January 2016 – Page 2 – Ivanhoff Capital

Some Corrections Turn into Bear Markets

“A bull market is when you check your stocks every day to see how much money you’ve made. A bear market is when you don’t bother to look anymore.” – Bruce Kamich

In her excellent book “Bull”, journalist Maggie Mahar interviews Richard Russell on the three psychological stages of a bear market:

“The earliest stage is characterized by denial, increased anxiety, and fear. The second stage is panic. People suddenly say, ‘I’ve got to sell.’ The third phase is despair.” In the third phase, investors are so tired of the stock market that they don’t want to hear about stocks anymore, at any price”

Most corrections will remain just that – corrections. They won’t turn into bear markets. They will last a few weeks or few months. In the end, indexes will recover to new highs.

And yet, some corrections turn into bear markets. They are rare, but over 30-40 years of investing or trading, you will probably experience at least two or three of them – if market patterns continue to repeat. As long as there are humans involved, you can count on it. Markets always overshoot to the upside and the downside, because people’s psychology is cyclical and people tend to underreact to new information, then panic and overreact. Overreactions create the foundations for mean-reversions. Booms eventually lead to busts and busts to booms.

My definition of a bear market – spending a long time (more than a year) under a declining 200-day moving average, leading to 50% or bigger decline in a major, wide-encompassing index, like the S & P 500 for example.

You can imagine if an index is down 50%, what can happen to many individual stocks. No stock is insured against a bear market. Apple and Google lost 60% during the bear market in 2008. Amazon lost 95% during the bear market of 2000-2002. Priceline lost 99% in the same period. All of them managed to recover and hit new all-time highs afterward, but do you really think that you could have stomached the drawdowns that you had to go through? Do you really think that you could have put $1 million into PCLN and watch it turn into 10,000 and ride it all the way back without spooking at some stage and selling everything? Think again.

Are you familiar with the 50/30/20 concept? It states that 50% of a stock’s move is defined by the general market direction; 30% – by its industry; and only 20% is impacted by the individual merits of the underlying company. In a bear market, the 50/30/20 rule of thumb become something like the 90/10 rule, where 90% of a stock’s move is defined by the general direction of the market and only 10% – by the individual characteristics of that stock.

Traders should trade. Investors should invest. Whether you are a trader or an investor, if you deal with individual stocks, you always have to have an exit strategy. Some stocks never come back from their big drawdowns during market corrections.

This is a small excerpt from my book CRASH: How to Protect and Grow Capital during Corrections

10 Notable Quotes from the Book “Hedge Fund Market Wizards”

All markets look liquid during the bubble (massive uptrend), but it’s the liquidity after the bubble ends that matters.
Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated.
Traders focus almost entirely on where to enter a trade. In reality, the entry size is often more important than the entry price because if the size is too large, a trader will be more likely to exit a good trade on a meaningless adverse price move. The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience.
Virtually all traders experience periods when they are out of sync with the markets. When you are in a losing streak, you can’t turn the situation around by trying harder. When trading is going badly, Clark’s advice is to get out of everything and take a holiday. Liquidating positions will allow you to regain objectivity.
Staring at the screen all day is counterproductive. He believes that watching every tick will lead to both selling good positions prematurely and overtrading. He advises traders to find something else (preferably productive) to occupy part of their time to avoid the pitfalls of watching the market too closely.
When markets are trending up strongly, and there is bad news, the bad news counts for nothing. But if there is a break that reminds people what it is like to lose money in equities, then suddenly the buying is not mindless anymore. People start looking at the fundamentals, and in this case, I knew the fundamentals were very ugly indeed.
If you don’t understand why you are in a trade, you won’t understand when it is the right time to sell, which means you will only sell when the price action scares you. Most of the time when price action scares you, it is a buying opportunity, not a sell indicator.
Normally, I let winners run and cut losers. In 2009, however, as a result of the posttraumatic effects of going through the September 2008 to February 2009 period—talking to clients who are going out of business and seeing 50 percent of your fund redeemed is all very wearing—I got into the habit of snatching quick 10 to 15 percent profits in individual positions. Most of these positions then went up another 35 to 40 percent. I consider my pattern of taking quick profits in 2009 a dreadful error that I think came about because I had lost a degree of confidence due to experiencing my first down year in 2008.
As an equity trader, I learned the short-selling lessons relatively early. There is no high for a concept stock. It is always better to be long before they have already moved a lot than to try to figure out where to go short.
Now that you have switched from net long to net short, what would get you long again? – Buying. If all of a sudden stocks stopped going down on bad news that would be a positive sign.

Source: Schwager, Jack D. (2012-04-25). Hedge Fund Market Wizards. John Wiley and Sons. Kindle Edition.

Peter Lynch on Picking Bottoms – If they don’t scare you out, they will wear you out

Bottom fishing is a popular investor pastime, but it’s usually the fisherman who gets hooked. Trying to catch the bottom on a falling stock is like trying to catch a falling knife. It’s normally a good idea to wait until the knife hits the ground and sticks, then vibrates for a while and settles down before you try to grab it. Grabbing a rapidly falling stock results in painful surprises, because inevitably you grab it in the wrong place. If you get interested in buying a turnaround, it ought to be for a more sensible reason than the stock’s gone down so far it looks like up to you. Maybe you realize that business is picking up, and you check the balance sheet and you see that the company has $ 11 per share in cash and the stock is selling for $ 14. But even so, you aren’t going to be able to pick the bottom on the price. What usually happens is that a stock sort of vibrates itself out before it starts up again. Generally this process takes two or three years, but sometimes even longer.

How many times have you heard people say this? Maybe you’ve said it yourself. You come across some stock that sells for $ 3 a share, and already you’re thinking, “It’s a lot safer than buying a $ 50 stock.” I put in twenty years in the business before it finally dawned on me that whether a stock costs $ 50 a share or $ 1 a share, if it goes to zero you still lose everything. If it goes to 50 cents a share, the results are slightly different. The investor who bought in at $ 50 a share loses 99 percent of his investment, and the investor who bought in at $ 3 loses 83 percent, but what’s the consolation in that?

The point is that a lousy cheap stock is just as risky as a lousy expensive stock if it goes down. If you’d invested $ 1,000 in a $ 43 stock or a $ 3 stock and each fell to zero, you’d have lost exactly the same amount. No matter where you buy in, the ultimate downside of picking the wrong stock is always the identical 100 percent.

Sometimes it’s always darkest before the dawn, but then again, other times it’s always darkest before pitch black.

Source:

Lynch, Peter; Rothchild, John (2012-02-28). One Up On Wall Street. Simon & Schuster, Inc.. Kindle Edition.