the tape shows, you’re headed for big trouble. The market can humble any and all of us at any time. Your best protection is to stay in gear with the trend
. In other words, don’t fight the tape.
CHAPTER 8
Sentiment Indicators—When to Part Company with the Crowd
There’s an old story about the promotional genius P. T. Barnum. He was staging one of his famous sideshows and the crowd kept growing, finally reaching far beyond the limits of the relatively small tent. He couldn’t simply ask people to leave—that would be a faux pas equivalent to a waiter requesting someone to vacate a table in a restaurant. Finally, his brilliant mind came up with a solution. He put up a sign with an arrow saying: “This way to the egress.” Many in the crowd, anxious to view the egress, suddenly found themselves exiting the tent. Instead of enjoying more of the show, those who departed wound up outside looking in.
This is approximately what happens in the stock market when the crowd gets too large. The crowd tends to follow the wrong signs near the market tops and bottoms. Consequently, many investors find themselves outside looking in when the market surprises them and changes direction.
Here’s roughly how it works. Let’s start in the depths of a bear market. The economy is usually in a recession or worse, business profits are tumbling, and investors are punch-drunk from suffering huge losses during a year or two of falling prices. Bad news is making headlines; good news is not even a dream at this point. Conditions have been so awful for so long that most people can see nothing else but the downtrend continuing. It’s amid such doom and gloom that bear markets bottom and bull markets begin, meaning that the vast majority is wrong, precisely at the bottom.
Why? Well, with the economy collapsing, the Federal Reserve will usually begin loosening credit, and interest rates will start to fall precipitously. This gives stocks additional value as the competition from yields on cash equivalents falls. Typically, though, the economy has another six months or more left on the downside, and the worst results for corporate earnings usually lie ahead.
Even if Wall Street is correct in anticipating these lower profits, it can hardly equate them with higher stock prices. There seems to be some inborn reasoning in Wall Street that better profits mean higher stock prices, but this simply is not true in the aggregate. The best gains made in bull markets, as seen in chapter 5, tend to come in the first six months of a fresh bull market, when profits are usually declining. So, it’s difficult for investors to be optimistic when they’re staring at a terrible outlook for corporate earnings.
At this point investors and speculators have built up extraordinary cash reserves on the sidelines, partly because of the higher interest rates during a bear cycle and partly because the outlook is so gloomy that they prefer to hold cash rather than stock. Individuals and institutions have high levels of cash and little or no willingness to purchase stocks. Pessimism reigns. But when rates start to decline, that acts as a catalyst in generating buying power because cash coupled with lower rates is not as attractive as cash coupled with higher rates. Moreover, the sharp drop in interest rates will usually stimulate the economy six to twelve months down the road. The stock market is a discounting mechanism, always looking ahead. So the current profit scene is not nearly as important as that anticipated.
With declining rates the usual stimulus, prices begin to rally as a new bull market is born. Not only is there tremendous pessimism before this initial rally, but that first rally traditionally is not believed. During the previous bear market, several rallies started, only to bite the dust, leading to lower and lower prices later. So why trust the new rally in the new bull market, especially since it tends to be the most vigorous rally seen in the cycle? The thinking is that if prices rally even more than usual in a short period, they have that much more to fall back.
So, the shrewd investor, going against crowd behavior, has two clues near a bear market bottom: first, extraordinary pessimism among the crowd at the bottom, and second, continued skepticism and pessimism during the first sharp rally in the bull market. In bear rallies the pessimism usually fades rapidly since investors are very eager to want to believe in the rally, hoping that the old bull market is resuming. But at the bottoms of bear markets the crowd has been hammered too many times and regards the first true rally in the new bull market as an opportunity to sell. The crowd tends to be wrong at exactly the wrong time.
As a bull market proceeds and the rally fails to give way to a major decline, many investors find themselves shut out. Slowly they begin to believe that the move might be for real, and the thinking is, “I’ll buy on the next decline.” The problem is that the declines are never large enough to make people feel comfortable about buying. That’s because there are too many bears on the sidelines eager to get in.
When prices back off just a couple of percent, several of these bears begin to buy, prematurely ending the decline and not allowing the bulk of the bears the opportunity to buy at lower prices. This trend continues as the market goes higher and higher with only small sell-offs. Eventually, the number of bulls becomes greater than the number of bears and, to some people studying the behavior of crowds, that becomes a signal to sell.
The idea is that if you use contrary opinion, you should go against the majority. But that’s an oversimplification and certainly not true in the middle of a bull market. Just because 51% of the crowd is bullish and 49% bearish is no reason the market cannot go higher. In fact, it probably will advance at that point. The time to be wary of crowd psychology is when the crowd gets extraordinarily one-sided.
As the bull market continues to move higher, more and more people turn bullish. The flash point is really hit when the crowd has gotten so optimistic that it has used up the bulk of its cash. Cash represents firepower in the stock market. When it’s depleted, the ammunition to blast stocks higher is gone. About the best the market can do then is hold the line. If interest rates climb or some other undesirable fundamental factor appears, the market would be in serious trouble if the cash levels were low.
Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. The crowd anticipates higher prices, and it “knows” that even if a sell-off comes, it will only be another buying opportunity and eventually will lead to still further advances.
At the top, optimism is king, speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. A small rise in interest rates can easily be the catalyst for triggering a bear market at that point. On the first decline, pessimism does not pick up very much. Remembering the lessons of the bull market, people rush to buy on the decline, figuring that prices will bounce right back to new highs. But the first rally falters, doesn’t get very far, and fails to make a new high. The next decline comes and carries prices even lower.
Now people begin to get a bit nervous and the pessimism slowly rises. It takes numerous sell-offs over many months before the pessimism really picks up speed. At some point in the midst of a bear market, business conditions worsen and the pessimism grows and grows. It finally reaches the depths of pessimistic thinking when business conditions are terrible. Then we’re right back to the beginning of the cycle at the bottom of the bear market, when pessimism is at a peak.
Some people call the idea of monitoring the crowd and going against it the art of contrary opinion. It’s okay to use that term, but just remember that you don’t always want to go contrary to the crowd—you only want to do so when the crowd is extremely onesided. It’s not easy to define extremely. There are many ways to measure the sentiment of a crowd, but the exact percentage of bulls or bears on any one indicator needed to give a buy or sell signal varies considerably from cycle to cycle. There is no magic level of optimism or pessimism that gives precise signals. That may be frustrating but it’s a fact of life.
Nonetheless, by measuring a significant sample of crowd sentiment, ranging from the cash positions of individuals and institutions to the amou
nt of speculative activity in short selling or option trading or the purchase of new issues, you can get a rough gauge of the degree of optimism or pessimism prevailing. When the crowd does get extreme, you should at least be wary. You can then integrate the sentiment readings, as crude as they might be, with monetary and tape conditions and have a fairly good sense of the major direction of the stock market.
MUTUAL FUNDS’ CASH/ASSETS RATIO
Let’s start with the first example of crowd behavior. Institutions are the most important investors today because they dominate the market, doing the majority of the trading. Mutual funds that deal in stocks control well over one hundred billion dollars’ worth of assets. Although that’s only a small fraction of the total represented by institutions, it’s a pretty big sample. More important, accurate data on the cash and assets holdings of mutual funds have been available since 1954.
The optimism or pessimism among mutual funds can be measured by constructing a simple ratio of cash divided by assets. If the funds are very optimistic, they will use up their cash to buy stocks, and the ratio of cash to assets will decline. If the funds are pessimistic, they’ll sell stocks, allow their cash holdings to jump, and the cash-to-assets ratio will rise.
To be sure, there is a problem in determining just how low is a “low” ratio or how high is a “high” ratio. But, with the benefit of 20/20 hindsight, we can observe when the cash/assets ratio hit various peaks and troughs throughout the last three decades. Recall, a peak in the ratio would show excessive pessimism, and a trough would indicate extreme optimism.
Table 25 shows the “forecasting” record of mutual funds since 1956. The second column lists the times when the funds reached extremes of optimism as signified by the various low points in the cash/assets ratio. For example, in July 1956, the cash/assets ratio bottomed at a low of 4.7%. The third column shows the extremes of pessimism as calculated by the various highs in the cash/assets ratio. After reaching an optimistic extreme in July 1956, the mutual funds became more pessimistic as stock prices declined. Finally, in June 1958, the cash assets ratio reached a maximum at 7.2%, the high for the cycle.