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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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There are some foreign investments that come into their own in bear marketsGlobalization, Terrorism, and Foreign Investment A traveler without knowledge is a bird without wings. Sadi, Gulistan (1258) In the last 20 years, a number of foreign funds came into being, and conventional wisdom was that a portion of a well-diversified portfolio should be invested in other countries. Has terrorism changed this idea? Will the world now revert to a 1930s mentality of barriers against trade? Answer: globalization is too far advanced to be reversed by terrorism. Europe has lived with terrorism for over 40 years without it unduly affecting their securities and bond markets. It is likely that Wall Street will be the same. Though events like September 11, 2001 directly affect markets over the short term, what moves markets over the medium and long term are the underlying economics. Those economics may indeed be affected by political actions, ideologies, or acts of terrorism and war. But these non-economic factors will only modify or amplify economic trends already in progress. They will not, unless they are exceptionally severe, reverse them. During the late great bull market, many American analysts suggested that a well-diversified portfolio should be as much as 50% in foreign investments and 50% in American securities. In todays highly unstable world, 40-60% would be wiser. There are some foreign investments that come into their own in bear markets. And, in some kinds of bear market, you can make more money investing abroad than you can make investing domestically. But you should take very seriously the quote at the start of this chapter. If you have little knowledge of a country, study their market charts. Charts are knowledge. Buying and selling foreign stock directly is a bit complicated until you get familiar with the way the issuing country operates. You can check if the shares are available via American Depository Receipts (ADRs). Or use a country fund (e.g., all Japan shares, or all Europe, etc.). ADRs An American Depository Receipt is a receipt for shares of a foreign company, deposited in an American bank. Once the initial transaction has been made, a bank issues the ADR, and thereafter those foreign shares trade in much the same way as any American shares do. ADRs are traded only in the US and not on the exchange of the country in which the shares are issued. For this reason, although the price of an ADR closely follows that of the stock it represents in its country of origin, there is sometimes a fraction of a point difference between the two, which very sophisticated traders use for arbitrage. Only major non-US companies are available in the form of ADRs. But for the average bear market investor who wants to buy non-US gold mining shares, or shares in any major foreign corporation, ADRs are a handy way to do so. GOLD MINING SHARES Some of the best gold mining companies are not American, but Canadian, Australian, or South African. In times of instability, gold mining companies tend to rise ahead of gold bullion, so gold mining shares are often a more attractive buy in the early stages of a bear market, particularly an inflationary bear market. Most major foreign gold mining companies have ADRs. CURRENCY PLAYS Another reason to invest abroad during a bear market is if you fear inflation will erode the value of your own currency. The late 1970s was such a time. If you simply want to put money abroad in a foreign currency at interest, the easiest way to do that is via a Swiss or Dutch bank. Swiss and Dutch banks are more internationally minded than most and cater to English-speaking foreign investors. They can set you up with time deposits or bonds for any major currency in the world. How do you open a foreign bank account? Answer: in exactly the same way you open a local account. You either mail your bank of choice a check with instructions to open an account for you, or you make a direct bank transfer. Some major Swiss banks require a minimum deposit in at least six figures, and a few private banks require at least a million dollars. So, check out the bank of your choice before you decide to open an account with them. But the majority will take a minimum $25,000 deposit. There are US branches of many major foreign banks where you can open your account in person. But, if you seek privacy, avoid them and deal direct. In any future inflationary bear market of the kind we saw during the 1970s then a Dutch or Swiss bank account would be a good investment move. Will inflation get as bad as it did in the 1970s in the foreseeable future? You will have to wait till Chapter 19 to find out! You can also trade currency futures on the International Monetary Market (IMM) in Chicago. Futures of any kind are for nimble traders. But its a skill like all others. It also demands time to monitor, more so than stocks or bonds. Margin requirements for futures are much lower than for stocks, so when you buy a future (in anything, not just a currency future), you are much more leveraged than when you buy a stock, even if you buy a stock on margin. This means if you are correct on the direction of a particular currency, then your profits are multiplied because of the leverage. But if you are wrong, you can lose dramatically. And because bear markets tend to be more volatile than bull markets, currency futures are not considered by many a bear market trading vehicle, even if your domestic currency is inflated. The leverage factor, plus the fact that all markets, including currency markets, are more volatile in bear times than in bull, make futures seem risky. But if you obey disciplines and use stop loss orders, they are useful. Yet, for the majority, its easier to open a foreign bank account, with a time deposit, if you want to hedge your own currency, than to trade currencies in the futures market. GLOBAL INVESTING IN MAJOR BEAR MARKETS Terrorism will dampen global investing somewhat, but will not eliminate it. Even if terrorism did not exist, the natural tendency of most investors is to seek higher risk during a bull market than in a bear. Unless domestic inflation becomes a major issue, as it was during the 1970s in both the US and Europe, during a bear market, less people are willing to invest globally, either directly or via a mutual fund. In addition, if a bear market bites hard, multinational companies will need to cut back. The first places they are likely to cut are the last places they invested in. It is likely that some multinationals will become less global in their reach over the next few years, for practical economic reasons. The international markets for new technology have, in the main, reached saturation point, even though there are, for example, billions of Chinese and Indians without computers. But high tech needs a basic infrastructure which many nonindustrialized nations do not yet have. Until that infrastructure is created, there are, in many cases, not even the roads to truck the computers to consumers, let alone electrical outlets to plug them into. A bear market is a time when companies regroup and consolidate rather than build new plants and try to nurture new business in foreign countries. And in this interconnected world, as America goes into a recession, most of the rest of the world follows. In any future major bear market, with the exception of gold mining shares, there will probably be fewer foreign companies worth investing in, just as in the US. As with multinational companies, a bear market is a time for the average investor to regroup and concentrate more on preserving capital, than taking risks in bull markets. STRUCTURE OF BEAR MARKETS Secondary Reactions One of the greatest pieces of economic wisdom is to know what you do not know. J.K. Galbraith In bear markets, we must turn our thinking upside down in many respects. For example, a reaction is now an up-move, because it is against the main trend. Every leg-down in a bear market is interrupted by a secondary reaction, which may come in two or three phases. These reactions are lifesavers for those who failed to take action when the bull market ended and are now stuck with giant losses. The secondary reaction gives us a chance to bail out at higher prices. It also gives an opportunity for shorting. Failure to sell out on this rally means you risk taking a bath when the next leg of the bear market comes into play at the end of the secondary reaction. Of course, the possibility is ever present in any bear market that the rally will turn out to be a primary reversal. To distinguish between a true secondary and a primary reversal, I can probably do no better than to turn to the words of William Peter Hamilton, the successor of Charles Dow, who developed Dows ideas into the Dow Theory we know today, and Robert Rhea, who further refined Dow Theory during the 1930s. DECEPTIVE RALLIES An understanding of a secondary reaction, wrote Robert Rhea, is needed by traders to about the same extent as a growing cotton crop requires sunshine. Yet, the secondary reaction is probably the most perplexing phenomenon with which the average investor must contend. To begin with, let us define our terms. Readers are aware that a bull market leg swing is a broad upward movement of stocks, while a bull market reaction is an important decline against the primary trend. However, under Dow Theory, during a bear market, one must reverse the terminology. In bear markets, the primary legs are downward while the secondary reactions, or rallies, are upward movements against the prevailing primary trend. Every bear market is made up of two or more downward legs (primary swings) and at least one secondary reaction. Some bear markets such as 1909-10 and 1987 were confined to the minimum. Others such as the bear markets of 1968 and 1973 had a number of primary legs and secondary reactions. The great 1929-32 affair was made up of no fewer than eight distinct primary legs and seven secondaries, a series not matched before or since. Secondary reactions, wrote Rhea, are as necessary to the stock market as safety valves to steam boilers. In other words, when the stock market steam engine is straining and too many passengers have climbed aboard, the safety valve (secondary reaction) is released. Although many reasons are given for every move of this kind, it may be said that all secondaries serve the following purposes: (1) to correct a primary market movement that has gone too far in one direction, but where the underlying economic reasons for the primary direction have not changed enough to cause a reversal of the primary trend. (2) To dampen the speculative ardor of the amateur trader. Despite their importance, most investors have great difficulty in recognizing the advent of a secondary reaction. It may be conceded at once, wrote Hamilton, that if it is hard to call the turn of a great bull or bear market, it is still harder to say when a secondary movement is due . . . To compound the hazards, secondaries often are mistaken for a true reversal of the primary trend. In bear markets, stockholders are anxiously awaiting the return of the bull tide; they are eager to seize upon any rally as the turn. In bull markets, most reactions end with a day or so of heavy volume, a characteristic that can be of real use in identifying the bottom. But a primary leg in a bear market may or may not end on heavy volume. Thus, the termination of a bear market leg and the beginning of a rally cannot always be spotted by volume indications alone. It often happens, however, that, after an extended bear market decline, there will be a day or two of high volume. If the decline then continues but volume shrinks drastically, the odds favor an early reversal. Moreover, while the precise turning point is difficult to recognize, after a long decline the price movement itself may give significant indications of an impending rally. These signs are described by Robert Rhea: A study of secondary reactions in bear markets will reveal that the development of those movements is usually indicated by a series of minor rallies and declines, with each rally generally carrying above the preceding one and declines terminating above immediate preceding lows. Such a formation in the averages forecasts a secondary advance, even though the primary trend is down! It should be remembered, however, that both Transportations and Industrials must confirm in such a movement before value inferences can be drawn. Reactions (whether in bull or bear markets) nearly always consume less time and are more violent than are movements in the direction of the primary trend. It is not unusual for a 3-week rally in a bear market to retrace 30% to 60% of a downward swing, which may have taken many months to complete. It is a tried rule which will help to guide us in studying the secondary reaction movements that the change in the broad general direction of the market is abrupt, while the resumption of the major movement is appreciably slower. Hamilton Following a reaction in a bull market, a base is formed at or near the reaction low, and it may take weeks or even months of accumulation before stocks begin the next bull swing. The explanation is simple: After a bull reaction, investors begin accumulating stocks and this is carried on as close to the lows as possible. But bear market secondaries, in contrast, often present a bouncing or turn-on-a-dime appearance; the rallies seem to spring from no visible base or area of support. Again, the cause is evident. Bear market reactions invariably result from a technical condition in which the market becomes oversold. The turn to the upside may be set off by professional short sellers who realize the time has come to cover. Amateur short sellers, having made their move too late, quickly follow the professionals lead. Floor traders, sensing the reversal, throw the weight of their buying behind the market. Thus, the rally is on. Obviously, such a phenomenon is not a forecast of a fundamental turn but merely a technical rebound in a market that has gone too far too fast. It is invariably easier to call the end of a bear market rally than the beginning. Rhea described one of the best methods for identifying the top: In such action the peak is frequently attained on a sudden increase in activity lasting a few days. It is usually impossible to pick the turn with any degree of precision; however if, after the high point has been attained, a further rally shows a definite diminution in activity, it is probable that an early resumption of the decline will occur. Dullness following the peak of a bear market rally is a common danger sign. However, it is often confused by the average investor who fails to realize that the old adage, Never sell a dull market, does not apply when the primary trend is down. Dow was the first to recognize the implications of dullness. In 1902, he wrote, . . . the action of the market after dullness depends chiefly upon whether a bull or bear market is in progress. In a bull market dullness is generally followed by advances, in a bear market by declines. He adds that, in bear markets, . . . prices fall because values are falling, and dullness merely allows the fall in values to get ahead of the fall in prices. Following a bear market rally, one Average often advances to a new high, but this may not be confirmed by the other Average. In such areas, dullness often occurs, after which both Averages sag below preceding decline points, and the primary downtrend is again resumed. Psychology during bear market rallies seems to follow a fairly consistent pattern. During secondary reactions in bear markets, wrote Rhea, it is a fairly uniform experience for traders and market experts to become very bullish. They are usually bearish about the time the upturn comes. The converse holds true of the psychology that precedes a bear market rally. Here, boardroom oracles are gloomy, investment services are pointing out the advantages of bonds and defensive stocks, and neophytes are trying their hand at shorting. The bad news, which already has been discounted in the downward swing, is appearing on all sides. At such times, a bear rally is in the making. ACTING ON REACTIONS Very long-term investors can ignore secondary reactions if they wish, but its a difficult if not dangerous course and one fraught with sleeplessness. Mind you, the definition of a long-term investor in a bear market is one who holds short positions for the entire life of the bear. I feel its best to move in and out of the market in conjunction with secondary movements. Some of them retrace two-thirds (more or less) of the prior move, and this possibility is too large just to ride out. And, of course, the short-term investor has no choice but to sell and buy in accordance with secondary moves. Thus, everyone needs to understand them and invest with them. PSYCHOLOGY OF REACTIONS In case I have not been clear enough on the rationale of a secondary reaction, lets point out that, after a collapse of prices, the market becomes temporarily oversold. And there remain a great mass of bulls who think any prices are bargain prices if they are substantially lower. Also, there are those who went short at higher levels who now decide to take some profits. It is this combination that creates a major rally, or secondary reaction in bear markets. The circumstances that bring the rally to an end are these: As prices rise to retrace about half the fall, traders will begin short selling again, and those who bought at the recent bottom will see nice profits, which they will begin to take. Those who have done nothing since the bear market started will see prices returning close to their cost price. Some begin to sell, willing to take a small loss in many cases. Since public confidence was shaken by the prior downmove, there will be few who will wait to see how far prices go; they will take a relatively reasonable price for their stock while they still can. To round out a chapter on secondary reactions, I think readers will enjoy these words from Robert Rhea, who, during the big rally (or secondary reaction) in 1930, wrote: I can remember having shorted stocks in early December 1929 after having completed a satisfactory short position in October. When the slow steady advance of January and February (1930) carried above previous intermediate highs, I became panicky and covered at considerable loss. With losses piling up every day, I forgot that the rally might normally be expected to retrace possibly 66% or more of the 1929 downswing. Nearly everyone was proclaiming a new bull market. Services were extremely bullish, and the upside volume was running higher than at the peak in 1929. A STEP-BY-STEP ANALYSIS Its always bullish just before the dawnof a new downswing. Another version of Rheas conclusion can be found in the writings of market analyst Jim Sibbet. He wrote: Whenever a sizable (over 10%) market movement occurs, it continues until the public, generally emotional, changes its mind and joins the movement. At first the tendency is toward disbelief, then gradually a few change, then more, and finally the overwhelming majority change their minds to such an extent that everyone will agree as to the prevailing majority opinion. When there is a conflict of opinion about the publics attitude, it is not overwhelming. The movement continues until there is no longer any doubt as to what the publics opinion is. The 1930 rally ran up until everyone was convinced another bull market had started. Right now there is considerable disagreement. Some think the public is still bearish and others think it has turned bullish, and still others think it is just beginning to turn bullish. Until there is unanimity of opinion, the current uptrends are likely to continue, because there are many people who are yet available to change their minds. Others who have already changed their minds are waiting for a good reaction to buy cheaper. This helps support the dips. It is the process of changing that makes prices move. After everyones mind is made up, the movement stops and reverses. THE SIZE OF REACTIONS Perhaps the most important aspect of secondaries is their average size. This is a facet few in the market today understand. Ask anyone you know how much a secondary reaction can be and they will likely reply: one-third to twothirds of the ground lost. This generalization can be very useful, but those who try to place an exact limit on secondary reactions are as doomed to failure as the weatherman who forecasts rainfall will be precisely one inch in the next 24 hours. When a secondary goes beyond 66%, virtually everyone throws in the sponge, claiming loudly that the secondary is now a bull market. But history shows otherwise. A secondary can be as little as 10% and as much as 99.9%. As Robert Rhea defined it: If we could say that the great majority of secondaries terminated around the 50% recovery point, speculation would be easy. Unfortunately, careful analysis shows that 7% of all reactions terminate after retracing 40-55%, 27% after retracing 55 to 70%, 8% after retracing 70 to 85%, with 14% of all secondary movements extending beyond 85% retracement. Those percentages have probably not changed much in the 70 years since Rhea observed this. SECONDARIES PURPOSE I wish I could remember where I read this, but I only recall that it was in the British Museum, when I was doing research for my first book on Bear Markets, nearly 40 years ago. Secondary Reactions51 To cure the exaggerations and extravagances of the preceding period of speculation is the function of a bear market. The difference between a technical reaction and a bear market is that the first is a purging of the market s internal position, while the second is a thoroughgoing rectification of all excesses that have crept into the ensemble economic structure. When contraction has proceeded far enough to remove the distortion and restore the balance, the bear market, from a fundamental standpoint, has ended. It has fulfilled its function. CONCLUSION If you would be successful during bear markets, when those around you are losing their shirts, learn the signs of the secondary. Ignore those who declare that any observations about markets prior to 1980 are irrelevant to todays world. The people who say that are often the same types who, in the 1960s, were suspicious of anybody over 30 and, in the 1990s, claimed that the dot.coms were such a wonderful advance that the old rules of good business planning didnt apply any more. Scientists build on the wisdom of those who have gone before them. They would not dream of discarding the works of Newton or Galileo. Yet, the fashion today is to discard all stock market wisdom older than 10 years. You buy into this view at the peril of your portfolio and lifestyle. |
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