Dear subscribers,
This is update #1099 for Thursday evening, January 21, 2010.
Today's main topic is bear essentials.
The financial markets are showing increasing signs of either having begun a major bear market, or at least of having initiated a correction. If for any reason you did not sell your equity funds when I had recommended taking such action, then it is probably too late to act at the present time; wait for a strong bounce and hope for the best. It is even more important to be aggressive when closing your positions than when you are opening them, since you will end up losing money on an unclosed position if the market moves adversely. On the other hand, if some of your opening orders were never filled--KOL below 9 comes to mind as one of my largest group of unfilled orders over the past few years--then you have lost nothing.
As I mentioned in yesterday's update, I have cancelled my orders to buy GDX, SEA, and MOO, as well as all other equity funds. Unless VIX at least reaches 34 or higher, I am not interested in purchasing equities or their funds during a severe bear market. I have added additional good-until-cancelled orders to purchase TLT below 90.
One of my subscribers noticed that in one respected survey, the percentage of fund managers who are bullish reached its highest level in four years:
The implications could be more negative if we knew the main reasons why these fund managers were so bullish at the present time. If one of these reasons was "to make up for losses in 2008" or "to regain my high-water mark to start collecting performance fees", then that would be an even more bearish signal since such conditions are when the worst mistakes are usually made.
The ratio of insider selling to insider buying recently reached 24 to 1:
Today's main topic is bear essentials.
For those who may have forgotten some of the details of the past few years, it is important to remember that bear markets during eras of stagnation tend to share certain common features. By recognizing those characteristics in advance, you can ensure above all that you do not lose money in a bear market. Secondarily, there may be some opportunities to make money, although you should proceed with caution since return of capital in a bear market is far more critical than return on capital.
The most obvious characteristic of any bear market is that it is not obvious to the vast majority of investors, even after it is well underway. On October 11, 2007, the S&P 500 completed an all-time intraday peak at 1576.09, which was 1.5% above its previous all-time high of 1553.11 on March 24, 2000 (and far lower after adjusting for inflation, but that is a topic for a future update). More than ten months later, in the second half of August 2008, investors in most surveys thought we were still in a bull market, and that the 10-1/2-month downtrend was nothing more than a typical modest pullback. Obviously those investors learned over the next three months what a real bear market looks and feels like.
One of the most easily identifiable clues from late 2007 and early 2008 was the extreme narrowing of the equity rally. Beginning way back at the beginning of June 2007, fewer and fewer stocks were able to make new highs during each rally phase. Before June 2007, nearly all equity sectors were moving higher in tandem, although some of course rose at more rapid rates than others. By October 2007, the Russell 2000 and similar indices and funds of midcap and smallcap shares had already been forming a bearish pattern of several lower highs. On October 11, 2007, the S&P 500 completed its final high, while the Nasdaq continued to set higher highs throughout October. By the final week of December 2007, even the Nasdaq had been forming lower highs, but some of the best-known Nasdaq names like Apple and Google were continuing to set new highs. In the first half of 2008, U.S. equities began bearish downtrends, but some emerging markets like Brazil and Russia continued to form higher highs. In July 2008, crude oil itself was one of the last risk assets to complete its peak.
I like to compare a bear market with the Titanic. One strategy on the Titanic, which I would call the prudent strategy, was to head for the lifeboats as soon as there was any sign of trouble. Another strategy was to continually shift into the highest-class cabins of those who were no longer on the ship, so you could enjoy some luxury in the short run while letting the long run "take care of itself". Those who kept shifting from one sector into another in the second half of 2007 and the first half of 2008, foolishly chasing whatever was going up, acted very similarly to those who kept changing cabins on the Titanic. They had fun for awhile, but in the end those who headed for the lifeboats earliest ended up happiest. The sooner you can recognize a bear market for what it is, the sooner you can take defensive action. You can also take offensive action by selling short, buying long-dated U.S. Treasuries, or following similar choices depending upon your risk tolerance. However, just as staying alive is the most important principle on a sinking ship, the most important principle in any bear market is not to lose money.
The media have no idea what a bear market is. After a particular well-known index has already dropped by 20% or more, such as the Dow Jones Industrial Average or the S&P 500, the media will uselessly inform you that "we are now officially in a bear market". That is about as helpful as seeing rocks pounding the hillside all around you as your hiking companion calmly informs you that "we are now officially in the middle of a landslide". In 1996, my wife and I stayed at a bed and breakfast in Ecuador where the proprietress calmly informed us that we were staying literally on the side of an active volcano (Pichincha). Naturally, I was alarmed, but she cheerfully proclaimed: "There's nothing to worry about. This volcano has not erupted since 1660." I didn't think any more about it until about three years later, when Pichincha was on the front pages of most newspapers including the New York Times, as it experienced a dramatic eruption which covered the streets of Quito in thick ash for a full week and caused unfortunate death and destruction.
It is somewhat easy to understand why most investors were not worried about a major bear market two years ago: there had not been even a real bear market since 1973-1974, and there had not been a decline of more than half in the S&P 500 since the 1930s. Today, however, investors are no more fearful of a bear market than they had been two years ago. This suggests that if those who sank on the Titanic were revived and given a second chance on a similar ship, then most of them still would have kept changing to higher-grade cabins rather than heading for the lifeboats. Anyone who loses half of his or her net worth once should learn to pay attention; anyone who loses half of his or her net worth twice absolutely deserves whatever punishment the market will deliver. More than 90% of investors will end up in this predicament, since they have learned nothing from the most recent bear market.
There are some subtle lessons to be observed in bear markets. There is a tendency for certain sectors to serve a leading role, such as semiconductors and gold mining shares, which will tend to move lower in advance of most other sectors and which will tend to similarly rally in advance of most other sectors. On the first trading day of January, SMH reached a high of 28.66 which was surpassed by only 6 cents on January 11, and which showed persistent relative weakness throughout the month. Gold mining shares, which have been probably the most reliable leading indicator since March 2008, peaked way back on December 2, 2009 and then completed a bearish lower high on January 11, 2010. The S&P 500, which has been a classic lagging indicator for decades, did not peak until January 19. Those who rely on chart patterns in the S&P 500 to make their trading decisions are like those who wait until they are up to their necks in water before deciding it might be a good idea to head for higher ground.
I very frequently hear from subscribers asking why I like to buy in advance of a market bottom, and I like to sell in advance of a market top. These people plead, "Why do you keep acting early? I think it makes more sense to wait for the market to turn. If you then act very quickly, you can get out ahead of everyone else." The problem, of course, is that if a billion people are all planning to sell as soon as the market turns, then there will be a sudden plunge lower and it will be too late to sell. In January 2008, many recognized that the Indian stock market was both ridiculously overbought and even more ridiculously overvalued--and yet they refused to reduce their holdings, figuring that they could easily sell ahead of everyone else. Once the market began to move lower, it surrendered more than two months' worth of gains in a single week. When natural gas was bottoming in early September 2009, everyone who traded it knew how absurdly oversold and undervalued it had become, and planned to buy it as soon as it staged a strong rally. In one hour, an entire week's worth of losses were regained; in two weeks, seven months' worth of losses had been recovered. Emotionally, no one likes to buy into weakness or to sell into strength, and therefore the financial markets will always reward the very few who are able to act in the manner for which many know subconsciously that they should act, but cannot bring themselves to do so.
One very important difference between a bottoming pattern and a topping pattern is that any asset which is bottoming during an era of stagnation tends to do so over an extended period of several weeks or even several months. There is no way to know in advance exactly when any given asset will bottom, or how often it will get knocked down by a combination of momentum players and panicked amateurs. Therefore, I always recommend taking advantage of a major market bottom by placing numerous ladders each containing about a dozen orders for any given security which I have identified as being ideal for accumulation. I have no way of knowing how undervalued it might get, so I place orders to buy it at many different prices. That way, I will succeed in getting the best possible average price. Even if it takes several months to complete my accumulation of that asset, I can be sure that it will be done in a mathematically optimal fashion. Of course, if my selection outperforms other choices, then the total return will be significantly greater than if I make a poor pick, but that would be true no matter what method I may use.
In sharp contrast, a topping pattern will usually occur very rapidly. This is not always the case; some assets could be leisurely sold short in 2007-2008 with little change in price for many months, as with QQQQ. However, in general, once a particular asset stops rising in price, there will be one selling wave after another which will emerge for different reasons. Therefore, it is usually necessary to sell quickly and decisively, generally using market orders, to protect yourself against a potential sudden market plunge.
On November 20, 2008, there was a sudden plunge for most equities which was followed by one of the strongest one-week rallies in world history. If you didn't have ladders of good-until-cancelled orders already placed in advance, then you probably could not have acted quickly enough to capture most of the amazing bargains from that day--KOL at 9.43 being only one of many notable deep discounts. One useful principle is that the more afraid you are to buy anything, the more you should be eager to act; the more reluctant you are to sell, the more aggressively you should do so. Without even realizing it, you are being subconsciously brainwashed by not only the mainstream media but also most people you will encounter in your daily life. When I was most aggressively accumulating RSX a year ago, which is a fund of Russian companies, the few people I knew who were intimately familiar with Russia were avoiding it at all costs since all they heard every day was gloom and doom, the exchange closing more than once during regular hours due to panic, and a frequently devaluing ruble.
One defining characteristic of all bear markets, whether in eras of prosperity or stagnation, is that they are inevitably accompanied by the strongest short-term rallies. Whenever there is an extended downtrend, a combination of momentum players will eventually jump onto the trend just as they would jump onto anything which appears to be moving in any given direction. A momentum player would happily jump aboard a group of lemmings heading for a cliff, as long as their charts confirmed the lemmings' direction. After any downtrend in a bear market has been intact for a sufficiently extended period of time, even clueless amateurs will tend to want to join in just as they will always be tardy to any trend in the financial markets. Whenever the short side becomes dangerously overcrowded, the market will suddenly surge higher to shake out the late arrivals before thereafter resuming its prior behavior. In 2008--and even in 2002--there were some astonishing one-day surges for the S&P 500 and the Nasdaq. In fact, in both the last bear market (October 2007-March 2009) and the previous one (March 2000- October 2002), there were more big up days for the stock market than during the entire bull-market stretch which preceded it and which was significantly longer in duration. Eras of prosperity are notable for the gradual nature of their rallies, whereas eras of stagnation are notable not only for their sharp pullbacks but also for their equally dramatic moves higher. If you compare 2008 with 2009, you will be quite surprised to see that it was 2008, a major down year, which had many more short-term surges upward than 2009, which was of course a major up year. If I am correct about the next several years, then we will have numerous strong short-term rallies over the next two years (give or take several months in either direction), and very few short-term rallies over the following few years (starting in 2012) which I think will end up becoming by far the strongest bull market since the Great Depression.
Of course it is very easy to say in hindsight, "You should have sold stocks on such-and-such a day." It is even easier to say that you should have bought KOL or RSX a year ago, or that VXX was a terrible buy over the past half year. It was much more difficult to recommend buying KOL in November 2008 with the remark that it is likely to triple in value. It was similarly difficult to sell 70% of my net worth over the course of a single week earlier this month. I am not a rear-window investor; those who drive without looking through their front windshield most of the time will end up crashing sooner or later. I am willing to accept making one or two notable mistakes each year, if it means enjoying windfall profits overall regardless of whether we are in a bear or a bull market. I like bear markets much more than bull markets because they separate the true from the false. Those who will be able to say five years from now that they achieved substantial double-digit gains every single year from 2007 through 2014 will be members of an exclusive club. Sure, I wish that I had avoided JOF and put all of that money into KOL, or that I had stayed away from VXX, or that I had put even more into CYMGF when it was completing its government-induced bottom in early September 2009. In hindsight, everything is trivial.
I should also point out that I am not always going to be accurate in the future with my buying and selling decisions. There is some luck involved, one way or the other, even though it is so difficult to quantify. Sometimes a chance remark or a single e-mail will serve as the tipping point for making a major buying or selling decision. Once, when I was wavering back and forth between selling gold mining shares and not selling them, I received two e-mails from nonsubscribers telling me that they were "finally going to follow my recommendation to buy gold mining shares, since I was obviously right". Of course this was many months after I had bought them; this was the best sell signal I could have asked for. I heard someone in my office a few weeks ago telling a friend on the telephone why he was going to purchase shares of a Chinese coal-mining company; this definitely cemented my decision to unload KOL and similar funds earlier this month. Occasionally, of course, even the most inexperienced amateurs will do something intelligent and that will tend to mislead me into incorrectly doing the exact opposite of their decisions. I would gladly make a mistake like that once in awhile, considering all of the times it has worked out for the better.
Whenever we have a major bear-market bottom in 2011 and/or 2012, it is likely to be similar to the 2008-2009 bottom in taking several months for various asset classes to complete their respective nadirs. Because the opportunities will likely be even more compelling than they had been a year ago, I will diversify into roughly 40 to 45 different funds, and will make each purchase using approximately 0.20%-0.25% of my net worth. In that way, it will be possible to make about 400 to 500 separate purchases before becoming "fully invested"--not that I would ever really become fully invested, since that limits the possibility of buying something else should there be an unexpectedly compelling lagging buying opportunity. Some subscribers have pointed out that if you have only a small total net worth, then splitting your buying into 400 or 500 orders will cause the total amount of commissions to be relatively high. That is a valid point, and there is no simple remedy. If you purchase fewer securities or make larger percentage purchases at any given time, then you will probably end up with the following problems: 1) overpaying for any given fund, which is bad; and 2) having too much of your net worth in a single fund, which is worse. Unfortunately I cannot find an easy solution for this dilemma. An ideal amount of money to manage would be about 20 or 30 million dollars. Once you have a few hundred million dollars or more, you end up moving the market when you make major trades and thereby getting a less favorable price; with less than a million, it is difficult to become properly diversified with thick ladders of orders without spending a significant percentage on brokers' commissions. With a small amount of money, perhaps you can find a broker who will charge you a certain percentage of your net worth no matter how frequently you trade (such arrangements do exist; shop around). There is no equivalent remedy if you have billions and you are constantly moving the market, but hopefully you're a "big boy" (or girl) and have learned to handle such adversity.
The most essential aspect of a bear market is being able to recognize it in advance, and to act accordingly. Fewer than 2% of investors and advisors made money in 2008, so this is obviously a lesson which is rarely learned. Even the personal experience of a recent bear market has not made investors any more savvy or alert to a repeat today as compared with two years ago. There's an apt saying: science always builds upon the achievements of prior generations, whereas the financial markets always repeat the mistakes of prior generations. (I'd like to take credit for this remark, but I'm not sure if it's original.) Investors always want to buy after a bottom and to sell after a top, but it is essential to be early rather than late since the market moves so dramatically whenever any major trend reverses direction. Since almost no one emotionally wants to be early, those who can stomach taking such action will usually be well rewarded. Bear markets inevitably enjoy the biggest short-term rallies. Bear-market bottoms usually persist for several weeks or several months, giving you ample time to buy using numerous thick ladders of good-until-cancelled purchase orders. In contrast, bull markets often end with a surge followed by a plunge, so you often have to sell in haste using market orders close to a major top. If you're unsure whether a bear market is imminent, find out what your friends, family, and neighbors think about the financial markets: the more unconcerned they are about a significant decline, the more likely that it will soon occur. The most important principle in a bear market is that return of capital--meaning not losing money--is far more important than return on capital. If you follow a fool's approach and try to squeeze out that extra 4% or 5% in price or yield, then you will usually end up sabotaging your primary objectives.
Take care.
--Steve
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