Monday, April 29, 2013

All Time High Effect

So, What Do All-Time Highs Really Mean for the Market?

All-Time Highs Beget More All-Time Highs

The accompanying charts suggest that, once you make an all-time high, there is a carry-over effect that lasts at least a few months, and perhaps as long as a year. The moral of this story is: don't try to time the top of this market. You can and most likely will get burned. Wait for the market to show its hand. Markets don't stop on a dime: the reasons that brought them to the all-time high in the first place remain in effect for some time thereafter, whether we think they are justified and valid or not.

Part of this involves NOT listening to people moaning and groaning in chat rooms every weekend about how the market is just teetering on its last legs. It most likely isn't (though some weekend they will, in fact, be right, and then they won't let anyone hear the end of it). That has been going on for a full year now, and longer. Many won't accept any S&P 500 level above 1000 as being rational, that's just the way some folks think. They, in fact, were right a couple of years ago, when the S&P 500 briefly ducked below 1000. But at that time they were saying the S&P 500 needed to go down to 600 to reflect fair value. And if it went to 600, then they would say it was too pricey at any level over 150. And so on and so forth.

Sir John Templeton was an amazing investor. During World War II, he decided to start buying stocks. Now, it turned out to be a good time to invest because prices didn't really recover from the 1929 Crash until the mid-1950s. However, his strategy worked, and here it is: he bought the Dow Jones Industrial stocks that were making highs. That's right, he bought the most expensive stocks of  all. How did he fare? He made a fortune! He realized, perhaps just intuitively, that if a position is going to double or triple or quadruple, it has to go through a succession of new highs, and those out-performers identify themselves each time they nudge up to a new high. That's simple math, and also simple market logic.

The Psychology of Bears

I know, you don't want to hear psycho-babble about motivations and reasons. The longer you are in this game, though, the more you will come to realize that you - the person reading this - make all your trading decisions for psychological reasons, and those reasons may be completely antithetical to your investing health.

This is a broad topic, but let me throw out a few random ideas. I think some of many Bears' absolute conviction in the face of overwhelming, continuing evidence against their short position has to do with their innate revulsion at modern finance. All this deficit financing and stimulus just isn't right and flies in the face of common sense, some believe. It is "phoney" and "robs from the next generation," and certainly is "unsustainable" and will "lead to huge inflation" so it is "evil." That is a perfectly legitimate and maybe even laudable attitude. I tend to agree with this line of thought: we are in an economy built on shifting sand, and the tide is rolling in. The only problem with the theory is that it doesn't predict the market. We currently are in an economic recovery. It may not seem like one, it may not act like the ones we remember from days of yore, and the way it is being nurtured with unnatural government cash inflows may be ruinous for the economy in the long run - but it still is a recovery. Markets rise during economic recoveries. You can look it up.

Another factor at work with Bears is a bit of veiled snobbery. I don't say that to besmirch people who short, because I short myself when I feel the time is right. What I mean is that there are some who are pessimistic about investments and tend to feel that buyers just don't understand the dangers of owning or don't have enough experience to know how fragile everything is. As usual, there is a grain of truth there - owning is dangerous, the bottom could drop out at any moment, valuations are fragile because they depend on nebulous public confidence in the value of whatever you own. With some Bears, however, it is almost an elitist thing, where they've seen market panics, remember wishing they had been short and how much money they could have made in half an hour, and feel that anyone else without their fear and with the willingness to be long in the face of the risk one of those occasional selling panics simply doesn't understand what they're doing.

In response to that, I submit this: buying and owning doesn't mean the buyer doesn't understand what he or she is doing. Buying is a legitimate response to some market conditions, just as selling is a legitimate response to other conditions. If the market is on an uptrend, doesn't it make sense to participate on the long side? Yes, it will end eventually, we all know that. But why not go short then, when conditions turn, rather than avoid the upside as that's happening and take losses on your shorts to boot? Living in a constant state of fear that the market will tank will occasionally be reinforced, so, like Pavlov's dogs, the tendency to be that way can grow in some people. The downfall of that, though, is that the market by some reckoning spends 70% of its time rising. Do you really want to be losing money or not making money 70% of the time? Also, valuations do increase over time for a variety of reasons such as inflation and wealth accumulation, so simply being short is a losing game unless done at the proper times.

Another factor is that some people, for whatever reason, psychologically feel that everything in nature returns to the mean, so that if stocks make an advance, they must later decline so that everything is in balance. That can be true under the right conditions, but a lot of the time it simply isn't. A clear case of "common sense" not being the same as "market sense," assuming an equal and opposite reaction of market prices has sent many a Bear to the poor house. Sell-offs are spasmodic and unpredictable. You might get lucky in a static market, shorting the rips which then fall off, but in a trending market, waiting for the countermove that never comes will just trap you with a loss. Sell-offs are tricky, and they occur when you least expect it. Also, to get the full return, you not only have to be short, but you have to time the bottom and cover at the right time, or else much of your profit vanishes. V-bottoms mean you have very little time to cover before everyone else leaps in to cover/buy, and prices will be back up before you know it. That's part of the reason why shorting is so tricky and dangerous.

Add in the fact that once a wrong decision is made, it takes real strength of character to realize your mistake, admit it, and reverse. You won't be a good trader until you can do that. That sounds easy to do, but it is the most difficult to learn as a trader. It requires you to take the opposite viewpoint than you had just minutes before. Doing this also can get you whip-sawed if you do it wrong, which is a deterring factor, but more likely it will save you if the market trends away from you and at least limit your losses. We all have egos and all must have faith in our decisions, so learning to reverse course when the market moves against you can leave you feeling lost and confused. People don't like to feel that way, so they avoid actions that will cause this feeling. This, I think, is why many Bears initiate a short position that they easily could get out of, but refuse to do it. They then spend countless hours on message boards touting all the evidence in their favor. In the end, they will be proven right to some extent, but there are better and more profitable ways to trade than that.

The final factor is raw fear. The stock market is scary, and everyone has heard stories about losing their fortunes and jumping off of buildings after being ruined (which actually was extremely rare in 1929, believe it or not, and may not have happened at all). Being short and buying puts controls that fear, even as it robs you of wealth in a trending market. My own rule of thumb is that my investment makes me feel too comfortable, too positive, and allows me to get much restful slumber, that's the time to be wary. The money is made when you are tense and nervous about your positions and it's hard to sleep, because you are going against the grain and so much that you hear seems to prove that the market will not go where you are betting it will.

Jesse Livermore

The Bears' patron saint is Jesse Livermore, the "Boy Plunger" of the 1920s who wrote must-read "Confessions of a Stock Operator." I admire Livermore, and the more I trade, the more sense his dictums make. He was a genius in his own way, far ahead of his time, and with market insight better than almost anyone in history. Here's the scoop of Livermore: he did predict the crash of 1929 and profit from it, but it was a last-minute revelation to him. He wasn't sitting around short for months at a time. Instead, through his own unique market office he had access to more more daily market information than almost anyone else alive at that time, more even than major brokers. Reading it day after day, that information slowly added up to signs of a market top in early September that started rolling downhill through the following two months. He was on the phone like a madman during the crash - that's when he was shorting. If you are sitting around with short positions from 100 S&P 500 points ago, you are no disciple of Jesse Livermore.

Another thing about Livermore: he played it long more than short. This got him in trouble in the 1930s, because that was a time when the declines weren't spasmodic and shocking, telegraphed ahead of time to those with the proper information sources. People now understood the danger of stocks and they went out of fashion. The major averages began a slow, grinding death where Livermore's information advantages did not come into play. The values were amazing, but as usual, the market over-corrected. Livermore went long too soon and wound up all but bankrupt, showing that even the greatest market timer in history encountered conditions he couldn't master. Jesse Livermore wound up shooting himself in a hotel bathroom.

Relying on Gut Instinct is a Losing Strategy

Which is not to say the market can't correct at any time, and hard. It most certainly can correct, and often does. Just don't mistake prosaic corrections for "The End." An uptrend continues until the proper indicators show it has ended - and the indicators many of us use don't show that yet during this particular uptrend. Find your own indicators and use them, but please make sure they reflect what the market actually  is doing, not what you think it should be doing. I respectfully submit, in the very best helpful spirit, that if the indicators you are using repeatedly suggest that the uptrend at the time of this writing is over and a precipitous fall is imminent, that you are using indicators that are not reflecting the market's true nature. Also, simply deciding based on gut instinct and what you know about the world that the market must correct hard and soon will lead you to poor decisions.

I am savvy enough to know that simply writing this isn't going to convince anyone. You must come to these realizations for yourself, that's why people lose so much when they are learning how to trade. Maybe reading this will help you on your own journey. Someday Bear-biased indicators and your gut instinct that other people have made too much money from rising stocks will, in fact, be right. Will you still be solvent if you blindly stay short until then just to prove yourself right?

Play the market, not preconceptions. Forget the two numbers, the 15, at the beginning of the S&P 500 level. If you just think of it as being at 88, with a chance to go to 95, it will be a lot less intimidating. Also, keep repeating, "We're still 25% from the all time high in real terms." You'll sleep better.

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