Category: Best Of

Bull markets last long enough to erase the memory of most market participants of how it feels to be in a correction and what should be done.

Back in January this year, most people disbelieved the rally and were very cautious. The second half of 2011 was the definition of a trendless, high-volatility, choppy environment and over time it conditioned most of us to be very nimble and take profits quickly. Most breakouts failed, mean-reversion from overbought and oversold reading worked almost flawlessly.

As the bull market climbed a wall of worry, more and more people started to figure out that breakouts are actually working and delivering solid results.

In bull markets, corrections happen under the surface and take the form of  sector rotation. When financials and tech took a breather, biotech and consumer discretionary took the leading role and the indexes barely budged. All dips were a great buying opportunity in hindsight. Somewhere along the way, people realized that instead of jumping from a setup to setup, they might be much better off just riding three or four strong stocks.

The market has been really accommodating in the first 3 months of the year, to a point that it created complacency. Naturally, when a shift in a character came, most people were slow to react.

We entered a choppy, high volatile environment, where many breakouts will be short-lived. We will see stretches of several red days followed by a pocket of green days that will continue long enough to confuse everyone.

Recency or our tendency to  pay enormous attention to the most recent price action has huge influence on our psychology. A few red days in a row and everyone turns bearish and give up positions bought on a dip, just before the market is ready to bounce. A few green days and everyone thinks that all is well and new highs are on the horizon. Don’t judge the market based on one day of market action.

Trednless markets could be very stressful to those who don’t notice the change of market character and rethink their tactics.  Stress leads to overtrading and the latter is a really dangerous endeavor in a choppy market environment. Overtrading leads to losses and losses lead to a loss of confidence, which is the last thing you want to happen to you, because your decisions will be ruled by fear and not rules.

Greed and fear often trump experience. The choices we make every day define the quality of our  lives. We are in the business to make money, not to make trades.

Choose wisely. Do less.

Empathy gap is the main reason behind most trading mistakes. Empathy gap is the difference between how you believe you will act under certain circumstances and how you actually act when the time comes.

For example:

– I want to grab that stock on a pullback to its rising 50-day moving average and then do nothing when the moment comes;

– I will buy this stock when it breaks out of this range on volume and when the time comes you don’t buy it, because the stock jumps 5% the minute it breaks to new high. You wanted to pay $50.25 and at $52 suddenly seems expensive. Then you watch it go to $60;

– I will short the crap of that stock when it loses that $100 support, but when it does, you don’t do anything;

– I am not going to chase that stock here. It is too extended and the risk to reward is not worth it and yet you still buy it because everyone you know is making tons of money in it;

– I will stick to my hard stops next time…

Most market participants have incredibly short-term memory. Greed and fear have the power to erase even the most well thought out plan and make the smartest people behave silly.

Ignorance is not the main hurdle. A lot of people have excellent understanding of how market works and what their biases are, but yet very few are able to put that knowledge into practice. It is the difference between knowing how to lose weight and doing it, but 10 times harder. This is why so many successful people are not afraid to share everything they know – the “secret” to their success. Most people will never put the efforts and the time to consistently apply that knowledge in their everyday trading/investing process. It is human nature.

It turns out that most hedge funds have severely underperformed the S& P 500 year-to-date, in a bull market. Sometimes being too smart is a hurdle in the market. You overthink, you overtrade and at the end of the day, you are just running to stand still.

Markets could be as complicated as you want them to be. There are some ways to make sense out of the insanity:

1) Bull markets are markets of stocks. Most stocks will appreciate in a bull market, but some will go up much more than the average. Stock-picking skills matter a lot under such circumstances.

2) Bear markets are stock markets. Correlation is very high and most stocks move together up and down, disregarding of fundamentals. Stock picking is irrelevant here.

3) Bear markets make long-term investors a lot of money. Forced liquidation brings down prices to drastically low levels, to a point that some reasonably sound businesses are priced for default. Those are the type of stocks that become the best performers once the market turns north. Look at the Sleep Index, which is up 7000% for the past 3 years.

4) Mean-reversion works, but what is your time-frame of operation. We all suffer from recency bias. This is why when an asset goes from $100 to 70$ in a month, it suddenly seems “cheap”. When an asset goes from $20 to $30 in a month, it suddenly seems too expensive. Our brains are wired to think in terms of mean-reversion, but the trouble is that we also expect instant gratification for our actions and mean-reversion works best in long-term time frames. What seems too “cheap” could easily become “cheaper”. What seems expensive could easily become “more expensive”. Irrationality often trumps patience and solvency.

5) Only price pays. No matter how smart you are, how sophisticated your market approach is and how great your investment thesis is, unless the rest of the market agrees with you, you won’t make a cent.

6) Trading is like dating. You should only keep the stocks that make you happy.

7) Never Say Never. Being wrong is not a choice, staying wrong is.

8)  You are your own biggest enemy. Intelligence helps to realize what  needs to be done to be successful in the market, but it doesn’t guarantee that you will be able to apply that knowledge in practice.

9) The press will never run out of negative headlines. Fear sells best. There is always something to worry about, but you should never worry about something that doesn’t depend on you.

10) Sometimes, short-term price moves are just nonsensical noise, designed to make you second-guess yourself and shake you out of well-thought out, reasonable positions. Stick to your plan.