Figure 6-2 S&P Composite versus the Discount Rate 1980-1986. Source: Pring Market Review.
It would certainly not be unreasonable for any investor to look at his losing position at this stage and, taking a cue from all the pessimistic news, liquidate his position. He could rationalize this hasty action by concluding that the discount rate approach was normally a good one but would not work this time "because conditions had changed." What we see here, though, is an investor letting events, rather than a thoughtfully considered investment philosophy, dictate his investment decision.
The investor entered the market on the basis that the Fed was easing the discount rate and that sooner or later this would favorably affect the economy and the stock market. In that respect, nothing had really changed. If anything, monetary conditions actually improved, because the discount rate was lowered again in July 1982. This indicated that the authorities in the Federal Reserve System were well aware of the weakening economy and the probable impending crisis. To the investor, it appeared as if the financial picture was deteriorating. The news was bad, and stocks were much lower than when he had entered the market. If the position had been liquidated in June or July 1982, it is unlikely that an investor in such a state of mind would have been able to get back into the market because of the speed of the subsequent advance. A great profit opportunity would have been lost. On the other hand, anyone who had faithfully followed the discount rate rule would not have had to worry about missing out because he would already have been positioned.
What often seems to happen is that people enter a market with the very best of intentions of following a system. They have proved to their own satisfaction that the approach has stood the test of time, and they begin the campaign with a great deal of enthusiasm. Unfortunately, they conveniently remember only the periods of good performance when they should be asking themselves how much they stand to lose if this current signal turns out to equal the worst one since the 1920s.
Failure to prepare for the worst raises expectations and leads to unnecessary frustration. When some bad news pushes prices lower, it is a natural instinct to head for the exits at precisely the wrong time. This is why it is so very important to stick to the rules for the approach that has been originally chosen. If it is a proven one, the chances are that the negative consequences of such a decision will be more than eclipsed by the benefits of staying the course.
We return to our example in the spring of 1984. At this time, the market was substantially higher than it was in 1982, but short-term interest rates had begun to rise. Dire predictions about the economy were being made at the time. In April 1984, the discount rate was actually raised from 8.5% to 9% after almost a year of rising short-term interest rates. It would have been quite easy to conclude that a second or even third discount rate hike was around the corner. The sensible thing appeared to be to liquidate stocks before the third hike. After all it was becoming fairly obvious that equities were in a bear market. Such anticipatory action would have been counterproductive because the market took off once again in the late summer. As it turned out, there were no more increases in the discount rate; indeed, several cuts took place before the rate was raised again.
By the summer of 1987, the discount rate had been raised twice, and the next major test occurred in October 1987 (Figure 6-3). This was the month of the stock crash in which prices declined by 25% in a matter of a few days. It would take tremendous will power for anyone to maintain an equity position after such devastation and in an environment of considerable uncertainty. The news background was extremely bearish, but interestingly the crash never spread from Wall Street to Main Street because the economy continued to expand. More to the point, the third discount rate hike did not come, and therefore the method called for a fully invested position. Ironically, the crash effectively extended the recovery as well as the bull market in equities, because the authorities lowered interest rates a little to maintain confidence. The third hike did not come until February 1989 when the Standard & Poor Composite Index stood at 290-300, slightly above its 1987 peak. Staying the course over the 1981-1989 period would have enabled an investor to ride the advance in the S&P Composite from 123 to 290.
Clearly, this approach to investing is not a perfect one. In the example shown, the method did not get the investor in at the bottom of the market and out at the top. But, as we discovered in Chapter 1, there is no such Holy Grail promising quick riches. The discount rate indicator system is one of many approaches to investing that over time keep you in the game for the big "up" movements, yet help you to avoid the worst aspects of a prolonged bear market. The chosen methodology could be something quite different. As long as it has a proven long-term track record and the practitioner feels comfortable with the approach, your chosen methodology will provide an invaluable form of discipline-provided, of course, that you follow the rules fairly rigorously.
Figure 6-3 S&P Composite versus the Discount Rate 1984-1990. Source: Pring Market Review.
An investment method's principal function, therefore, is to keep its adherent from becoming prey for the many traps and delusions that hinder sound decision making. Our example showed that the investor could have almost tripled his money using the discount rate indicator, but he would also have needed tremendous patience and discipline. If he had kept his eye on the ball, it would have worked very well, but just one incorrect move at the wrong time would have caused him to miss out on some spectacular opportunities.
Traders
The same principles apply to short-term traders in the futures markets. In this case the leverage is much greater and time horizons substantially shorter. With $1,500, it is possible for example, to "control" $35,000 worth of gold or $100,000 worth of bonds, and so forth. If the price of these contracts rises, correctly positioned traders can make a killing. Unfortunately, leverage works both ways so if the bet is placed in the wrong direction, in the absence of sound money management, it is just as easy for the equity in the account to be wiped out. For this reason, traders in the futures markets cannot afford to let the market go too far against their position.
Again, let's consider a mechanical indicator that might be employed in the bond market. Let's say that as a trader you are not interested in making a killing or getting in at the bottom and out at the top. You would be quite happy if you could adopt some kind of approach that can give you a satisfactory profit. One possibility might involve a simple 25-day moving-average crossover. The moving-average crossover works this way: You calculate a 25day moving average of bond futures, buying when the price crosses above the average and selling when it moves below it. This approach does not consistently return profits. We are using it as a vehicle to explain a point, not as a recommended system. For the purposes of the example, it is assumed that this crossover method has been successfully back tested with historical data.
Figure 6-4 shows that a "buy" signal was generated in April of 1991 at Point A. Our hypothetical trader would have entered the market with great hopes for a profitable trade, but he would have soon been disappointed because it quickly turned into a loss. Undaunted, he reentered the market once again, only to be rebuffed by a further loss, Point B. It is only natural that he now begins to doubt the system. Even though he knows that it has turned in an overall profitable performance during the previous three years, and he recognizes that there have been some unprofitable periods, doubts still creep in. Nevertheless, he decides to enter the market once again when the next buy signal is generated, Point C. For a few days, his expectations rise as the market moves in the right direction. Then, some unexpectedly bad news occurs, pushing the price down once again and further compounding his losses. Now he is totally dejected, his system no longer seems to operate, and the news background is so terrible that he cannot face the prospect of getting back in when the next buy signal comes along, Point D. Figure 6-4 shows that this is precisely when he should have reentered the market, because the price subsequently experiences a very worthwhile rally. It is a f
act of investment life that some of the best price moves are often preceded by a period of confusing price action in which markets fluctuate within a frustratingly narrow band. The failure of the moving-average crossover system to operate profitably is a symptom of this characteristic.
Figure 6-4 Treasury Bond Futures (3-Month Perpetual Contract) versus a Twenty-Five Day Moving Average April-Sept. 1991. Source: Pring Market Review.
Our trader made two mistakes. First, he allowed the news background to influence his trading decision. Second, he failed to give the system enough time to work. In effect, he took his eye off the ball at the wrong time, a mistake that left him with an unprofitable performance.
Anyone who has traded in the markets will recognize this failure to stay the course as a fairly common form of weakness that periodically attacks all traders. How many times have we seen investment books or software programs that promise their readers and users instant gratification? It is doubtful that any purchasers of such merchandise ever profit to the extent of their expectations. To start, most such schemes or systems do not deliver what they promise, but those that do are rarely practiced in the recommended way. Hopeful investors and traders may start off with the best intentions but will rarely stick with their plans. They see the evidence that the system works, but they do not have the patience and discipline to follow the rules.
This phenomenon is not limited to the financial markets. Many health-conscious people, for example, purchase expensive exercise equipment with the objective of getting fit or losing weight. After an initial bout of enthusiasm, however, they lose interest, relegating the equipment to the basement, garage, or attic. It's one thing to know what to do, but it is quite another thing to put our knowledge into action.
In Figure 6-1 we saw that it is normal for a bull market to be interrupted by countercyclical movements known as secondary reactions. This idea of a primary uptrend consisting of a series of rising peaks and troughs also indicates that even if a purchase is made at the top of a rally, such mistakes are only temporary, because the rising trend will eventually bail us out. This leads us to another aspect of "keeping your eye on the ball."
Most of the time it is not possible to have a firm opinion about the direction of the main trend, but when you do, it is usually very unwise to position yourself against it. Let's take a look at a system that I first introduced in Technical Analysis Explained. It involves a very simple idea of buying and selling the pound sterling based on a mechanical technique. The rules are described in Table 6-2. The arrows in Figure 6-5 represent the buy and sell signals between 1974 and 1976. This system has been tested back to the early 1970s and would have been very profitable. I calculated that by 1980 anyone who had followed it religiously using a margin of 10% and reinvesting the profits would have turned an initial $10,000 investment into more than $1,000,000. Since then, the system has done even better.
The principle point I am trying to make is that a close examination of the performance shows that the profits have come almost entirely from buy signals that have occurred in the direction of the main trend. In Figure 6-6 the top series is the equity line. It shows how an initial $1,000 investment would have fared by following the system on a nonleveraged basis between 1980 and 1992. Some counter-cyclical signals are flagged by the arrows. Note that these reflect the largest losing trades.
This principle of trading in the direction of the underlying trend applies to any intermediate trading system and to most short-term ones as well. Obviously, it is not always possible to have a firm opinion as to the direction of the main trend. When you do, however, it is clearly of paramount importance to trade in its direction, however tempting it may be to do otherwise. The idea of staying on a predetermined and well-tested course is sensible, but it is also important to keep an open mind because underlying financial conditions can and do change. This advice may sound somewhat contradictory, enabling us even to do some Monday morning quarterbacking as conditions suit. But that is not really the case.
Figure 6-5 Mechanical Trading System for the Pound 1974-1976. Source: Pring, Martin J. (1991). Technical Analysis Explained. New York: McGraw-Hill.
Most of the time, anticipations of business-cycle conditions propel the financial markets. The economy is not responsive like a car or a speedboat. It's more like an oil tanker; it takes time to change direction. Consequently, any indicators that you are monitoring also will have the tendency to move slowly and deliberately. Some are bound to fail from time to time and that is why no investment decision should be based on one indicator alone but on a consensus.
Figure 6-6 Pound Trading System. Source: Pring Market Review. This chart has been plotted from the Metastock Professional charting package. The system testing abilities are covered in the "System Testing" segment of the Exploring Metastock Professional II video by the author (International Institute for Economic Research, P.O. Box 329, Washington Depot, CT 06794, reproduced with permission.)
Keep Your Eye on the Ball, but Remain Flexible
Occasionally, though, institutional changes will affect the reliability of a specific indicator. Under such circumstances, it makes sense to disregard the indicator's signals, since they are unlikely to be as reliable as they were in the past. A classic example of this occurred in the 1980s when stock-index futures and other derivative products were introduced. These products resulted in some brand new trading and arbitrage activities, the most notable of which was program trading. Not surprisingly, this new activity distorted some of the indicators that market technicians had been using with great success since the 1930s. The most notable casualty was the short-interest ratio. (The ratio of the short interest to average daily trading volume for the month.)
Similar institutional distortions occurred in the 1970s when inflation was rampant. Reported earnings, for example, failed to take into account inflationary conditions. Profits were thus greatly exaggerated when large but unsustainable inventory gains unduly overstated the true earnings picture. Investors basing an approach on price-earnings ratios without regard for this important change could easily have run into trouble. They may have had their eye on the ball when selecting a stock in the sense that the selection criteria remained the same. Environmental changes, however, may have greatly distorted the quality of the stock's earnings.
Another example of an institutional change occurred with the growing popularity of money-market funds in the 1970s and early 1980s. Originally these deposits were not included in the money supply numbers. As the amount of cash squirreled away in these funds increased, the money supply numbers became more and more distorted. Eventually, money market funds were incorporated into some measures of money supply. However, anyone who continued blindly to use changes in the money supply as a basis for making investment decisions prior to these definitional changes could have been badly misinformed.
These are all examples of the importance not only of following your chosen investment approach but also of periodically reviewing it in case any significant and fundamental economic changes may have taken place.
This Time It's Different
One of the worst traps to snare any investor is departing from a tested methodology or philosophical approach and then rationalizing the decision by saying, "This time it's different." All too often, some rationalization for even higher prices will seize the imagination of the crowd after a market has reached and often exceeded its normal technical or fundamental benchmarks. Such arguments are usually compelling, because they appear when optimism is rampant and everyone expects prices to move higher. The arguments are typically based on hope rather than on the facts, which are conveniently overlooked. The "new era" thinking is therefore welcomed with open arms, and little thought is given to the underlying investing concept, or the fact that betting on a "first-time" event usually has disastrous consequences.
A classic example occurred in the 1920s when many investors believed that stock prices had reached a new plateau because the outlook for business continued to be very positi
ve. Few individuals concerned themselves with the fact that stock valuations were excessive and margin debt extremely high. Merger mania and similar phantom concepts captured the imagination of the public who were prepared to take their eyes off the ball by accepting the delusory concept of a "new era."
In the early 1970s, money managers fell in love with the "Nifty Fifty." These were companies whose consistent growth rates and sound financial standing made them so-called onedecision stocks. Examples included Avon, Xerox, and Polaroid. During this mania, the price-earnings ratios of these stocks were bid up to extremely unrealistic levels, but no matter how expensive they became, prices continued to advance. Their valu ation was not only excessive in historical terms but in relation to the rest of the market as well. Not surprisingly, they suffered considerable damage in the 1973-1974 bear market, and most took a decade before they returned to their former highs.
In situations similar in nature to those of the 1920s and the 1970s, the warning signs come early-usually too early-because a lot of investors will correctly recognize the sign of an impending top and get out. The problem is that prices continue to advance making it appear that they will never come down. These same investors then return to the market at precisely the wrong time, forgetting all the principles that had encouraged them to get out earlier. In effect, they have chosen to take their eyes off the ball and then must deal with the consequences of their actions. In both examples, the underlying rationale for higher stock prices was false, since prices were way beyond normal benchmarks of valuation.
Random Economic Numbers Play Havoc with Your Financial Health
Investment Psychology Explained Page 10
