The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

14 September 2008

Far from the Madding Crowd

Chip, chip... chop, chop... saw, saw... c r a c k... "Timber!"... CRASH.

Sound familiar? Yes, you could be logging, but in this instance you are a participant in the investment markets, circa October 2007 to today. It ain't pretty; in fact, this market is downright ugly. While we each could point to a favorite epoch in the market environment that rhymes with today's abysmal markets, the one I rank as comparably difficult would be the 1970s.

Remember that market environment? The markets back then endured one whammy after another -- from two separate but related oil crises (1973 and 1979), runaway inflation, stagflation, the Death of Equities (thanks to the notorious Business Week cover article)... and so on, all the way to the death of America itself. Through it all, the markets, as measured by the DOW Industrials average, traded sideways for 16 years (1966 - 1982) from approximately 1000 to 600. The high trade during this epoch occurred at ~1072 (January 1972), the low trade at ~550 (December 1974) a whopping 50% decline from high to low. And then back again -- up, down; up, down; up, down -- for 16 long, l o n g, lonely years. The joke among investors during that epoch was that stocks were so toxic that an investor needed asbestos gloves just to touch them.

Note the 1966-1980 trading range (2 years prior to its breakout) in the chart below, the substantial 50% decline included (highlighted in yellow)...

Dow Industrials average: 1960 to 1980 (pre-1982 breakout)

View the chart below to place the entire 16 year trading range within context, its continuum...

[Dow Industrials: 1900 to today (9.15.2008)

... a 100+ years uptrend that includes -- and envelopes -- the abysmal bear market of 1972 thru 1974, the trading range of 1966 to 1982... even the Great Depression. In other words, what at first glance might appear to be stocks dropping off a cliff is nothing other than more of the same. Even Irving Fisher's ridiculed comment made during the initial phases of the 1929 decline, "Stock prices have reached what looks like a permanently high plateau" proved prescient when viewed from the perspective of the long term investor. Of course, to quote John Maynard Keynes, one of the all time great stock traders, "[F*** the long run.] In the long run we all are dead." By the way, please do not confuse the terms, "long term investor" and "buy & hold investor," which are neither synonomous nor interchangeable.

Not much has changed today from the 1970s, but then it never does. The more things change, the more they remain the same. Bull and bear markets come and go, but the bad news remains out there always, awaiting its time in the sun. Consider the following litany from today's market (with help from
1) Fannie Mae/FNM and Freddie Mac/FRE got taken over by the government;
2) Lehman Brothers/LEH plummeted 77% and was thought by many to be doomed to fail if it wasn't acquired by another company;
3) AIG dropped 46% on concern it needs to raise capital;
4) The EU downgraded its economic growth forecast;
5) Retail sales were soft;
6) Auto manufacturers seek billions in government loans to help meet new fuel efficiency standards;
7) A major hurricane barreled through the Gulf of Mexico, shutting in production and posing a serious threat to a large number of refineries.
8) The US$ suddenly and startlingly (and enduringly?) powers higher, which fact changes the calculus on nearly every outstanding transaction. (No less the investment markets);
9) Final eight weeks of silly season -- er, the US Presidential campaign;
10) Geo-political instability;
11) the price of everything -- stocks, bonds, commodities, real estate -- declines. There is no refuge;
12) Etc, etc, ad infinitum.

And as I write this post on Sunday evening, the bleak news re AIG, Lehman/LEH, and Merrill Lynch/MER radiate outward from the epicenter; panic reigns as emergency weekend meetings occurred yesterday and today with the Federal Reserve Bank and the better capitalized, still standing banks such as JP Morgan/JPM. Venerable Merrill Lynch/MER suddenly is gone, acquired by Bank of America/BAC for the inconceivably small sum of $50 billion. Inconceivable, that is, until recent events and days. Lehman/LEH teeters on the brink of bankruptcy and collapse. AIG seeks a massive $40 billion 'bridge loan' from the Fed to hurdle over its sudden financing needs brought about by indiscriminite selling of its stock and swap spreads bid up to once unimagined levels. Which is so much spin; in fact, what the company struggles with today is the direct result of bad decisions made by former and current company executives. And to throw salt on an already-suppurating wound, stock market futures indicate a singularly ugly opening for Monday morning; current indications show the DOW Industrials down perhaps 300 or 400 points, with proportionately similar sized gaps for other market indices and averages. The Fed strives and struggles, but like Sisyphus, it just cannot push the boulder (of confidence) up and over the mountain of no confidence.

And yet, and yet... nothing in the charts says unequivocably that current market dynamics are anything other than a garden-variety, standard, typical bear market; a bear market that remains within the larger periodicity's trading range, which itself remains within the long term up trend. Just like the 1970s. If today's market trend were a monolithic bear market, then all stocks would crater concurrently. But such is decisively not the situation. Oh sure, 'good' stocks implode, while 'bad' stocks rise high and higher -- but that very action self-denotes as a non-monolithic market.

My definition for bear market is a declining price trend of (no fewer than) two lower highs and two lower lows. Perceived thusly, most investors can see quickly that the market averages and indices qualify today as bear markets; most stocks fare even worse. The average bear market endures for ~18 months... from old peak to matching high (amplitude, not magnitude); the current bear market now is ~10 months old, so it is long in the tooth. But it is more than that...
• Place the current bear market within its context, a decade long trading range bounded by S&P 500 1600 and 800 (so far; more years of sideways trading likely yet to endure);
• The current 10 month old decline is hellacious, because it comes from the high of the range, with more room for lower prices and yet would remain in the presumed base;
• Any extant, but old, trend has a tendency to reverse course during the first month of each quarter (January, April, July, October); typically during the second full week of that month; and best on Tuesday, aka Turnaround Tuesday. (A concept misappropriated by investors who do not understand its correct application.) UPDATED and INCLUDED: This confluence marks Tuesday, 15 July 2008 as a possible major turn up, at least for this phase of the decline. That is, the major portion of the price damage to most stocks has been accomplished, and now the continuing correction becomes more of time (its passage) than price. And many truly scary moments, such as this morning. Please remember to apply the lesson I shared previously; i.e., how tops and bottoms build in waves of 3...

The diligent investor always searchs for divergences; divergences of price, volume, trend, relative strength, etc. In a non-monolithic market, there are always leaders; something somewhere is always in a bull market. Long term, long investors seek and invest these opportunities. This post attempts to show you how to do that...
• The various market averages and indices became overweighted to the financial stocks, as their bull markets waged on. As those stocks declined (plummeted) in their bear markets, the market at large also declined;
• Include the groups and sectors exposed to the economy's cycles -- the cyclical stocks: banks, insurance companies, mortgage lenders, home builders, auto manufacturers, etc -- and the reasons for the market's 10 month decline become more obvious.

Now seek divergences...

• Note how the market's non-monolithic tendency asserts itself, as many banks look to have made hard bottoms;consider, for example, Bank of America/BAC:

A 2 year old decline (1) accelerated its pace of decline from October 2007 (2), before falling off a cliff in a meltdown that culminated in the 15 July 2008 hard low (3), and finally forms a bullish quarter-note pattern (4). Other bank stocks out-perform B of A/BAC, and other sectors also have hit tradable lows, possibly even investable bottoms, auto manufacturers (GM) included. The first positive divergence thus identified, the bear market's leaders (those stocks, groups, and sectors that led the market down) now act bullishly -- even as market commentators scream, "The sky is falling!" and market averages get pummeled seemingly day after day.

Buried beneath the blaring headlines are opportunities:

• Several sectors, including the previously mentioned health care and retailers (Surprise!) lead the market to the upside; e.g., long time favorite, Johnson & Johnson/JNJ (health care) and Urban Outfitters/URBN (retail) trade at, or near, recently established all time highs, after breakouts from intermediate term bases. This notable price action is both positive (obviously) and very bullish.

Despite the increasingly ubiquitous hysteria and panic, I remain optimistic. Before you label me a Pollyanna, please understand that I do not argue for unwitting investments. I view an investor to be that person who delves beneath the (screamingly) obvious to find the less apparent, more subtle truths... And, yes, to invest when everyone else rushes for the exits. However, you must know in advance of your investments:
1) Why you invest at all;
2) Why you invest in a specific opportunity;
3) At what price you will purchase a specific opportunity; and
4) At what price, or set of circumstances, you admit to being wrong... in your time frame.

Yes, we all prefer our portfolios would only rise in value -- but not before we complete our investment purchases. Other tell-tale clues, though, can betray (soon to occur) rising share price; for example, the inability to decline while the market declines broadly, deeply, and enduringly. When invested in the market's bullish leaders, we hang on; when identified but yet to invest, we purchase at opportune moments. Of course, we each define "opportune moments" in a manner that befits each investor's portfolio needs, tolerance for risk, and time frame. No size fits all because no two investors [needs and wants] are alike; some investors rely on company fundamentals, or measures of valuation, and some investors rely on charting or technical analysis. Unfortunately, the exclusive use of charting and other forms of technical analysis tends to be fool's gold because most investors do not really know the rules, and/or their correct application. Too, analyzing a stock's trend, and its placement within that trend, can betray when to purchase -- but rarely what.

Dorsey Wright offers some crucial insights and understanding...
"The inclination to take action, despite the probabilities, is prevalent in portfolio management. When you take action in a portfolio, is that action rooted in probabilities or is it taken to simply make yourself feel like you are doing something? There is a substantial amount of research on relative strength investing that highlights the superior returns that can be achieved over time by sticking to the rules of systematically holding on to the winners and cutting out the losers. Our research suggests that focusing on longer-term relative strength is much more rewarding than focusing on short-term (and high turnover) relative strength. As a result of focusing on longer-term relative strength, inactivity is often the order of the day. It can be uncomfortable to implement such a strategy because of the times when it is temporarily out of favor, but we believe that the rewards to sticking to the rules will put you in company with a select few premier performers over time." (Italics mine -- dmg)

The attempt by investors to marry the mirror realities of trading the recent out-performers and investing long term (i.e., wealthbuilding) in the desire for an always-increasing portfolio value is perilous at best. I consider the stocks of bad companies to rise for only a season or two, whereas the stocks of good companies decline for the same season or two. And those declines prove to be nothing other than a high level consolidation, as was the 16 year trading range (1966 - 1982). See again the chart above.

My (recomposed) Core Opportunities do not even come close to measuring up (er, down) to the bear market of the past 10 months, although Google/GOOG trades (traded) downright ugly. You could feel as though "The bear [market] has clawed you deeply...", if invested in Google/GOOG, but what were your reasons for its inclusion in your portfolio? Have those reasons changed because the stock trades up, sideways, and (lately) down? Please recall that I cautioned repeatedly Google/GOOG, from time to time, would trade in its own high level consolidation; this seems to be one of those times.

Markets take off (up) seemingly on a moment's notice, so long term investors purchase at opportune moments, not willy-nilly. A portfolio with no investments is no portfolio, just as an investor with no investments is no investor. And the lack of investments only causes investors of all stripes to scramble in the bid to catch up to prices that rocket higher -- without them aboard. The acquisition prices for these investors tend to be substantially dearer and the position size smaller than the ideal prices and lot sizes assigned in advance (of the move). In practice this means that true long term investors purchase during moments of fear and rapidly dropping prices -- an increasing level of uncertainty, which allows them to purchase the entire position at a favorable price... but also a scary price because the market seems to go nowhere but down, down, down. Things change. The shrewd investor knows how to identify, and always is mindful, of harbingers of change.

Investing is a waiting game: 80% frustration, 10% deflation, and 10% elation. But that 10% elation time pays off big time, and amply rewards our patience (frustration). But only, crucially, if our chosen investments are the same the market wants but failed to know in advance. Which means other investors scramble to catch up via paying a rapidly escalating share price for partial positions. Meanwhile, we smile. And profit. And all that was required of us was the willingness to embrace uncertainty, a large measure of intestinal fortitude, and a whole lot of patience.

I have tried to explain many concepts in this post that are difficult to understand even when explained well; I might have failed in the attempt. Your questions and comments posted here could help achieve more, or better, clarity for all readers.

Full Disclosure: Long Google/GOOG and Johnson & Johnson/JNJ.

Good fortune to All,
-- David M Gordon / The Deipnosophist

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