Neither of these indicators is infallible and that is why both the technically and value-oriented individuals in this example must also consider the position of several other indicators in their decision-making process. The approach or time frame makes no difference. The important thing is to make sure that you have the patience to wait for a low-risk entry point for your specific system and time horizon. There is nothing in the rule book that says you have to invest. Your impulses may encourage you to get in. Disregard them. Let your head make the decisions.
The first principle in applying patience, then, is having the patience not to get in too soon. When you are in a position to conclude that most of the indicators or conditions that are associated with a major bottom are in place, this will give you a far higher degree of confidence to stay with the trade or investment when things get rough.
When I talk about a bottom, the term "major" in this context refers to a significant point in your own personal time frame. Thus, if you are a conservative, long-term investor, a major bottom in bonds or stocks may occur only every other year as the appropriate juncture in the four-year business cycle is reached. On the other hand, a major bottom for a short-term futures trader may appear once a month.
Figure 5-1 S&P Composite versus Its Dividend Yield 1966-1992. Source: Pring Market Review.
Figure 5-2 S&P Composite and a Twelve-Month Rate of Change. Source: Pring Market Review.
Why Playing the Markets Is Different from Other Businesses
A portfolio or trading account at a broker should be run just as any other business. Operating principles should be established, goals should be set, plans should be followed, and the risks and rewards from potential transactions ascertained. We have already discussed that the perceived cost of entry into the investment business is far lower than any other business and that this encourages the inexperienced to try their hand. People who would never take a plunge in a business in the "real" economy are often willing to commit a large proportion of their net worth to the markets. This is due not only to the ease of entry and the view that playing the markets is relatively simple but also to the fact that markets are very liquid.
Let's compare the ease of buying and selling a stock or bond with that of buying and selling any other business. For example, you might purchase a small retail store and then find that running the business is not as easy as you had thought. Perhaps the hours are inconvenient, personnel problems are more difficult than you had originally estimated, and the tangle of government regulations becomes a burden. For whatever reason, getting out is not as easy as getting in. Retail stores are not that liquid, and no buyers are waiting with cash in hand. If there are, you may not like the bid and decide to wait for another one. You will probably have to pay a substantial commission to a business broker, normally 10% of the price. All these considerations add up to the fact that most businesses take time and money to liquidate.
On the other hand, in a financial market there is always a bid-and-ask, meaning that our asset can be readily priced. This liquidity is a powerful reason investing in the market is far more attractive than investing in any other business.
Unfortunately, this readily available pricing mechanism also has its downside. Every time you look at price quotes in the paper or call your broker, you know exactly how much your investment is worth. You can watch it when the price goes up, which will make you happy; and you can follow it when it goes down, which will depress you. This constant access to the pricing mechanism draws you into the market emotionally. Since it is very easy and relatively inexpensive to liquidate the position when your "business" temporarily hits the skids, the temptation is to do just that. So you sell. The odds are strong that you are responding emotionally to the fluctuation in the price rather than the change in the underlying market conditions.
On the other hand, consider the example of a person who buys a manufacturing business for which there is no easily available pricing mechanism. Initially, he may find that things go well. The cost-cutting measures that he takes immediately increase his cash flow. He uses the savings as capital to invest in more plant capacity and equipment to spur future growth. After awhile, though, he runs into problems; sales slow down and the economy looks weak. Our entrepreneur may decide to sell his business, but he is less likely to do so because he cannot find a suitable buyer. Eventually, he no longer experiences the urge to sell and hangs on until retirement several years later. When he finally liquidates the business after 15 years, he finds that it has appreciated in value to a considerable extent and he now has a wonderful nest egg. In this example, the business owner concentrated on running his business. He was not constantly looking to see how much it was worth each day for the principal reason that he couldn't. The nature of his business was such that it forced him to be patient. He could, of course, have sold it any time during those 15 years, but the costs and difficulties involved in selling were strong enough to keep him from taking that step.
Investing in the stock market, on the other hand, is much different. There, the constant price fluctuations, the market's addictive response to news, and its emphasis on short-term performance drag us in by our emotions, causing us to make hasty and ill-considered decisions. The liquidity and pricing mechanism that make it easy to enter the financial markets have their downside: They literally try our patience. We have a tendency to think that to be successful we need to have constant access to prices and other information. As we have seen in previous chapters, too much access actually works against our best interests.
Patient Investing Usually Means Profitable Investing
In an article in the Burlington, Vermont, Free Press of March 5, 1991, Eric Hanson of Fraser Publishing quotes a study done by Jack Vander Vliet of Dean Witter, the brokerage house. The study assumed that a person put $2,000 into the stock market in each of the preceding 21 years, right at the market's yearly high. Each contribution was left to grow and was never sold. Even though each purchase was made at the worst possible time, the fictitious portfolio nevertheless appreciated at a compound average rate of 11.6%. The seed capital of $42,000 would have grown to $180,000. This strategy would have worked principally because the market advanced significantly during this 21-year period, according to the study. Even so, it is important to recognize that this time frame also embraced the devastating 19731974 bear market as well as the 1987 crash. Anyone buying bonds between 1960 and 1980 using the same methodology would not have fared so well, because bond prices were in a secular, or very long-term, decline.
The argument is not that you should blindly buy, hold for the long-term, and expect to prosper, because this just isn't the case. No, the real point of the example is that if you enter an investment with an optimistic and soundly reasoned view, the chances are that it will be profitable. If you respond to every news item and price setback you may or may not make money, but you will almost certainly fail to realize the profit potential of your idea. It is important to sit patiently with the investment-provided the underlying conditions have not changed-because then your odds of success will be that much greater.
To quote from Mr. Hanson's article, "The point is long-term planning. It's far more important to decide how much risk you want to take, how much money you are comfortable investing and how those assets should be divided among stocks, bonds, real estate, etc. than it is to worry about what is going to scare the market tomorrow." In other words if you do your homework properly, just relax and let the markets do the rest.
I can cite some personal experiences to back this up. In the early 1980s, I perceived, correctly as it turned out, that interest rates had reached a historical peak and that over the course of the next 10 years or so bond prices would rally. I also knew from studying markets that this huge rally was unlikely to be a straight-line affair but would be interrupted by some fairly important countersecular price moves lasting a year or more. Interest rates on government bonds were in the 11%-14% range at the time. Having done my homework, the next step was to purchas
e some bonds, which I did for both a personal account and a corporate pension fund that I was managing. Since the pension fund did not need the interest, was not subject to capital gains, and had a long-term profit objective, I purchased some zero coupon bonds. Regular government bonds were purchased for the personal account. Things began very well for both investments as interest rates did, in fact, decline.
After awhile, I began to study the economy and the technical position of the bond market a little closer and did not like what I saw based on a one-year outlook. This encouraged me to liquidate the bonds in the personal account. You can see that I had already broken one of the rules of investing, because I had originally estimated that some major corrections could be expected along the way. And, as it so often turns out, my short-sighted trading decision was wrong. Liquidation took place in the very early part of January 1986 at around a price of 87. By March, the market had reached 105. In the space of three months the bond gained as much as it had in the previous 16 months. You can imagine the exasperation and frustration I felt as a result of this foolish mistake. The psychology of the situation was that I was expecting yields to fall even further in this "once-in-a-lifetime" bond bull market. In 1984, I was very happy that I had indeed "locked in" historically high double-digit yields, even though the first part of the decline from 15% to 11.5% had been missed. But now I was actually out of a market that seemed destined to rally forever.
Frustration at this point drove me into the Australian bond market, where it was still possible to earn 13% on governmentbacked paper. Again my homework was quite accurate and over the next few years both the bonds and the currency rallied. It would have turned out to be an extremely profitable investment if I had the patience to stay with it. But, of course, I did not. Within a few weeks, both the bond price and the Australian dollar began to dip. I had also bought a substantial position and was not psychologically prepared for the twofold risk that was being undertaken. These were market and currency related. Australian bond prices declined and so did the Australian dollar-I lost heart and sold. During the ensuing five years I made various forays back into the U.S. bond market based on my expectation for the secular or very long-term trend. While each of these expeditions was profitable, none came anywhere near realizing the potential of the overall price move.
The lesson in patience comes from a comparison of my performance in the personal account as opposed to the pension account. You will remember that in 1984 the pension account purchased zero coupon bonds with the identical long-term objective as the personal one. The difference was that when I came to liquidate the pension account I found that the spread between the bid and ask price was considerable, because the bonds were illiquid. This meant that if I was going to repurchase the bonds at a later date and was wrong, the cost of doing so would have been prohibitive. Consequently, it was the expense of getting in and out that forced me to have the patience to stick with the position. If I had lost total faith in the secular interest rate decline thesis that would have been another matter, for then it would have paid to have liquidated regardless of the cost. But my fears were always of a short-term nature, and I could always justify getting out of a position in the personal account because of the ease and low cost of getting back in. What I did not realize was that the desire to reenter the market would fade rapidly once the price had moved above my point of liquidation.
I had read about the danger of losing your position in the middle of a trend in Edward LeFevre's Reminiscences of a Stock Operator, but it wasn't until I had gone through the process myself that the lesson began to sink in. The word "began" has been emphasized because it takes a long time for a learning experience to become a habit.
Staying the Course
One of the most difficult aspects of investing and trading is staying with your original investment philosophy. Quite often, you will find yourself reentering the market after a string of losses with the thought, "This time I will stick to my plan. I will not get sidetracked." It really doesn't matter whether you are a trader or an investor; you face the same problem. Only the time horizons or events may differ.
It sounds like a relatively simple proposition to make an investment or trading decision based on a particular approach and then to stick to that plan come what may. In practice, though, it is difficult. Many people, developments, and psychological hurdles are ready to trip us up at the very first opportunity. We begin with the very best of intentions; yet so often we find ourselves changing our plans in midcourse and losing out on what could have been a very profitable investment or trade.
While it is important to stay the course, it is also necessary to remain flexible enough to change direction if the need arises. This advice may sound contradictory. In fact, it makes eminent sense, but only if your shift in tactics or strategy is based on changes in the underlying economic conditions. Most of us face quite a different problem. We set off with a plan and, after awhile, get diverted by an unexpected news event, a comment by our broker, or a news story. We either totally forget or choose to ignore that nothing has basically changed. In fact, there has been a change. It is internal, however, and has taken place in our minds. It is not an external event that will affect the outlook for our investment. Something has happened to affect our perception of what is taking place rather than what is actually taking place. Let's examine a couple of examples. The first one involves an investment; the second, a trading approach.
Sticking with the Plan
Investments
The business cycle lasts approximately four years from trough to trough. Equity prices are essentially determined by the attitude of investors to the outlook for corporate profits. Profits revolve around the business cycle, so bull markets for equities should last about half the length of the business cycle, a period of about two years. In fact, market history shows that cycles last a little longer, since it normally takes a longer time to build than to tear down. Price trends in financial markets are rarely straight-line affairs. They usually take the form of rallies interrupted by a retracing movement as shown in Figure 6-1. The overall trend is up but these corrections, known in the trade as secondary reactions, are usually of sufficient magnitude and suitably deceptive appearance to cause even the most stalwart bull to question the validity of the primary uptrend and vice versa in a bear market.
Secondary reactions typically retrace one-third to twothirds of the previous rally and can last anywhere from six weeks to six months. Nothing is more likely to shake anyone out of an investment or trade than a market going against his position. The successful people are those who are able to ride out the storm psychologically because they refuse to abandon the underlying philosophy that originally led them to the market. The type of approach is not important, provided that it has a proven track record.
Let's suppose that you are lucky enough to recognize the start of a new bull market at a relatively early stage and that you are employing a very simple but tested investment plan. This approach recognizes that changes in financial conditions and Federal Reserve policy strongly influence equity prices. The method states that if the Fed lowers the discount rate following a series of hikes, equities are likely to experience a bull market.
Conversely, trouble is signaled after three successive hikes in the rate. The market, of course, is affected by many factors other than financial ones, but Table 6-1 shows that between 1956 and 1991 this simple approach worked reasonably well. There were periods such as 1958 when the third hike gave a premature sell signal and 1981 when the signal came early, but by and large this approach has proved to be a profitable method for long-term investing.
The rationale for its success is that easier money and lower interest rates sooner or later help stimulate the economy. Thus, expanding business means higher profits; greater profits imply higher dividends, which in turn mean higher stock prices. After a point, rising interest rates kill the economy. This in turn results in a bear market in equities.
Figure 6-1 Secondary Corrections within
a Primary Trend. Source: Pring, Martin J. (1991). Technical Analysis Explained. New York: McGrawHill. Used with permission.
Looking objectively at the table, it is difficult to see why someone who had adopted this approach would not or could not fail to follow it in view of its long history of profitability. The fact is that most people would not. A quick recount of the events and market action following one of the signals can help explain this apparent irrationality that lurks inside the psyche of most investors.
One of the best bull markets of all time occurred in the 1980s. Let's take a look at when the discount rate signal for this bull market was triggered and then at what followed. The rate was raised quite rapidly between the middle of 1980 and the beginning of 1981 and then was lowered in December 1981. This was the signal to enter the stock market. Figure 6-2 shows that the market rallied for a while and then sold off to a new bear market low. Almost immediately, the investment was under water. It also looked as if short-term interest rates had begun a new cyclical rise, because they rebounded from their December 1981 lows in January and early February. However, the discount rate did not change, so following the rule would have meant staying with the position.
During the next few months, there were plenty of reasons to bail out of stocks. In May 1982, for example, the market sold off substantially due to fears of some major bankruptcies. More bad news occurred in July 1982, as the headlines began to focus on the debts of Mexico and other Third World countries. Most investors at the time feared an economic collapse triggered by an impending crisis due to overindebtedness.
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