Long-Term Investors Need Trends to Make Money
Most of us would prefer to be investors instead of traders.
Investors, with an intermediate to long-term time horizon, must be aligned with
a positive trend in order to make money. This is true even for value investors
who focus on a company’s valuation rather than a trend that can be seen on a
chart. For the value investor to make money, eventually the position must turn
up.
The chart above is not designed to convey that spotting a trend
reversal is easy. It is not, but as more evidence gathers as to the probable
legitimacy of the new trend, the less risk you need endure to participate. If
the stock or market does not trend upward for a significant period of time,
long-term investors do not want to participate. The point is you can afford to
miss the early part of the new trend. Let the traders show us the way while
putting their capital as higher risk. The strategies and goals of shorter-term
traders are quite different from those of a long-term investor. When you
understand this, it becomes clear that many buyers at a "bottom" are traders who
have no intention of keeping the stock for a long-term investment, which means
they will be happy to sell at the first sign of trouble (creating many false
bottoms). Long-term investors do not necessarily want to enter a market at the
same time as traders who have much shorter holding periods. This concept
currently applies to the ETFs SPY, QQQQ, DIA, XLF, EFA, and the list goes
on.
Volatility and Risk Management While Capturing a
Trend
Depending on how you manage it, volatility can be your friend or
your enemy when attempting to make money in financial markets. Fear is an
investor’s biggest enemy and volatility is what drives fear. To remind everyone
of what could be at stake here and what can happen in bear markets, below are
the devastating losses suffered in the S&P 500 (SPY) and NASDAQ (QQQQ)
during the 2000-2002 bear market.
It is evident above that volatility should be respected since
losses can wipe out years of hard work if a portfolio manager does not adopt
proper risk management measures. How can volatility be our friend? Those who
study and understand the volatility characteristics of any investment or market
will have a much better chance of staying with and capturing the gains available
in long-term trending markets. As illustrated in Chart A below, any investor
would have loved to ride the NASDAQ’s meteoric rise from 1995 through the first
quarter of 2000. I have removed the volatility from Chart A to illustrate a
trending market without the gut-wrenching and emotional effects of the market’s
inevitable ups and downs within the context of the primary trend. Our goal is to
stay in an upward trending market long enough to profit, while not staying
invested too long during what appears to be
more than a "normal"
correction (see Chart C).
Chart A
Chart B
Chart C
Chart D (below) shows both the current uptrend in oil (USO) and
recent corrections within the context of the uptrend. The percentage drop in the
large pink circle from peak to trough was 34%, but those who held even a reduced
position were able to profit from the remainder of the trend. The percentage
drop in the green circle was 13%, but those who held on through the correction
were able to profit. If oil dropped 12% from its recent peak of $145 it would
fall to $127.50. If oil dropped 34% from its recent peak, it would fall to
$95.95. In a form more simple than how we would actually make decisions, an
investor in oil should not get too concerned until $127.50 is taken out on the
downside. Based on your risk tolerance, you may decide to cut back on your
holdings below $127.50. If $95.95 is violated on the downside, it is possible
you would exit the entire position or at least make a significant reduction in
your exposure.
Chart D
In the real world, a portfolio manager would use several factors
to make calls on when to cut back or exit a position. If trend lines are broken
that adds to the negative evidence. If an investment has had an extended run,
like oil, the manager may be more inclined to cut back earlier rather than
later. Fundamental factors come in to play as well. The cons for oil are the
reduction in demand that comes during periods of economic weakness and the
aforementioned long in the tooth trend. The pros for oil are well known;
questions about supply and increased demand from China, India, etc.
Let’s Put Some Charts on a Wall
As shown in the chart below of a resource stock mutual fund, the
long-term trendline from 2002 in commodity stocks has been breached. The closing
price of PSPFX has now breached levels which move the current declines beyond a
"normal correction" for this investment. While we are not calling a top, the
evidence we have should be used in your risk management efforts.
It is worth keep an eye on the depth of the current pullback in
gold mining stocks. A new high in TGLDX, a mutual fund, has not been made in
quite some time.
The great bull market in stocks began in 1982 after years of
lackluster inflation adjusted returns. The chart below shows the trendline from
1982 has now been broken.
While financial stocks have hit a violent intermediate bottom
and could rally for a while longer the odds favor lower lows in the months ahead
as housing prices continue to decline. The chart below illustrates the
structural nature of the problems facing the housing and financial industry.
There are fundamental reasons financial stocks have been hit so hard, reasons
which go way beyond short selling. Additional bank failures in the coming months
would not come as a surprise, which is supported by the rapid deterioration of
the sector. Since our economy has become so dependent on the availability and
use of credit, these problems will continue to impact U.S. and global
growth.
A recent Bloomberg article illustrates the vast difference
between supply and demand in housing. The banks and GSEs (Fannie & Freddie)
are overloaded with foreclosures. Vandals often step in making homes near
impossible to sell.
July 23 (Bloomberg) -- Fannie Mae, the largest U.S.
mortgage finance company, couldn't find a buyer who would pay $6,900 for the
three-bedroom house at 1916 Prospect St.
