The dangers of deflation

In long-term perspective there are two scenarios for the global economy: severe deflation and strong inflation, as they might come one after another in this order.
Severe deflation will mean further shrinking of consumption, unemployment in the double digits. More downside for commodities. Oil might take the elevator to the lower 30s. If this happens, we might see another 30-50% decline in the stock markets, as soon as next year. Earnings expectations are still elevated and negative earnings surprises in the coming quarter might shave the Dow with razor number 6. Many emerging countries will default on their credit following the example of Ecuador last Friday – a dangerous practice that usually leads to tightening of the credit markets, which hurdles economic growth. Severe economic crises around the world might lead to forced change of governments and a revival of nationalistic political systems. No country is insured against the unsatisfaction of the crowds. Countries which have enjoyed higher economic standards during the last decade should be particularly aware of sudden economic slump. People seem to be motivated more by the thought of losing something that by the thought of gaining something of equal value. James Davis states that we are most likely to find revolutions at a time when a period of improving economic and social conditions is followed by a short, sharp reversal in those conditions. Thus, it is not the traditionally most downtrodden people – those who have come to see their deprivation as part of the natural order of things – who are especially likely to revolt. Instead revolutionaries are more likely to be those, who have given at least some taste of a better life. When the economic and social improvements they have experienced and come to expect suddenly become less available, they desire them more than ever and often rise violently to secure them. For instance, it is little recognized that at the time of the American Revolution, the colonists had the highest standard of living and the lowest taxes in the Western World. According to historian Thomas Fleming, it wasn’t until British sought a cut of this widespread prosperity (by levying taxes) that the Americans revolted.
The other, and ironically the preferred path, is inflation. The US government desperately is trying to inflate the economy, trying to prevent Great Depression number two from happening. The financials injections in the economy will lead to severe weakening of the dollar. People, who keep their money under their mattresses or in low interest savings’ account will get poorer. The only way to offset the decline in the purchasing power of your dollars will be to be invested in the stock markets, which are supposed to rise during periods of inflation. Commodities will renew their upward spiral.

Analysing yourself

“At the end of each trading day (week) you shouldn’t focus solely on your P/L. Instead, focus on your thought process during the day and how well you executed your plan. If you consistently execute your trades according to plan and still lose money, then you need to reevaluate your approach. While there is definitely a cyclical rhythm to the market, no strategy will always work. You need to constantly  and objectively  review what is working and what is not so you can make necessary adjustments to you plan.”

Brian Shannon

Having a plan

Having a plan of action allows you to be objective when others are often reacting emotionaly. Every weekend I sit and create a list with potential trading candidates for next week. I choose 5 longs and 5 shorts, representing different industry groups, which my analysis reveals that might have a significant move during the week. Watching such a small number of stocks helps me to be more focused and objective. Usually only 2 or 3 out of the chosen 10 stocks will behave the way I expected, but in my scheme of things this is more than enough.

Thinking out of the box

The current market is unique. It has never been so volatile; therefore the danger and the opportunities have never been so plentiful. No one has ever traded in such market, so past knowledge and experience may only be a hinder to adopt faster in the new environment. No system is profitable all the time and traders with 20+ years of profitable track record are in the process of realizing that. In time of extreme changes survives the one, who is more flexible, not the stronger one.

Conventional wisdom will bring you only losses. You have to learn to think out of the box. Conventional wisdom says that in bear markets you should be only short or neutral. In case you absolutely have to have long positions in your portfolio, you should choose among the stocks with highest relative strength – the ones that somehow managed to weather the storm.  Wrong. Buying high RS in this market doesn’t work. Current price leaders are not only underperformers during sharp bear market bounces, but one by one, industry group by industry group, they are all taken down. In bear market they are all taken down, sooner or later.

Conventional wisdom says that we should short low relative strength (52 week lows for example) in this market environment. This is a strategy that makes sense, but a very, very dangerous one. Remember, market can remain irrational longer than you can remain solvent. Some of the most powerful daily and weekly upside moves have happened during severe bear markets. Last week there were 148 stocks that went up 20%+. (Priced above $2 per share and average daily volume above 50k). The majority of them did that from their 52 week lows – the most beaten down stocks. Every week there is an industry or two that revive from the dust. Past week that was Medical instruments and Insurance companies. The week before was good for solar companies. The week before that was good for gold miners. The one before that was good for airline companies.  Stocks tend to move in groups. When you are looking for short-term trading opportunities, you should look at industry groups’ moves first.

Certainly trying to pick a bottom is a very dangerous game. Last week 189 companies went down 20%+. Most of them were close to their 52 week lows and had their leg down after a short-term bounce. More than half of the worst performing stocks last week belong to Oil related industries.

Market is so volatile that it takes stops out on a regular basis, shaking out both long and short swing traders. Percentage stop losses don’t work in this environment.  If you are going to survive and thrive, you need to decrease your trading horizon and the size of your trading. I remember that about a year ago, I found out that many, who were swing traders at the beginning of their careers at some point switched to day trading. I wondered why and started asking questions. My initial guess was that the tremendous volatility in 2000-2001 has made those traders change their strategy. The answers received were a little bit different. Most traders told me that it is a more psychological thing. They have found what suits their personality and goals best.

Markets are made from people. In theory everyone could be profitable if there is a continuous flow of fresh money into the market. Recently this has not been the case. Someone has to lose. In order to be profitable you need to follow a very simple rule – to buy only what you could sell later at higher price and to sell short only what you could buy later at lower price. Like the owner of a small shop, you should not buy inventory that you personally like, but stuff that could easily be sold this season. Yes, stock traders are in the retail business and their products are called stocks. I realize that such how scrupulous such way of thinking sounds and that it contradicts the initial purpose the market were created, but this is the reality.

Initially markets were created :

          To offer an alternative exit strategy (therefore motivation) for entrepreneurs;

          To provide new means of cheaper financing for business’ expansion;

          To allow ordinary citizens, who don’t have the idea, the will or the necessary capital to start their own business, with the opportunity to participate effectively in the economic growth of the country/the world.

All those things don’t matter anymore. Markets have long turned into a speculation arena, where everyone tries to outsmart the other.  

 

Trends

In uptrends, it is more profitable to be long all time highs and positive reactions to earnings. In downtrends, it is more profitable to be short all time lows and negative reactions to earnings. Every trend experiences normal corrections on its way up/down. Such corrections are often good buying opportunities as the trend tends to continue in its major direction. Sooner or later every trend ends. No one knows when. But to maximize and protect profits, we gradually raise our stops to levels, which when broken indicate an end of a trend. There will be times when our stops will shake us out too early from a trend, but we don’t need to catch the exact top or bottom in order to be profitable.