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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Before you make any investment decision, you shouldMONEY-MAKING TACTICS Money is like a sixth senseand you cant make use of the other five without it. Somerset Maugham Preservation of Capital during a Bear Market Solvency is entirely a matter of temperament and not of income. Logan Pearsall Smith, 1931 During the 1990s, increasing ones capital was the thing, and the simple preservation of capital was considered old-fashioned. But, as I have already discussed in prior chapters, no matter whether the future brings bull or bear markets, the kind of euphoric and wild bull market we witnessed during the 1980s and 1990s is unlikely to happen againfor at least the next decade or so. Though this book is concerned mainly with bear market tactics, what I will discuss in this chapter applies to future bull markets as well. Preservation of capital is primary. Profits are acutely important but secondary, and, before you make any investment decision, you should first ascertain the risk inherent in that investment vehicle and decide in your own mind what the worst possible outcome could be. Only when you have gone through this type of risk reflection, can you make an informed decision of whether the particular investment is right for you. The human condition is to look at best case not worst case. ACTING ACCORDING TO THE STAGE OF THE MARKET The strategy key is to be found in determining what stage of the market you are in. Thus, if you are well along in the last stage of a bull market, you sell out your common stock holdings across the board, even though you are rather sure the market averages still have some upside distance ahead though with fewer stocks on board, as is typical for bull market endings. If you get greedy and reach for the precise top, youll more often regret it. SQUEEZING OUT PROFITS The manner of selling out should be normally via stop-loss orders, set in accordance with the stocks short-term uptrend line. Often, this will be from 5 to 15% below the current price. Its necessary to look at a daily chart to do this properly, and the extra profits are worth the extra trouble. If you find that your indicators suddenly point to the early stage of the bear market, you may just sell out, without stop-loss orders. By the time you have recognized all the signs, it may be rather late and you will wish you had sold sooner. Emotionally, youll wonder if it isnt too late to sell now. But, if you believe you are in the middle stage of a bear market (which comprises the major portion of all bear markets), then you lean heavily on your technical tools or indicators to determine if, at that moment, they point to a secondary reaction (up). My chapters on market tools and secondary reactions will aid in making this determination. ACTION IN THE ADVANCED OR MIDDLE STAGE OF A BEAR MARKET If such a secondary reaction is already under way, you have several choices: 1. Sell in stages what you hold long, using your technical tools to gauge the top of the up-move. This you must do if you rate capital preservation high. The top of a secondary reaction (up) in most bear markets offers the highest prices that will be seen for probably 1 to 5 years. This is because the bear market assumedly has time left to run, after which it will normally remain dormant awhile, then slowly build up to a new bull market, all of which takes time. The prices on this reaction will be the best you can hope for, even though they may look pitifully low to you, since they had been so much higher 6-12 months before. the long-term investor must get out here. We are not dealing with certainties in the stock market (or in any other phase of life) but with probabilities, and you cant afford the risk of going against the probabilities here. The odds favor lower prices are long. And for a long time. This choice sounds easy on paper, but in practice its agonizingly difficult. Why? Because, as the rally mounts, the talk will be that the bear market is over, or that we are starting a new bull market, or that maybe it wasnt really a bear market anyway. Some will say the DJIA is going 500 points higher in the next 30 days. Volume will probably mount. Some good business news will be available. Most brokers will be bullish and urge customers to buy. You will be torn between the stage scenery (those 500 points especially) and what you are pretty sure is backstage. But experience teaches that those extra 500 points are a mirage most of the time. If you like only short odds in your favor, then stick around. Maybe youll be lucky. Each man must kill his own snakes, as Robert Rhea once said of stock market decisions. This book can tell you where the snakes are, but you have to take the action yourself, and its never, never easy. Only on paper is it easy. Partly, thats because we live only 1 day at a time, whereas on paper we can span 6 months in a paragraph. In this situation, we again face what we discussed in the chapter on human psychology in the stock market. Winning in the market is largely a matter of fighting a battle within yourself. Intellectual domination of your emotions will win the day, if it is indeed won. The majority will fail to win the day, for the majority cannot, or will not, try to control their emotions. So, this simple choice of selling on the rally will prove a massive barrier to you unless you develop nerves of steel and act against what some of your emotions are coaxing you to do. You must ignore both profits and losses, and forsake what appear to be probable profits ahead, and sell when the signs say so. The most difficult part of all is not to let your bullish emotions, in a rally, cause you to make rose-colored interpretations of an indicator. For example, if the number of daily new highs fails to exceed the new lows (or does so only moderately) during a rally, you will be tempted to discount it (because subconsciously you want to hide such evidence under the rug). You may say, Well, youve got to expect the highs to be fewer because the market is well down from its peak. So much for this simple choice number one. 2. Buy a few stocks that look bullish on their charts (see Chapter 11 on charts), as perhaps 10 to 25% of total stocks may, if it is not too far along in the intermediate term, up-move (i.e., the secondary reaction in a bear market). Thus, youll get a nice play for several points profit, assuming you have done your chart reading properly. You should pick stocks that have little apparent downside risk and good support levels: stocks that are in a new uptrend and enjoy increased volume, and perhaps have something fundamentally bright. Sometimes, the blue chips are best on secondary rallies; sometimes, the lowprice stocks; sometimes, the cyclicals or the utilities. No two situations can be the same, and thats why I advocate making your selection on the basis of chart action. The charts tell you which group is strongest and/or which are making reversal patterns. It will usually be a logical group to advance, based on conditions at that stage of the economy or market. Watch the volume leaders for candidates. That may not seem appropriate for preservation of capital, but in truth it is, provided you do not invest too heavily in this stage. Its like Napoleons advice that to attack is the best defense. One must go with the trend, even the short or medium-term trend at times. Probably 25 to 30% should be your maximum commitment in this period. There is always the risk that you have not made correct interpretations of the signs of the times and the technical tools, and what you calculate to be an intermediate-term rally may in fact be a primary reversal; thus, some investment in it will be welcome. If, for the buy and hold crowd, this sounds like peculiar advice, let me quote part of friend John Templetons strategy that created his huge fortune. Even at the height of the 1990s bull market, he never mentally, or emotionally, put all his money in stocks. His buy and hold portion of his portfolio was only ever 50%. The other 50% was sometimes in bonds or defensive issues, if he felt doubtful about the trend. Thats a good strategy to adopt. But, because Templeton is a multi-millionaire, he could afford to risk a higher percentage of his assets than most people. However, in good conscience, the best advice for ultra-conservative preservation of capital is to participate in these contra-trend moves in closed-end mutual funds. Holding this type of share lets you sleep better, doesnt make you quite such a devotee to your charts, and doesnt subject you to the whims of news and the hype that most TV newscasters use to keep you watching and their sponsors happy. You dont make nearly as much profit this way, but, on a normal intermediate secondary reaction (up), you should make enough points to make it worthwhile. If you are also short, this hedges your position nicely. Even this method, however, is not perfect. At times, some closed-end mutual funds tend to specialize in specific industries and would be the equivalent of buying into just one industry group. So, if you like this fund idea, make sure you know exactly what they are invested in and how diversified they are. To hold something both long and short is a common practice with many sophisticated investors. If you feel you know charts well enough to pick the strong stocks to hold long and the weak ones to hold short, this is a reasonable approach as you are balanced and invested with individual stock trends. Whether you buy a mutual fund or a stock is obviously an individual choice, based on how much risk you want to absorb and how far you have progressed in your study of market trends and chart analysis. You pay your money and you take your chance. . Sell short at the top (you hope) of the rally (secondary reaction). Although this possibility is the most profitable of the lot, its against your nature and the one youre least likely to want to do (see Chapter 13 on short-selling techniques). Not only is it difficult psychologically for most people to sell short, but its made doubly difficult by the fact that it should be done when prices are still inching upor just beginning to slip a bit; whereas the odd lotter/amateur will only have the courage to sell short when the specter of a crash triggers his mental fear screen, which is usually when the down leg is almost over. short as soon as prices start to dip is much safer, for you can rest assured by all stock market history that even bull market up phases have reactions. The big bonus is that shorting near what appears a rally top enables you to place a logical stop-loss order very near your short-sell price at above the rally peak. The longer you wait, the bigger that gap. So, a short in a bear market is more likely to make a profit and with less risk placed at this immediate post-rally stage, than after prices have been falling for some days. But even shorting late in the game is not fatal because, if you are in a bear market, prices must eventually go lower, even if there is another rally soon after you sell short. You can in theory wait it out, just as you do in bull markets when you buy a stock, and then the stock turns down. You then wait for the market to come back and make you well. But, success in this case depends on how much heat you can stand. A stop is necessary in either case. Ill discuss stop-loss orders again in the short-selling chapter (Chapter 13), but let me say that stops give you peace of mind, especially when you are new at shorting. Later on, you may use them or not as you prefer, depending on how close you are to the market. . Selling out and staying out is the fourth course of action. This choice is one rarely practiced; yet, it contains wisdom for some people. But, then, thats the hallmark of wisdom, something not widely known or, if known, not widely practiced. When you find a rally (secondary reaction type) about to start or already under way in a bear market and you have sold out (as per choice 1 above), then you need not follow choices 2 or 3, but take this opt-out choice instead. You need not either go long to make a few points or short on the rally high, since both involve some risk and both require much attention to indicators. You can simply play it safe by selling out and then staying out, putting your money in Treasury bonds or other defensive fixed-interest paper. Or, in the case of an inflationary bear market, in tangible investments gold, real estate, art, etc. The act of staying out is just as much a positive action as buying or selling, and, in fact, requires more courage at times. Robert Rhea, in 1937s bear market, wrote: A bear market is a good time for a vacation, and I am taking one. Or, another way to put it: Often, riding at anchor is the best course. This choice depends on your self-analysis. Are you temperamentally suited to shorting? Can you apply yourself to indicators, tools, charts? Will you be unhappy out of the marketdoing nothing as you watch the action? You alone can answer these questions. You may not know the answer till you study more, or paper trade, or try your hand with bear market strategies. 5. Never go against the trend. We can call this choice 5 or give it a subheading under choice 3. (Its not important how you categorize them, just so you incorporate them into your thinking.) This calls for never going against the trend. It means that you go short only until you see a secondary (up) reaction at hand. Then, you cover your shorts and stay out until the turndown starts again. Then, you short again. You keep shorting and covering, shorting and covering. Never going long, only short. Thus, you never buck the major trend. And you are never in the market during major rallies, which, it must be admitted, are tricky affairs in bear markets, and thus you avoid the risk of being whipsawed. SUMMARY So much for the choices in a middle area of the bear market. I summarize them by saying you should sell out (on a secondary rally); you should buy a few stocks long (for a secondary rally); you ought to go short if you want to cash in on the bear; and/or, if you want to be very safe, you will sell out and stay out. ACTION IN THE LATE STAGE OF A BEAR MARKET If you find yourself in the late stage of a bear market, and have confirmed it thoroughly with both signs of the times and the technical tools, your choices are simplified. You know that you are going to be buying soon. You have only to decide when and what you should buy. The when means: Shall I buy now and collect dividends while I wait for the usually lengthy simmering period before a new bull market begins, or do I wait until it has actually begun rising? This decision is facilitated by asking yourself what you will do with your money if you wait. If you have no better place for it, it may as well be collecting dividends (while you keep checking your market indicators). The what means you dont just buy any stock that looks healthy; you pick those that traditionally (not certainly, mind you) rise fastest in the first phase of a bull market. This usually means low-priced stocks or, if you want to be more conservative, the low-priced medium-quality stocks. Blue chips normally come later. Watch for relative strength of individual stocks and groups. PEACE OF MIND And, for all stages of both bull and bear markets, you should Take a View (which we discussed in Chapter 3). It helps to know the overall context in which your technical tools give you their signals. Taking a View requires, however, that you pay more than a little attention to non-technical indicators, to make it possible to take a long enough look ahead to make your view a sound one. Then, check your view each week to see that nothing has changed in the superstructure of the world economy. This sounds simple, but it takes practice and discipline. The greatest rules and truths are always simple things. But they are rarely appreciated and even less often followed. Charles Poore put it well when he wrote, There is nothing quite so complicated as simplicity. Infinitudes of distractions and irrelevancies must be forced into perspective to achieve it. Golden words! CONCLUSIONS Whatever stock market you invest in, the tactics remain the same. As communications get ever better, so all world markets tend to rise or fall together, though the degree of difference is critical. And it is now possible to trade your account, from anywhere to anywhere. Perhaps the most important tactic in any kind of market anywhere is to get rid of your weakest investments, hold your strongest, cut your losses quickly, use stops, and leave your better-acting securities alone until they bring comfortable profits. This sounds like just plain common sense, but, because of our emotions, we quite often do the opposite. A CAUTION The long and medium-term investor should use almost identical techniques in bear markets. I have never been convinced that the long-term investor is fully justified in riding out reactions. Yes, sometimes, the investor is saved from the 100-point fall by an eventual equal rise, but one can never be sure how long the market will take to come back or indeed how low it will go before it does come back. Thus, it is my personal view that, during a bear market, the interests and tactics of the long, medium, and short-term investor should be virtually the same. |
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