Here is a quick quiz for you. When should you pay attention to the safety demonstration and the laminated instruction sheet offered on airline flights? At the beginning of the flight? Or as your bum hurtles earthward at 600kph and everyone around is discovering God because you are all about to be turned into ‘people pate’?
The correct answer is, of course, at take-off, but most people don’t pay attention to disaster planning until they’re about to become a giant skid mark on the landscape. Most disaster planning is done after the event when it is somewhat pointless.
Consider the current shake out in the market. If you’re one of those people desperately ringing brokers, astrologers or lifeline asking whether it is too late to sell, then you are probably about to become part of history. Not because any action you take may prove to be incorrect, but because you have left your disaster planning until it is far too late to implement.
The same goes for people who are desperately searching for a hedging system without understanding that all a hedging system does is lock in the status quo. Contrary to the marketing of these things, it does not make you money. If you are in either of these positions then you are caught in no man’s land – no matter what decision you make it will be painful and most likely costly.
The Law of Gravity
Granted, the market is fairly sick at present, especially if you are one of these people who can only trade the long side and were convinced that the law of gravity had been repealed and that things never ever go down. However, assume that you are one of the sensible ones who have a long-term exit signal or the ability to trade short.
Your thinking should now be focused on what you will do when the market turns – and markets do eventually turn. It may take some time for all the bears to wash out of the system and for a final act of market capitulation – but the market will eventually reverse.
To predict how long a market decline might last is folly and is best left to the talking heads on TV who constantly embarrass themselves with their stunningly inaccurate predictions. However, we do know that markets recover. So our thinking should not only be focused on how to manage our current trades, but also looking forward to the time when we will have to adjust our current approach.
All trading systems require a macro timing tool that orients the portfolio in the direction of the prevailing market trend. And if there is a single technical tool that will save you a fortune it is a simple on/off switch that tells you when to be long equities and when to be short equities. These tools are incredibly easy to generate and can be as simple and as effective as a moving average over a weekly chart of the All Ordinaries.
The data below pertains to the S&P500 and tracks every major market fall since 1965. As I said, the aim of this is not to try and predict when the current fall might end, but rather to get a sense of what happens when it stops falling.
1966-66 – 35 weeks
1968-70 – 77 weeks
1973 -74 – 90 weeks
1976-78 – 75 weeks
1980-82 – 89 weeks
1987-87 – 13 weeks
2000-02 – 121 weeks
2007-2009 – 68 weeks (still in progress)
The interesting thing about this data is that the crash that is seared into the brains of most traders is 1987. Yet in our sample group it is the shortest of the crashes at only 13 weeks duration. Certainly with a loss of some 53% it was a short savage downturn, but the crash following the tech wreck wiped 43% of the index and the current move down has lopped some 48% off the index.
It could be argued that because of the duration of the downturns, the damage done by the tech wreck and the current credit crisis has been more damaging to investors. The current move down has certainly affected investor’s overall psyche because of the double whammy of a fall in equity markets plus a fall in real estate values.
If we examine 1974 and 2000 a little more closely we see an interesting pattern of reversals. In 1974 the market put on 43% within 11 months of making a bottom. The reversal post the tech wreck was a little more subdued, the market put on 44% over the next two years.
Now all the usual caveats of indices apply – just because the index goes up doesn’t mean your stocks will. In fact your stocks may continue to fall until they experience the same financial oblivion as ABC Learning. However, you will need to set up a checklist of what you will do when the market becomes more buoyant. I would suggest that your checklist should include some of the following.
1. How will you decide that the market has changed tone?
Will it be by simple trend analysis, the number of stocks making new highs, long sided signals being generated by your system or a combination of factors? Irrespective of which one you use you will only be able to make the judgment that the bear market has ended in hindsight. However, this is not a concern since if you have a trend trigger it will automatically orient you in the direction of the predominant trend.
2. How will you begin to re-enter the market?
This question touches on the notion of how we structure our portfolios if they have been out of the market for some time with the bulk of our holdings in cash. If you have been trading short through this period then your system will simply swing about and you will not need to answer this question. For those who have been in cash, the question is a complex one. I don’t believe in simply lumping all your money in the market on the first few signals you receive. I am a fan of staged entry that is dictated by the market – you set a maximum level of exposure or risk at any one time and you enter the market according to changes in this risk profile.
3. When you will you opt for gearing?
The policy of banks lending vast amounts of money to people who could never possibly afford to pay it back is what got us in the poo in the first place. However, that doesn’t mean we should ignore the earnings multiplier effect that gearing can have. This is particularly true if you trade an index vehicle or fund. Gearing can increase the rate of return over and above the market return you could achieve simply by holding these instruments. Add to these the creative use of options and you have an interesting trading model. It may be that because the market is exiting a period of being smacked around the head that your first forays into the market are un-geared. This is a personal choice and reflects your personal risk profile as detailed in your trading plan.
Before you decide to enter any trade, ask yourself, “Is this the highest probability trade that I can make right now?” This may help you act only on trades that comply with your rules, and ignore those trades that are less scientific in nature. Also, work on your trading plan, and do everything in your power to stick to it. If you’d like a FREE copy of a trading plan template to help guide your trading plan development, register at my website – www.tradinggame.com.au, and I’ll email you one straightaway.
A change in market sentiment represents an opportunity for the astute trader. Unfortunately many do not recognise this opportunity until it is too late or they have been so shocked by the ferocity of the decline that they are paralysed into inactivity. The most important thing for a trader to realise is that the market is in a state of flux and no condition is permanent. Bear markets are followed by bull markets and vice versa. This is simply the natural order of markets. Make sure you’re ready to capitalise on the next market phase. If you’re not quite sure about what to do, you have a limited period of time in order to sharpen your axe and commit to your own education. Your future fortune relies on it.
Chris Tate – www.tradinggame.com.au
for Money Morning Australia.
Editor’s Note: Chris Tate is a trading veteran of 30 years and one of the first people to ever release a sharetrading book in Australia. Best selling author of ‘The Art of Trading’ and ‘The Art of Options Trading in Australia’, his brutally honest approach and meticulous pursuit of excellence qualifies him as Australia’s foremost derivatives trading expert. To find out more about Chris Tate visit www.tradinggame.com.au