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.
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