Five Market Insights from Peter Lynch

Peter Lynch managed the Magellan mutual fund at Fidelity Investments between 1977 and 1990. He averaged a 29% annual return and managed to increase his fund’s assets under management from $18 million to $14 billion. Magellan started as a private investment arm for Fidelity’ founding Johnson family. The fund didn’t open to outside investors until 1981. Between 1981 and 1990, Lynch managed to return 22.5% per year vs 16.5% for the S&P 500. During that period, the average investor at Lynch’s fund made 7% a year. Why the big discrepancy? Well, many investors sold Magellan fund when it had a down year and bought it back when it had a good year.

The majority of Peter Lynch’s returns came when he was managing a relatively small amount of capital. He was also lucky to start at Magellan at the end of one of the biggest and longest bear markets in financial history, which brought many stocks to extremely low valuations.

Peter Lynch is also one of the most prolific writers, whose market thoughts continue to be widely quoted and applied to these days. Here are some of my favorite:

The two biggest mistakes that investors make

There are two ways investors can fake themselves out of the big returns that come from great growth companies.  The first is waiting to buy the stock when it looks cheap.  Throughout its 27-year rise from a split-adjusted 1.6 cents to $23, Walmart never looked cheap compared with the overall market.  Its price-to-earnings ratio rarely dropped below 20, but Walmart’s earnings were growing at 25 to 30 percent a year.  A key point to remember is that a p/e of 20 is not too much to pay for a company that’s growing at 25 percent.  Any business that an manage to keep up a 20 to 25 percent growth rate for 20 years will reward shareholders with a massive return even if the stock market overall is lower after 20 years.

The second mistake is underestimating how long a great growth company can keep up the pace.

Let Your Winners Run

It’s easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds.  If you’re lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it.  Let’s say you have a portfolio of six stocks.  Two of them are average, two of them are below average, and one is a real loser.  But you also have one stellar performer.  Your Coca-Cola, your Gillette.  A stock that reminds you why you invested in the first place.  In other words, you don’t have to be right all the time to do well in stocks.  If you find one great growth company and own it long enough to let the profits run, the gains should more than offset mediocre results from other stocks in your portfolio.

Look for situations, where perceptions are worse than reality

The big winners come from the so-called high-risk categories, but the risks have more to do with the investors than with the categories.

Embrace market corrections

It is not entirely clear what causes deep market corrections (a clear prove that markets are irrational), but without them many of the best performing long-term investors would have never achieved their spectacular returns.

The biggest winners are usually a pleasant surprise

The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a ten-bagger doing that.

Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is.

3 Major Takeaways from the Crash in 1987

October 19. 2016 marks 29 years since the so-called “Black Monday” when Dow Jones lost 22% in a single day. Coming into Black Monday, DJIA was already down 20% from its annual highs achieved in August and trading below its 200-day moving average. Paul Tudor Jones, who was one of the lucky guys to make a fortune in 1987 says that he used the 200-day MA as a sign get out and get short. He made 127% net of fees that year.

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Not everyone was as fortunate as PTJ in 1987.

Stanley Druckenmiller lost a lot of money during the crash by trying to pick a market bottom.The Friday before the 1987 crash, Druckenmiller goes from net short to 130% long. Here is his conversation with Jack Schwager in The New Market Wizards’ book:

– You’ve repeatedly indicated that you give a great deal of weight to technical input. With the market in a virtual free-fall at the time, didn’t the technical perspective make you apprehensive about the trade?

– A number of technical indicators suggested that the market was oversold at that juncture. Moreover, I thought that the huge price base near the 2,200 level would provide extremely strong support— at least temporarily. I figured that even if I were dead wrong, the market would not go below the 2,200 level on Monday morning. My plan was to give the long position a half-hour on Monday morning and to get out if the market failed to bounce.

***

Another important lesson to be drawn from this interview is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. Had he been less open-minded, defending his original position when confronted with contrary evidence, or had he procrastinated to see if the market would recover, he would have suffered a tremendous loss. Instead, he actually made a small profit. The ability to accept unpleasant truths (i.e., market action or events counter to one’s position) and respond decisively and without hesitation is the mark of a great trader.

The infamous day trader, Marty Schwartz had a tough day on October 19, 1987, but he managed to cut his losses quickly:

I came in long. I have thought about it, and I would do the same thing again. Why? Because on October 16, the market fell 108 points, which, at the time, was the biggest one-day point decline in the history of the stock exchange. It looked climatic to me, and I thought that was a buying opportunity. The only problem was that it was a Friday. Usually a down Friday is followed by a down Monday.

The high in the S&P on Monday was 269. I liquidated my long position at 267.5. I was real proud of that because it is very hard to pull the trigger on a loser. I just dumped everything. I think I was long 40 contracts coming into that day, and I lost $315,000.

One of the most suicidal things you can do in trading is to keep adding to a losing position. Had I done that, I could have lost $5 million that day. It was painful, and I was bleeding, but I honored my risk points and bit the bullet.

I thought about going short, but I said to myself, “Now is not the time to worry about making money; it is the time to worry about keeping what you have made.” Whenever there is a really tough period, I try to play defense, defense, defense. I believe in protecting what you have.

Looking at the charts above, I have a few main takeaways from 1987.

1.  Crashes in stock indexes rarely happen when they are near their 52-week highs. They happen below 200-day moving averages.

2) The tape gave plenty of warning signs to decrease substantially your equity exposure. SPX made lower low below its 50dma a week before the event. People had plenty of time to raise cash or hedge their long-term long positions.

3) Any quick pullbacks of 20% or more in the general stock market are usually a good buying opportunity for long-term investors. The market took its sweet time to recover from that flash crash and I am sure that buying the right stocks made a big difference in returns.

Five Market Insights from Gerald Loeb

It is funny how the best traders of all times basically repeat the same things with different words.

Gerald Loeb is the author of ‘The Battle for Investment Survival’ and is one of the most quotable men on Wall Street.  Here are five of the smartest things he has ever said about the stock market:

Financial markets are often forward-looking.

The market is better at predicting the news than the news is at predicting the market.

To make money in the stock market you either have to be ahead of the crowd or very sure they are going in the same direction for some time to come.

Patiently wait for your pitch

Profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed.

Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival.

The single most important factor in shaping security markets is public psychology.

In addition to many other contributing factors of inflation or deflation, a very great factor is the psychological. The fact that people think prices are going to advance or decline very much contributes to their movement and the very momentum of the trend itself tends to perpetuate itself.

How to recognize future leaders

One useful fact to remember is that the most important indications are made in the early stages of a broad market move. Nine times out of ten the leaders of an advance are the stocks that make new highs ahead of the averages.

It is not important how often you are right or wrong, but how much money you make when you are right and how much you lose when you are wrong.

The difference between the investor who year in and year out procures for himself a final net profit and the one who is usually in the red, is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.

 

Five Market Insights from Jesse Livermore

The fastest way to become a legend in financial markets is to make a lot of money when almost everyone else is losing a lot of money. It doesn’t matter what you do afterward. Jesse Livermore made 100 million dollars during the market crash in 1929. Five years later, in March 1934, Livermore filed for bankruptcy. No one really knows how he managed to lose so much money in such short period of time. Nowadays, he is still one of the most quoted men in the trading circles. His book “How to Make Money in Stocks” is cited as one of the favorite trading books by just about everyone who is anyone in finance.

Here are a few of Livermore’s most interesting thoughts about markets and speculation:

1. The only leading indicator that matters

Watch the market leaders, the stocks that have led the charge upward in a bull market. That is where the action is and where the money is to be made. As the leaders go, so goes the entire market. If you cannot make money in the leaders, you are not going to make money in the stock market. Watching the leaders keeps your universe of stocks limited, focused, and more easily controlled.

2. Patterns repeat because human nature hasn’t changed for thousand of years

There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly build into human nature, that always gets in the way of human intelligence. Of this I am sure.

All through time, people have basically acted the same way in the market as a result of greed, fear, ignorance, and hope. This is why the numerical formations and patterns recur on a constant basis.

I absolutely believe that price movement patterns are being repeated. They are recurring patterns that appear over and over, with slight variations. This is because markets are driven by humans — and human nature never changes.

3. Your first loss is your best loss.

When the market goes against you, you hope that every day will be the last day – and you lose more than you should had you not listened to hope. And when the market goes your way, you become fearful that the next day will take away your profit and you get out – too soon. The successful trader has to fight these two deep-seated instincts.

When you make a trade, “you should have a clear target where to sell if the market moves against you. And you must obey your rules! Never sustain a loss of more than 10% of your capital. Losses are twice as expensive to make up. I always established a stop before making a trade.

4. On the importance of sitting tight and being patient with your winners

They say you never go broke taking profits. No, you don’t. But neither do you grow rich taking a four-point profit in a bull market.

I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit.

The market does not beat them. They beat themselves, because though they have brains they cannot sit tight. Old Turkey was dead right in doing and saying what he did. He had not only the courage of his convictions but also the intelligence and patience to sit tight.

After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting.

5. You don’t have to be active every day.

First, do not be invested in the market all the time. There are many times when I have been completely in cash, especially when I was unsure of the direction of the market and waiting for a confirmation of the next move….Second, it is the change in the major trend that hurts most speculators.

Always remember; you can win a horse race, but you can’t beat the races. You can win on a stock, but you cannot beat Wall Street all the time. Nobody can.

There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time. No man can have adequate reasons for buying or selling stocks daily– or sufficient knowledge to make his play an intelligent play.

Remember this: When you are doing nothing, those speculators who feel they must trade day in and day out, are laying the foundation for your next venture. You will reap benefits from their mistakes.

Five Market Insights from Stanley Druckenmiller

Who is Stanley Druckenmiller?

Here is what hedge fund manager Scott Bessent says about Druckenmiller in the book “Inside the House of Money’:

Stan may be the greatest moneymaking machine in history. He has Jim Roger’s analytical ability, George Soros’s trading ability, and the stomach of a riverboat gambler when it comes to placing his bets. His lack of volatility is unbelievable. I think he’s had something like five down quarters in 25 years and never a down year. The Quantum record from 1989 to 2000 is really his. The assets grew from $1 billion to $20 billion over that time and the performance never suffered. Soros’s record was made on a smaller amount of money at a time when there were fewer hedge funds to compete against.

What is most interesting to me about the breaking of the pound was the combination of Stan Druckenmiller’s gamesmanship – Stan really understand risk and reward – and George’s ability to size trades. Make no mistake about it, shorting the pound was Stan Druckenmiller’s idea. Soros contribution was pushing him to take a gigantic position.

Druckenmiller is famous for making concentrated bets:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

If you don’t look at it from different perspectives, you might get disillusioned that Druckenmiller recommends to always take very concentrated bets. There are some nuances that you have to consider:

1. He always has an exit strategy. When Soros and Druckenmiller made their famous bet against the British Pound, the knew exactly how much they could lose – their entire YTD gain of 12%.

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.

2. He says that the right conditions to make a concentrated bet happen only once or twice a year. Not everyone is able to recognize those conditions. Proper Timing is Everything when you trade big. A good entry point allows you to go through normal market reactions.  An amazing entry point allows to use tighter stop and therefore bigger position size. Here’s hedge fund manager Scott Bessent on Stan Druckenmiller:

One of the things that I learned from Stan Druckenmiller is how to enter a trade. The great thing about Stan is that he can be wrong, but he rarely loses money because his entry point is so good.

3. You have to earn your right to bet big first.

It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it.

The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

What else, other than taking concentrated bets and impeccable timing, stay behind Druckenmiller’s exceptional performance?

A) Flexibility

The Friday before the 1987 crash, Druckenmiller goes from net short to 130% long. Here is his conversation with Jack Schwager in The New Market Wizards’ book:

– You’ve repeatedly indicated that you give a great deal of weight to technical input. With the market in a virtual free-fall at the time, didn’t the technical perspective make you apprehensive about the trade?

– A number of technical indicators suggested that the market was oversold at that juncture. Moreover, I thought that the huge price base near the 2,200 level would provide extremely strong support— at least temporarily. I figured that even if I were dead wrong, the market would not go below the 2,200 level on Monday morning. My plan was to give the long position a half-hour on Monday morning and to get out if the market failed to bounce.

***

Another important lesson to be drawn from this interview is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. Had he been less open-minded, defending his original position when confronted with contrary evidence, or had he procrastinated to see if the market would recover, he would have suffered a tremendous loss. Instead, he actually made a small profit. The ability to accept unpleasant truths (i.e., market action or events counter to one’s position) and respond decisively and without hesitation is the mark of a great trader.

***

Druckenmiller flipped the portfolio from short to long, a reversal that saved Quantum in 1999, but then hurt it a few months later in 2000. Druckenmiller finished 2000 up for the year. He went from down 12% in March to up 15% for the year in his own portfolio. If you remember, the Nasdaq dumped in March 2000 but then it almost made a marginal new high in September at which point he changed his mind again, went from net long to net short, and caught the whole move down from September to December 2000.

Stan is better at changing his mind that anybody I’ve ever seen. Maybe he stayed with it a little too long, but one of the great things about Stan is that he can and does turn on a dime. To paraphrase John Maynard Keynes, when the facts change, he changes his positions.

B) What actually matters in trading.

I’ve learned many things from Soros, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity

Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

C) Great defense wins championships

Druckenmiller’s entire trading style runs counter to the orthodoxy of fund management. There is no logical reason why an investor (or fund manager) should be nearly fully invested in equities at all times. If an investor’s analysis points to the probability of an impending bear market, he or she should move entirely to cash and possibly even a net short position.

D) You could be right on a market and still end up losing if you use excessive leverage.

One basic market truth (or, perhaps more accurately, one basic truth about human nature) is that you can’t win if you have to win. Druckenmiller’s plunge into T-bill futures in a desperate attempt to save his firm from financial ruin provides a classic example. Even though he bought T-bill futures within one week of their all-time low (you can’t pick a trade much better than that), he lost all his money. The very need to win poisoned the trade— in this instance, through grossly excessive leverage and a lack of planning. The market is a stern master that seldom tolerates the carelessness associated with trades born of desperation.

Sources:

INSIDE THE HOUSE OF MONEY, STEVEN DROBNEY, WILEY, 2008
Schwager, Jack D. (2009-10-13). The New Market Wizards: Conversations with America’s Top Traders. HarperBusiness.