It May Get Worse Before It Gets Better

“Life can only be understood backwards; but it must be lived forwards.” – Soren Kierkegaard, 1813-1855, Philosopher

One piece of the profit/loss puzzle of investments that is so easy to see in hindsight, is that market pull backs, or corrections present investment opportunities. The bigger the drop, the better the opportunity. Therefore, in theory, a successful investor would be happy to see market lows, but that’s not how the story goes for a variety of reasons. The hard part is how to keep your cool and implement this wisdom in the midst of crisis, fear and while losing the market value of your invested funds.

Has the market bottomed? Is it time to buy? If you act too soon to buy, you may find yourself catching a falling knife. If too late, you’ll risk missing the profit train and kick yourself, thinking “I knew I should have bought it then.”, only to repeat this pattern again. Plus, what if this is the beginning of the next bear cycle? How do you know?

“Don’t fight the trend” and “be wary of extremes” both offer sound advice, but how do you reconcile these seemingly conflicting strategies?

Bring it Home

After a steep uptrend till Jan 26th, within two weeks major stock indexes lost over 10%, stepping in correction territory by Feb 8th. From there, prices bounced back up, gaining more than half of their losses by March 9th, only to visit the same low point as of this newsletter is written, at the end of March.

First, you have to use every opportunity to learn and evaluate your actions of the past. It is not too late to go back and see what you’ve missed. In fact, it’s mandatory for future success. If you can’t make sense of what has happened in hindsight, how can you live it forward?

You could have lowered stock exposure, re-balanced to your target weights, limited exposure to higher risk (beta) investments, and potentially raised some cash when the market was significantly overvalued and way above trend lines (some charting and technical analysis come in handy here). Probably towards the end of last year or the beginning of this year was the sweet spot. Yes, this is in hind sight but it does have some forward-looking remedies embedded.

If you believe this is the beginning of the next bear cycle, it’s never too late to start selling. (I am in the temporary and healthy pull back camp, which I will talk about next).

Second, you have to decide for your investments, whether or not the uptrend is still intact. What you’ll do next shall differ significantly from an investor who is convinced that a bear trend has emerged.

Even though political risks have risen and the volatility has come back, the global economy is in its strongest phase since 2008, and central banks are still accommodating. There is very little to no inflation for the most part, and employment numbers are strong (at least in developed economies), so recent moves are probably healthy and needed pullbacks. In fact, the down trend may have to get worse before it gets better. It is true that economies and markets can and do act differently sometimes, but not for too long.

Recent pullbacks have happened so fast in either direction, the volatility didn’t leave enough time for investors to shake up their complacency. The counter intuitive aspect of markets is that excessive enthusiasm is a bearish sign, and the opposite is also true. This is where and how you can aim to reconcile the question we’ve raised above, of how to be friendly with the trend but wary of extremes. Balance, is the key to all…

Just as too much voracity brings over-bought conditions, extreme doubt usually brings over-sold. Now, comes the hard part: for this reason, you almost want to see things get bad enough to get greedy again, and so far, I don’t see it. By the time you read this letter, capitulation may have occurred, but as of now, even though shaken, investors are not fearful, yet.

Last two points, 1 – Bull markets don’t die of old age and can resist recessions. Two of the last long term (secular) bull markets were between 1949-1966 and 1982-2000, 17 and 18 years respectively. Our current bull cycle is now 10 years old. 2 – The stock market is a leading economic indictor and usually signals economic recessions. Currently, a recession is a low probability event, and so by reverse engineering, a bear stock market.

In short, we may see a bit more volatility and down pressure before the next uptrend resumes, but when viewed as a technical pullback within the later stages of a bull market, recent action is/was probably a needed shake up.

Update on 4/2/18: After today’s (Monday) deep drop, the S&P 500 index has broken it’s 200 day moving average. If you needed a bearish sign, this should be on your list. My overall claim is intact, but with a tighter leash.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.