Month: January 2016

The Difference between a Bull and a Bear Market

Bull markets reward risk-taking, but when the bear puts out honey, he is usually laying a trap: “In recent years, U.S. investors have felt that they must be playing the market—even when the risks are high,” Marc Faber observed. “They learned to think that they should invest like George Soros—but the average investor is not George Soros. When I play tennis, I don’t try to play like Agassi,” Faber added. “I have to play a different game. Agassi can play to win. I have to play a game where I don’t make any mistakes.” In a bear market, this is what is most important: not making mistakes. The goal is to conserve capital. When a long bear market finally ends, those with cash will find bargains galore.

In each case, investors were following the rule that they learned in a bull market: “The trend is your friend.” But in a bear market, “you have a whole different rule book,” Ralph Wanger observed. “In a straight-up growth market, your rule is to be 100 percent in equities all the time. Buy strength. Disregard risk. Only look at the income statement. And all stories are true because we want them to be true. It’s like the nice guy you met in the bar telling you he loves you truly—and he does. “In the volatile bear market that tends to follow an exponential growth market, many of these rules invert,” said Wanger, speaking from experience. “You don’t buy strength; you sell strength. You don’t look at the income statement, you look at the balance sheet [which shows a company’s debts]. All stories are false. It turns out that the guy in the bar is a married orthodontist from Connecticut.”

Source: Mahar, Maggie (2009-10-13). Bull! – HarperCollins. Kindle Edition.

Predictably Irrational – 10 Interesting Thoughts

piWithout pretending that the quotes below capture the essence of Dan Ariely’s book Predictably Irrational, here are a few of his conclusions that I think are interesting. I added some comments next to some of them (in blue).

1.Humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly. (For instance, we don’t know how much a six-cylinder car is worth, but we can assume it’s more expensive than the four-cylinder model)

2.Most people don’t know what they want unless they see it in context. We don’t know what kind of racing bike we want—until we see a champ in the Tour de France ratcheting the gears on a particular model. We don’t know what kind of speaker system we like—until we hear a set of speakers that sounds better than the previous one. We don’t even know what we want to do with our lives—until we find a relative or a friend who is doing just what we think we should be doing.

3.The New York Times ran a story recently about Gregg Rapp, a restaurant consultant, who gets paid to work out the pricing for menus. He knows, for instance, how lamb sold this year as opposed to last year; whether lamb did better paired with squash or with risotto; and whether orders decreased when the price of the main course was hiked from $39 to $41. One thing Rapp has learned is that high-priced entrées on the menu boost revenue for the restaurant—even if no one buys them. Why? Because even though people generally won’t buy the most expensive dish on the menu, they will order the second most expensive dish. Thus, by creating an expensive dish, a restaurateur can lure customers into ordering the second most expensive choice (which can be cleverly engineered to deliver a higher profit margin).

4. We are always looking at the things around us in relation to others. We can’t help it. This holds true not only for physical things—toasters, bicycles, puppies, restaurant entrées, and spouses—but for experiences such as vacations and educational options, and for ephemeral things as well: emotions, attitudes, and points of view. We always compare jobs with jobs, vacations with vacations, lovers with lovers, and wines with wines.

5. The more we have, the more we want. And the only cure is to break the cycle of relativity.

6. In order to make a man covet a thing, it is only necessary to make the thing difficult to attain.

7. Although initial prices  are “arbitrary,” once those prices are established in our minds they will shape not only present prices but also future prices  – first impressions matter; recency bias has a huge impact on our decision making. It explains why a $30 per barrel oil seemed expensive in 2002 (it was a new 10-year high at the time) and why a $30 oil seems super cheap today (it is a 10-year lows).

8. With everything you do, in fact, you should train yourself to question your repeated behaviors. We should also pay particular attention to the first decision we make in what is going to be a long stream of decisions (about clothing, food, etc.). When we face such a decision, it might seem to us that this is just one decision, without large consequences; but in fact the power of the first decision can have such a long-lasting effect that it will percolate into our future decisions for years to come. Given this effect, the first decision is crucial, and we should give it an appropriate amount of attention.

9. WHAT IS IT about FREE! that’s so enticing? Why do we have an irrational urge to jump for a FREE! item, even when it’s not what we really want? I believe the answer is this. Most transactions have an upside and a downside, but when something is FREE! we forget the downside. FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is. Why? I think it’s because humans are intrinsically afraid of loss. The real allure of FREE! is tied to this fear. There’s no visible possibility of loss when we choose a FREE! item (it’s free). But suppose we choose the item that’s not free. Uh-oh, now there’s a risk of having made a poor decision—the possibility of a loss. And so, given the choice, we go for what is free. – not sure that free is always alluring. In fact, if you go on the street and start offering people free money or a free apple, most won’t take it, because they’ll think that something is wrong. More importantly, they won’t take it because they don’t know you and therefore, they don’t trust you yet and because your offering seems ludicrous.

10. A great way to increase sales is by offering people something for free. The small cost of something for free is usually more than justified by the increase in sales…LET ME TELL you a story that describes the real influence of FREE! on our behavior. A few years ago, Amazon.com started offering free shipping of orders over a certain amount. Someone who purchased a single book for $16.95 might pay an additional $3.95 for shipping, for instance. But if the customer bought another book, for a total of $31.90, they would get their shipping FREE! Some of the purchasers probably didn’t want the second book (and I am talking here from personal experience) but the FREE! shipping was so tempting that to get it, they were willing to pay the cost of the extra book. The people at Amazon were very happy with this offer, but they noticed that in one place—France—there was no increase in sales. Is the French consumer more rational than the rest of us? Unlikely. Rather, it turned out, the French customers were reacting to a different deal. Here’s what happened. Instead of offering FREE! shipping on orders over a certain amount, the French division priced the shipping for those orders at one franc. Just one franc—about 20 cents. This doesn’t seem very different from FREE! but it was. In fact, when Amazon changed the promotion in France to include free shipping, France joined all the other countries in a dramatic sales increase. In other words, whereas shipping for one franc—a real bargain—was virtually ignored by the French, FREE! shipping caused an enthusiastic response.

Zero is not just another discount. Zero is a different place. The difference between two cents and one cent is small. But the difference between one cent and zero is huge!

Source: Predictably Irrational, Dan Ariely

Is Cash Really A Position?

Josh Brown, who I tremendously respect, made an interesting comment on Twitter about going to cash in times of turmoil:

In this case, he does not refer to hedge funds or individual trading accounts, but to people’s retirement savings.

I can see why he would suggest that most investors should not go to cash and should continue the course of dollar-cost averaging each month:

First, past history shows that many investors are not very good at timing the market. Here’s Joel Greenblatt in the book Hedge Fund Market Wizards by Jack Schwager:

The single best-performing mutual fund for the entire decade was up 18 percent a year, on average, during a period when the market was flat, yet the average investor in that fund lost 8 percent. That is because every time the fund did well, people piled in, and every time it underperformed, people redeemed. The timing of the money flows was so bad that investors, on average, turned a fund that was making 18 percent a year into a losing investment. I think that says it all. Institutions make the same mistakes as smaller investors.

Second, achieving average returns would be a great success for many investors.

And third, many investors are likely to be reluctant to buy at higher prices. Psychologically, it is difficult to buy an asset at $200 if you sold it at $170. In life as in markets, if you want to achieve bigger than average results, you often have to do things that are psychologically challenging for the majority of people. If it was easy, everyone would do it and the potential reward would be much smaller.

These are all good arguments, but constantly staying 100% invested and diversified is not the perfect solution for many.

1. Some don’t invest in well-diversified ETFs and own individual stocks in their 401k in order to achieve higher returns.
2. Those that are well diversified geographically and in terms of market cap and non-correlated assets, also go through deep drawdowns because correlations often go to 1.00 during deep market correction. It doesn’t matter if you own Apple or Snapple. Your portfolio is getting hit during market panic. When your portfolio goes through a deep drawdown, you are very likely to panic and sell near the lows. What happens when you sell near the lows? You lose your confidence and you don’t take advantage of the recovery.

3. If you manage to minimize drawdowns during deep market corrections, you will be able to grow your capital faster and be in a better psychological position take advantage of much lower panic prices.

If you are an investor that prefers to ride some trends in a long-term perspective, you need to learn how to hedge. One simple way to hedge long-term holdings is to buy some short-term protection (put options or put spreads) when your stocks start to show signs of distribution and close below their 50dma.

If you are a trader, it is very simple. You diligently take your losses and make sure that they are small, so the size of your winners can overshadow them. As George Soros was famously quoted by Druckenmiller – “it is not important whether you are right or wrong, but how much money do you make when you are right and how much money do you lose when you are wrong”.

Is market timing possible? I believe it is. It is not an exact science, but there’s a process to the madness. There are some clear signs in the market that hint when it makes sense to raise cash, hedge and go net short – distribution days in major stock indexes, price action in market leaders, changes in market breadth, changes in trading results, etc. I wrote about them in more detail in my book Crash – How to Protect and Grow  Capital during Corrections.

To answer Josh’s question about “when do you get back”

There are a few things we will be watching ranked in terms of importance:

1. Stocks setting up on the long side are starting to break out and following
through. These are the next market leaders that we want to own
aggressively.
2. Multiple days of heavy buying in the major indexes: up 1.5% on bigger
than the average 50-day volume; the signal is much stronger if indexes
finish near the high of their daily range. Sustainable bottoms are formed by
heavy buying, not heavy selling.
3. A retest of the momentum low with a smaller number of stocks making
new 20-day lows or larger number of stocks trading above their 20-day
moving averages – with other words, a retest with some form of market
breadth divergence. Retests are not always necessary for a bottom to form.
They matter from a psychological perspective because they flush out the last
remaining weak hands in the market, which makes the recovery smoother
and faster.
4. The major indexes close back above their 200-day moving averages and
stay there. They start to move higher.
We could gradually increase our long market exposure depending on how
many of those points are met: 25% when point 1 is met; 50% when 1 & 2,
etc.

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