When I first started to seriously invest I thought that the only thing that you really needed to do to be successful was pick a great stock and let it ride. Now I know that stock selection, while surely an important part of the recipe, is not the sole ingredient. There are certainly many moving parts to a good trading system and I think one critically overlooked area is portfolio management. In this post I would like to share a simple yet incredibly effective method for managing your positions and protecting yourself in dangerous market.
Before we go any further, I want to be upfront and say that this is the exact method that got me out of the market in its failed rally in December 2007 and August 2008. I managed to side step the worst part of the market’s terrible declines and sit comfortably in cash watching these historic events unfold. This strategy saved me tens of thousands of dollars and preserved much of my nest egg.
The Rule of Three’s is a simple method that protects you from a floundering market or a flawed trading system. Just like in baseball it is three strikes and you are out. I picked this method up from IDB and a variation found in Alexander Elder’s book “Entries and Exits”. Here is how it works:
1. Once my trading system indicates that the general market has had a change in trend, I make my first stock purchase. You can use this to go either long or short as long as you are on the correct side of the trend.
2. I make my first pilot buy based on my selection criteria. A pilot buy is a percentage of the total position that I hope to ultimately establish. The purpose of the pilot buy is to confirm that my judgment is correct and if it isn’t it allows me to get out of my mistake as cheaply as possible.
3. The initial pilot buy can be anywhere from 1/3 to ½ of the total position. I average up as the price increases. For example, if I have $10,000 to invest I make an initial buy with $5,000.
4. If the stock shows good action and the price increases 2-3% I make another buy of $3,000. Finally I round out the rest of my position if it appreciates another 2%.
5. If the initial pilot buy declines 3-4% I cut my loss and get out. I don’t hope, pray or argue with the market. I know that my biggest winning stock picks have always started out as winners and normally do not decline in price. My losers start as losers so I want to get out as cheaply as possible.
6. I normally, but not always, try to build out one full position or get stopped out before moving on to a second pick. Now I repeat the process twice more once an outcome as been reached on the first position.
7. If I get stopped out three times in a row, I stop all trading activity for three weeks.
The final point is the real key. Stopping and taking a breather is my system's safety valve and it serves to protect me from greater damage. The natural question is, why stop?
Three strikes in a row means something is either wrong with my trading selection or the market in general. This is an indication that I need to take time to review my activity or give the market time to sort itself out.
In practice, following this rule can be a challenge because after all I want to make money to achieve my own personal goals. I want these goals met now, but I know that the market operates on its own scale. This rule protects me from me.
Now I want to demonstrate how this rule protected me from the great fall that began in September 2009. Executing this procedure forced me into 100% cash and allowed me to watch the subsequent market crash with a macabre fascination.
At the beginning of August 2008 the market logged a follow through day. This indicated a potential change in market trend and gave the green light to start buying high quality stocks as they broke out of sound bases. One such stock I had been following for quite a while was retailer Buckle (BKE).
The stock has a strong mix of fundamental and technical indicators and I thought it could be an early leader for a new rally. I made several attempts to purchase the stock only to get stopped out. Finally, my lack of success forced me out of the market two weeks before Labor Day.
Labor Day week the general market seemed under pressure and the subsequent rally failed. I was 100% in cash at this point. On September 29th 2008 the NASDAQ alone lost nearly 200 points and ushered in many terrible weeks for the market and the global economy. On those horrible days I took satisfaction that I had followed my rules and protected my self from an event that I had know idea would happen.
Sunday, March 29, 2009
Sunday, January 25, 2009
Could the S&P 500 Close Below 500?
The conventional wisdom holds that the stock market bottomed in November of this past year. 2008 was truly one the worst years that the market has ever seen; in fact the whole system seemed close to a complete melt down in September and October. I like everyone else, was looking for a strong rally after such a steep decline but alas I think we may have to wait.
This past year, after reading Van Tharp’s Trade Your Way to Financial Freedom, I became intrigued by the idea of secular bull and bear markets. In a nutshell this means that the market moves in large waves of expansion and contraction. On average secular bull markets last 15 years while the average bear market lasts 18 years. The crash of 2000 marked the end of the secular bull market which began in 1982. We are now in secular bear market which could easily last well into 2018. Before you jump off that bridge, there are a couple of important points to understand about secular bear markets.
1. P/E Valuations decline in secular bear markets even though stock prices may increase.
2. Some of the largest sustained market rallies, those lasting 18 months or more have occurred in the middle of secular bear markets.
3. The biggest rallies tend to occur when P/E valuations have entered the single digits.
Robert Shiller, author of "Irrational Exuberance", maintains an extensive spreadsheet of historical price earnings (P/E) which clearly illustrates the point that during secular bear markets prices may rise while overall valuations decline. The two big secular bear markets of the twentieth century ran from 1929-1949 and 1966-1982. Shiller’s spreadsheet makes for an interesting read and may shed some light on the market’s current path.
June of 1932 marked both the price and valuation low of the Great Depression. P/E values were a measly 5.57 and the S&P stood at 4.77. Market prices trended up for the next years until the dawn of the next golden bull in 1949. Valuations however peak at a P/E of nearly 22 in 1937 and then gradually declined back to 9 over the next 12 years. Price peaked at 18 and meandered back and forth finally setting at 13.97.
September of 1974 marked the price and valuation low of the 1966-1982 secular bear market. The S&P price was 68.12 with a P/E of 8.68. The market’s followed the same pattern as in 1932 meaning prices increased with occasional rallies but this time the market couldn’t even get above a P/E of 12 during this period. It finally bottom with a P/E of 6.64 in the fall of 1982 and soon began our last secular bull market. Price increased from the 1974 low of 68.12 to 110.80 in 1982 with some peaks and valleys in between.
So what does history say about today? We suffered through a terrible decline and I truly hope the worst is behind us however the P/E numbers plus the trend history of 1932 and 1974 indicate turbulence ahead.
Today the S&P 500’s P/E, according to the Shiller spreadsheet, is 15.39 which means that we are roughly at historical averages. As I illustrated above secular bear markets tend to bottom when the P/E reaches single digits. Based on current earnings, for the S&P 500 to achieve just a P/E of 10 would mean the current price would have to drop to 485. Today the price is 805. To reach single digits the S&P 500 would have to go even lower.
Now for the good news. When secular bear markets bottom in both price and P/E it creates the conditions for large sustained rallies even though the overall price trend of the market is down.
I have borrowed the table below from Martin Zweig Winning on Wall Street to demonstrate the point. I have added the S&P 500 P/E from the Shiller spreadsheet to show correlation but not necessarily causation for large bull runs.
This past year, after reading Van Tharp’s Trade Your Way to Financial Freedom, I became intrigued by the idea of secular bull and bear markets. In a nutshell this means that the market moves in large waves of expansion and contraction. On average secular bull markets last 15 years while the average bear market lasts 18 years. The crash of 2000 marked the end of the secular bull market which began in 1982. We are now in secular bear market which could easily last well into 2018. Before you jump off that bridge, there are a couple of important points to understand about secular bear markets.
1. P/E Valuations decline in secular bear markets even though stock prices may increase.
2. Some of the largest sustained market rallies, those lasting 18 months or more have occurred in the middle of secular bear markets.
3. The biggest rallies tend to occur when P/E valuations have entered the single digits.
Robert Shiller, author of "Irrational Exuberance", maintains an extensive spreadsheet of historical price earnings (P/E) which clearly illustrates the point that during secular bear markets prices may rise while overall valuations decline. The two big secular bear markets of the twentieth century ran from 1929-1949 and 1966-1982. Shiller’s spreadsheet makes for an interesting read and may shed some light on the market’s current path.
June of 1932 marked both the price and valuation low of the Great Depression. P/E values were a measly 5.57 and the S&P stood at 4.77. Market prices trended up for the next years until the dawn of the next golden bull in 1949. Valuations however peak at a P/E of nearly 22 in 1937 and then gradually declined back to 9 over the next 12 years. Price peaked at 18 and meandered back and forth finally setting at 13.97.
September of 1974 marked the price and valuation low of the 1966-1982 secular bear market. The S&P price was 68.12 with a P/E of 8.68. The market’s followed the same pattern as in 1932 meaning prices increased with occasional rallies but this time the market couldn’t even get above a P/E of 12 during this period. It finally bottom with a P/E of 6.64 in the fall of 1982 and soon began our last secular bull market. Price increased from the 1974 low of 68.12 to 110.80 in 1982 with some peaks and valleys in between.
So what does history say about today? We suffered through a terrible decline and I truly hope the worst is behind us however the P/E numbers plus the trend history of 1932 and 1974 indicate turbulence ahead.
Today the S&P 500’s P/E, according to the Shiller spreadsheet, is 15.39 which means that we are roughly at historical averages. As I illustrated above secular bear markets tend to bottom when the P/E reaches single digits. Based on current earnings, for the S&P 500 to achieve just a P/E of 10 would mean the current price would have to drop to 485. Today the price is 805. To reach single digits the S&P 500 would have to go even lower.
Now for the good news. When secular bear markets bottom in both price and P/E it creates the conditions for large sustained rallies even though the overall price trend of the market is down.
I have borrowed the table below from Martin Zweig Winning on Wall Street to demonstrate the point. I have added the S&P 500 P/E from the Shiller spreadsheet to show correlation but not necessarily causation for large bull runs.
Greatest S&P 500 Advances – 1926 to 1996 | ||
Date of Low | P/E | Max. % Gain within 18 months of low |
6/1/32 | 5.57 | +154.5 |
2/27/33 | 7.83 | +120.6 |
3/31/38 | 12.38 | +62.2 |
4/28/42 | 8.54 | +60.2 |
6/13/49 | 9.07 | +50.0 |
9/14/53 | 11.34 | +65.2 |
10/22/57 | 14.15 | +49.2 |
5/26/70 | 13.98 | +51.2 |
10/3/74 | 8.74 | +66.1 |
8/12/82 | 6.64 | +68.6 |
12/13/84 | 9.60 | +53.3 |
10/11/90 | 14.82 | +52.1 |
The above table illustrates an amazing fact that the market’s biggest rallies can and do occur after things have gotten really bad and pessimism reins supreme. I was surprised to see that the top 4 rallies occurred during the Great Depression and in the middle of World War II. In recent times the market stage big rallies after the disastrous period from 73-74 and the gloomy recession of 1982. The market was up 50% after its perilous decline from 2000-2003.
So what does this mean for you today? First, historical precedence seems to indicate that we have a while before the market will truly bottom however that doesn’t mean that significant short term rallies can’t occur. Second, to capture both the short and ultimately the long term move you need to have a trading system to help you navigate these troubled waters. If you don’t have system to trade individual stocks in this market environment then it is best to sit in cash until the storm passes. Finally, those of you sitting in mutual funds do not open your statements for quite a while.
Tuesday, December 9, 2008
CANSLIM(R) - Part 1
I am an avid follower of the CANSLIM investment methodology. In a nutshell this strategy uses a blend of fundamental and technical analysis to identify the strongest stocks in the strongest groups at crucial market turning points. CANSLIM has uncovered such monster stocks as Cisco, Apple, Hansen and Research in Motion which made the investment careers of those who bought at the right time. For every one Apple we may have 100 ho-hum stocks which yield of mixture of winners and losers while we wait for that one special stock o appear. What to do in the meantime?
CANSLIM is a great way to search for those shooting stars, but let’s be honest people who bought Apple or RIMM or Cisco when they first broke out had no idea how far these stocks might go. They may have had the attributes of past winners, as many other stocks at the time did, but there was no sure fire way to quantify how far the stocks might rise. For every Apple I am sure that there are 100 other similar stocks that either modestly grew or just fizzled. We can use fancy computer screens and advanced charting software to aid in our selection but when you boil it down buying stocks is a gamble.
When I first started to invest I really focused on finding that one great stock that would make me. I followed the CANSLIM tenants to cut all losses short when a purchase declined 7-8% from my buy point and I concentrated my holdings in 4 to 5 stocks. I would let my winners run and cut my losers short. I had no real money management or position sizing strategy which Van Tharp defines as “how much”. I was really more of a steady state investor. I divided my capital into fifths and would purchase stock in those amounts. I soon ran into an interesting problem.
In a down or struggling market this steady state method would chip away at my capital if I hit a losing streak. For instance if I had $10,000 and bought one stock that showed a 20% profit or $2,000 it was possible to have 3 or 4 losers in a row that could wipe out my gain. So if I purchased a 3 more stocks for $10,000 each and cut my losses short at 7% I would have lost $2,100. This is actually pretty easy to do in a weak or struggling market like we have now. I thought there must be a better way to do things instead of just getting pounded while waiting for market distribution days to pile up.
In Part 2 of this series I will discuss how I came upon the money management algorithm which I use today and why I credit it for my survival in this year’s market.
CANSLIM is a great way to search for those shooting stars, but let’s be honest people who bought Apple or RIMM or Cisco when they first broke out had no idea how far these stocks might go. They may have had the attributes of past winners, as many other stocks at the time did, but there was no sure fire way to quantify how far the stocks might rise. For every Apple I am sure that there are 100 other similar stocks that either modestly grew or just fizzled. We can use fancy computer screens and advanced charting software to aid in our selection but when you boil it down buying stocks is a gamble.
When I first started to invest I really focused on finding that one great stock that would make me. I followed the CANSLIM tenants to cut all losses short when a purchase declined 7-8% from my buy point and I concentrated my holdings in 4 to 5 stocks. I would let my winners run and cut my losers short. I had no real money management or position sizing strategy which Van Tharp defines as “how much”. I was really more of a steady state investor. I divided my capital into fifths and would purchase stock in those amounts. I soon ran into an interesting problem.
In a down or struggling market this steady state method would chip away at my capital if I hit a losing streak. For instance if I had $10,000 and bought one stock that showed a 20% profit or $2,000 it was possible to have 3 or 4 losers in a row that could wipe out my gain. So if I purchased a 3 more stocks for $10,000 each and cut my losses short at 7% I would have lost $2,100. This is actually pretty easy to do in a weak or struggling market like we have now. I thought there must be a better way to do things instead of just getting pounded while waiting for market distribution days to pile up.
In Part 2 of this series I will discuss how I came upon the money management algorithm which I use today and why I credit it for my survival in this year’s market.
Sunday, November 9, 2008
Where We Stand Today
On October 28th the market logged a follow-through day which indicates a potential change in direction. Is this the eagerly awaited bottom or just another head fake? An important secondary, but often ignored, indicator for a change in market direction is that leading stocks start breaking out of sound bases. Right now only a handful of leading stocks have managed to breakout and many of their group mates have struggled which means caution is still advised.
The medical sector, especially home health care, is trying to lead the way but only a few stocks have managed to make any progress while their group mates struggle. Consider the following:
1. Almost Family (AFAM) scored a strong break out on October 30th and has gained nearly 20% in that period. Contrast this with group mate Amedisys (AMED) whose stock is struggling to build the right side an erratic loose base. Normally strong group moves yield a vibrant crop of breakouts. Think oil stocks this past spring and solars a year earlier.
2. Biotech stocks, lead by Emergent Biosolutions (EBS), is another source of potential leaders but group mate Celgene (CELG) has its own challenges. Celgene’s 50 day moving average recently crossed under its 200 day moving average which is a particularly bearish signal.
What actionable information does this mean right now for investors? First and foremost, the dearth of breakouts and the subsequent struggles of their group mates mean go slow and exercise patience. If you find a stock you like make a small purchase and only add follow-on buys if the price advances. Cut your losses quickly if the stock declines more than 7-8% from its purchase price. We are still in a bear market so treat follow through days and stocks as guilty until proven innocent.
The medical sector, especially home health care, is trying to lead the way but only a few stocks have managed to make any progress while their group mates struggle. Consider the following:
1. Almost Family (AFAM) scored a strong break out on October 30th and has gained nearly 20% in that period. Contrast this with group mate Amedisys (AMED) whose stock is struggling to build the right side an erratic loose base. Normally strong group moves yield a vibrant crop of breakouts. Think oil stocks this past spring and solars a year earlier.
2. Biotech stocks, lead by Emergent Biosolutions (EBS), is another source of potential leaders but group mate Celgene (CELG) has its own challenges. Celgene’s 50 day moving average recently crossed under its 200 day moving average which is a particularly bearish signal.
What actionable information does this mean right now for investors? First and foremost, the dearth of breakouts and the subsequent struggles of their group mates mean go slow and exercise patience. If you find a stock you like make a small purchase and only add follow-on buys if the price advances. Cut your losses quickly if the stock declines more than 7-8% from its purchase price. We are still in a bear market so treat follow through days and stocks as guilty until proven innocent.
Tuesday, October 28, 2008
Plan for the Impending Rally, Part 2
The market has given conflicting signals over the past several weeks. October 16th, the market logged a Follow-Through Day which often indicates a change in market trend. As IBD is fond of saying, “no market uptrend has ever started without a follow through day, but not every follow through day means a new bull market”. How should an investor reconcile what on the surface seems like contradictory advice? In part one of “Plan for the Impending Rally”, I said that investors need a system that at a minimum answers these four questions:
1. A signal that the market has bottomed and is now heading higher
2. A process to identify the strongest stocks in the strongest industries as the market turns
3. A money management plan which allows you to put more money to work if the market appreciates
4. A stop loss policy to protect your capital if your individual security begins to crumble
Before we go any further I just want to point out that during the week of October 22nd the market suffered two straight days of heavy volume losses coupled with a traumatic Friday start when the market opened with limit down curbs in place. The poor daily and weekly action negates the follow-through day mentioned above. Today, October 28th, the market logged yet another follow through day on decent volume and big price gains.
Now that the market direction may have changed, where do we go from here? The market is clearly whipsawing creating a dangerous environment. The media is filled with pundits calling this an opportunity of a life time and value investors have started to come into the market lead by Warren Buffet. Tread lightly.
As I mentioned in my prior posting, if you are a long term mutual fund investor with a 10+ year time frame keep putting money to work and double up if possible. In 20 years you will glad you did.
What should you do if you have a more speculative outlook? First review the four main points above and begin constructing an appropriate system so you can effectively invest in this challenging market environment which could last for years. There are literally thousand of stock market systems out there but keep in mind you must find one that matches your market outlook and personal psychology. Be realistic and know that it will take several years to master a given system so in the meantime how should you operate in today’s’ market?
Here is a game plan to consider. The plan allows you to spot a potential market turning point, identify new leadership, pick strong stocks and effectively manage your money.
1. Look for the market to log follow through day. This indicates a potential change in market direction and could potentially signal the long anticipated bottom. This event occurred today.
2. Now that the market has followed through, look for stocks making new highs while preferably breaking out of new bases. Ideally you would find several stocks form the same industry group moving in tandem to new highs. This is an excellent way to confirm market sector leadership.
3. The bear market has damaged just about every stock, so even though a follow through occurred not many stocks may fit the parameters mentioned above. You must exercise patience and resist the urge to jump in because you will miss big gains. We are in a nasty correction and you must exercise skepticism above all else and make the market prove itself before you risk your hard earned money.
4. Once you have found a stock that meets your selection criteria, make a small initial purchase as close to the proper buy point as possible. The initial purchase should be only a very small amount of your total portfolio. My last initial buy used only 2.5% of my total portfolio, but I risked even less. More on that below.
5. Put a stop in place when you make you initial buy. I normally put my stop loss at 5% below my first purchase price but you could go as far as a 10% stop. My experience is that once a stock begins to show a loss it will eventually hit my stop so I try to get out as cheaply as possible.
6. Stops limit what you actually risk in the market. For instance if you purchase $5,000 worth of stock with a 5% stop you aren’t wagering that total amount but just $250 which on a $100,000 portfolio equals just .025%. Think about this the next time you see the whole market swoon 10%.
7. If the initial buy shows a profit, add more as the stock gains 2-2.5% from your last purchase price. Make three buys of even amounts and be sure you do not buy any further than 5% past a proper buy point.
8. If your stock increases enough to make three buys make sure you have stop in place to protect that whole position. Again I prefer a 5% stop for a complete position.
9. If the first position is a winner look for a second stock to buy. The market has shown strength so now repeat steps 4-7 but it is safe to increase the amount of capital that you use from 2.5 of your total portfolio to 4% when making the next purchase. Don’t forget the stop!
10. If your first position is stopped out take it as a danger signal. The market is not working for you. Consider sitting on the sidelines but if you are compelled to make another stock purchase repeat steps 4-7 but this time only use 1.5% of your portfolio take make that first buy and don’t forget the stop!
11. If you buy three stocks and you stop out on all three take three weeks off before making any more buys. Use the time to evaluate the overall market condition because three strikes is the market’s way of telling you something is wrong. This is by far that hardest thing that I have to force myself to do because I have a psychological weakness that I believe the market will increase. I have put this rule in place to protect me from myself.
In closing the market has followed through indicating a potential change of trend. Use a sound set of trading principals like the ones outlined above of search for one that fits your own personal style. Above all, exercise caution and use stops to protect yourself in a dangerous market.
1. A signal that the market has bottomed and is now heading higher
2. A process to identify the strongest stocks in the strongest industries as the market turns
3. A money management plan which allows you to put more money to work if the market appreciates
4. A stop loss policy to protect your capital if your individual security begins to crumble
Before we go any further I just want to point out that during the week of October 22nd the market suffered two straight days of heavy volume losses coupled with a traumatic Friday start when the market opened with limit down curbs in place. The poor daily and weekly action negates the follow-through day mentioned above. Today, October 28th, the market logged yet another follow through day on decent volume and big price gains.
Now that the market direction may have changed, where do we go from here? The market is clearly whipsawing creating a dangerous environment. The media is filled with pundits calling this an opportunity of a life time and value investors have started to come into the market lead by Warren Buffet. Tread lightly.
As I mentioned in my prior posting, if you are a long term mutual fund investor with a 10+ year time frame keep putting money to work and double up if possible. In 20 years you will glad you did.
What should you do if you have a more speculative outlook? First review the four main points above and begin constructing an appropriate system so you can effectively invest in this challenging market environment which could last for years. There are literally thousand of stock market systems out there but keep in mind you must find one that matches your market outlook and personal psychology. Be realistic and know that it will take several years to master a given system so in the meantime how should you operate in today’s’ market?
Here is a game plan to consider. The plan allows you to spot a potential market turning point, identify new leadership, pick strong stocks and effectively manage your money.
1. Look for the market to log follow through day. This indicates a potential change in market direction and could potentially signal the long anticipated bottom. This event occurred today.
2. Now that the market has followed through, look for stocks making new highs while preferably breaking out of new bases. Ideally you would find several stocks form the same industry group moving in tandem to new highs. This is an excellent way to confirm market sector leadership.
3. The bear market has damaged just about every stock, so even though a follow through occurred not many stocks may fit the parameters mentioned above. You must exercise patience and resist the urge to jump in because you will miss big gains. We are in a nasty correction and you must exercise skepticism above all else and make the market prove itself before you risk your hard earned money.
4. Once you have found a stock that meets your selection criteria, make a small initial purchase as close to the proper buy point as possible. The initial purchase should be only a very small amount of your total portfolio. My last initial buy used only 2.5% of my total portfolio, but I risked even less. More on that below.
5. Put a stop in place when you make you initial buy. I normally put my stop loss at 5% below my first purchase price but you could go as far as a 10% stop. My experience is that once a stock begins to show a loss it will eventually hit my stop so I try to get out as cheaply as possible.
6. Stops limit what you actually risk in the market. For instance if you purchase $5,000 worth of stock with a 5% stop you aren’t wagering that total amount but just $250 which on a $100,000 portfolio equals just .025%. Think about this the next time you see the whole market swoon 10%.
7. If the initial buy shows a profit, add more as the stock gains 2-2.5% from your last purchase price. Make three buys of even amounts and be sure you do not buy any further than 5% past a proper buy point.
8. If your stock increases enough to make three buys make sure you have stop in place to protect that whole position. Again I prefer a 5% stop for a complete position.
9. If the first position is a winner look for a second stock to buy. The market has shown strength so now repeat steps 4-7 but it is safe to increase the amount of capital that you use from 2.5 of your total portfolio to 4% when making the next purchase. Don’t forget the stop!
10. If your first position is stopped out take it as a danger signal. The market is not working for you. Consider sitting on the sidelines but if you are compelled to make another stock purchase repeat steps 4-7 but this time only use 1.5% of your portfolio take make that first buy and don’t forget the stop!
11. If you buy three stocks and you stop out on all three take three weeks off before making any more buys. Use the time to evaluate the overall market condition because three strikes is the market’s way of telling you something is wrong. This is by far that hardest thing that I have to force myself to do because I have a psychological weakness that I believe the market will increase. I have put this rule in place to protect me from myself.
In closing the market has followed through indicating a potential change of trend. Use a sound set of trading principals like the ones outlined above of search for one that fits your own personal style. Above all, exercise caution and use stops to protect yourself in a dangerous market.
Tuesday, October 14, 2008
Plan for the Impending Rally - Part 1
This past week saw historic market losses; in fact it was the worst week ever for the stock exchange. The cover of Time Magazine shows a soup line from the 1930’s and questions if we are heading for another depression. Many popular commentators now openly use the term “Great Depression 2” as a real possibility if the markets cannot be righted. For the first time in my life, excluding 9/11, there is genuine almost primal fear in the country. Yet history shows us that these times may be the best to start putting money back to work in the market. In order to fully capitalize on this opportunity you must have a game plan to take advantage of the impending rally.
John Boik discusses many market crashes and the ensuing market rallies in his book How Legendary Traders Made Millions. Each market crash such as 1929, 1962, 1973, 1987 and 1998 saw significant market rallies that bagged gains of 50%, 100% or more in the subsequent recovery. No matter how bad the market gets, it will always make a rally attempt.
This does not mean that the market bottoms, rallies, and then goes straight up. The 1974 recovery saw the market bottom in the fall of that year, rally for 5 weeks then roll back over undercutting the prior lows. The market then got itself back together in the beginning of 1975 before it started its big run. Monday saw the US exchanges rocket over 11% in one day. Many people may take this as a signal that we have bottomed, but historically big one day percentage gains often happen during a Bear market so caution is still advised.
Who knows how the market will recover from the 2008 crash, but there are three distinct rally scenarios that you must be ready for.
1. The markets will rally and logged a quick gain of 20%+ since stocks have been beaten down so much and so quickly by panic selling.
2. The markets will put together a suspect rally that last for several weeks which is just long enough to get people to start buying again before it rolls over and heads lower.
3. The market will rally but trend sideways for several months in order to heal itself before heading higher or potentially lower based on world events.
How should investors approach the three scenarios? In general, there are two classes of investors, the first group is long term mutual fund holders and the second group is short term traders who invest in individual securities. Each should approach the market differently.
If you are a long term mutual fund holder who makes monthly contributions towards your retirement and you have a 10-20 year horizon then stay on track and resist the urge to stop putting money into the market because of scary headlines. The markets will certainly be higher 20 years from now and you will be well rewarded.
For those of you who want to invest in individual stocks your job is much harder but it does offer greater rewards. To maximize your gains you must have a game plan and a system to capitalize on the impending rally while protecting yourself from a potential market head-fake. Your system and game plan should include the following:
1. A signal that the market has bottomed and is now heading higher
2. A process to identify the strongest stocks in the strongest industries as the market turns
3. A money management plan which allows you to put more money to work if the market appreciates
4. A stop loss policy to protect your capital if your individual security begins to crumble
Monday’s big gain offers hope that the worst is behind us and that we may be at dawn of a new golden Bull market. The only way that we will know for certain is if market prices continue to rise. Caution is the way now; make sure that you have a plan and a system that can help you navigate these historic but dangerous times. If you do not have a system, I strongly suggest that you visit Investors Business Daily and get a free two week subscription to this great publication.
John Boik discusses many market crashes and the ensuing market rallies in his book How Legendary Traders Made Millions. Each market crash such as 1929, 1962, 1973, 1987 and 1998 saw significant market rallies that bagged gains of 50%, 100% or more in the subsequent recovery. No matter how bad the market gets, it will always make a rally attempt.
This does not mean that the market bottoms, rallies, and then goes straight up. The 1974 recovery saw the market bottom in the fall of that year, rally for 5 weeks then roll back over undercutting the prior lows. The market then got itself back together in the beginning of 1975 before it started its big run. Monday saw the US exchanges rocket over 11% in one day. Many people may take this as a signal that we have bottomed, but historically big one day percentage gains often happen during a Bear market so caution is still advised.
Who knows how the market will recover from the 2008 crash, but there are three distinct rally scenarios that you must be ready for.
1. The markets will rally and logged a quick gain of 20%+ since stocks have been beaten down so much and so quickly by panic selling.
2. The markets will put together a suspect rally that last for several weeks which is just long enough to get people to start buying again before it rolls over and heads lower.
3. The market will rally but trend sideways for several months in order to heal itself before heading higher or potentially lower based on world events.
How should investors approach the three scenarios? In general, there are two classes of investors, the first group is long term mutual fund holders and the second group is short term traders who invest in individual securities. Each should approach the market differently.
If you are a long term mutual fund holder who makes monthly contributions towards your retirement and you have a 10-20 year horizon then stay on track and resist the urge to stop putting money into the market because of scary headlines. The markets will certainly be higher 20 years from now and you will be well rewarded.
For those of you who want to invest in individual stocks your job is much harder but it does offer greater rewards. To maximize your gains you must have a game plan and a system to capitalize on the impending rally while protecting yourself from a potential market head-fake. Your system and game plan should include the following:
1. A signal that the market has bottomed and is now heading higher
2. A process to identify the strongest stocks in the strongest industries as the market turns
3. A money management plan which allows you to put more money to work if the market appreciates
4. A stop loss policy to protect your capital if your individual security begins to crumble
Monday’s big gain offers hope that the worst is behind us and that we may be at dawn of a new golden Bull market. The only way that we will know for certain is if market prices continue to rise. Caution is the way now; make sure that you have a plan and a system that can help you navigate these historic but dangerous times. If you do not have a system, I strongly suggest that you visit Investors Business Daily and get a free two week subscription to this great publication.
Thursday, October 9, 2008
Definition
Given the current market conditions, I think it is appropriate to define and explain the namesake of this blog. The term “Ever-Liquid Account” was a phrase coined in Gerald Loeb’s book the “Battle for Investment Survival”. For those of you not familiar with Loeb, he was a legendary trader who got his start the early 1920’s and made a fortune in the stock market over a long and fabled career. The “Ever-Liquid Account” is essentially a money management and strategy for trading stocks.
Loeb suggests the following:
1. A major component of stock market success is predicated on the ability to stay completely in cash until the right market opportunity appears.
2. When an upward market trend is established, buy liquid market leaders or those stocks with the potential to become market leaders.
3. The method favors concentrated purchases and eschews diversification since the investor must have strong convictions about both the positions established along with the general trend of the market. An investor may hold up to four carefully chosen stocks.
4. This style of investing lends itself to pyramiding. This means that when a new position is established the entire stake is not bought at once. Rather, a small pilot purchase is advised and if this initial buy shows a profit then more can be bought as the price advances. The initial buy may be 1/3 to ½ of the full position. Subsequent buys may be made in additional thirds until the position is rounded out.
5. If the first full purchase shows a profit then a second position can be established in a new stock using the method above.
6. If the original purchase shows a loss it should be closed out. The stop may be anywhere from 3%-10% below the first purchase price. If a compelling new stock is found after this first loss, a new position can be started albeit with a smaller amount.
7. A limited amount of capital deployed in concentrated positions will allow the shrewd investor to outperform the market. In certain circumstances 20-25% of one’s capital may be invested in individual positions but this is the exception rather that the rule unless a compelling market event appears.
This style of investing is not easy and requires extreme patience and discipline. The main advantage of this system is that it keeps one out of weak markets by taking small losses on pilot purchases and additional funds are only deployed as prices appreciate during an uptrend.
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