Following last week’s stock market plunges I am starting to hear fear creeping into the mentality of many traders. 6 months ago the most common brag of punters is he or she invested in this stock or that stock and made X% in so many weeks. Now, the most common brag is that he or she got out of the market last year having read the signs from technicals/sub-prime/interest rates/[insert reason here]. Nobody is talking about buying. And this goes not only for Malaysian traders, but also traders all over the world, with stock markets all over the world plunging into levels when people start wondering whether it will ever recover to its previous highs, and even solid blue chips with low betas are following the market south. Even bond prices have been falling, wreaking havoc on diversified portfolios. In short, only long commodities funds were unaffected. Amidst all this, many people are trying to figure out what to do next and considering whether to buy, or sell, or wait. In the light of all this here a few points to consider:

1) Were you caught unprepared by the recent stock market plunge? If so then the key lesson to take away here is how hard it is to time the market. (Tradingmalaysia has been bearish on the stock market for over 1 year, and is pleased even to have gotten it right by that margin!). Therefore you should be honest with yourself and seriously reconsider whether your trading tactics will really be able to help you time the next market bull if they failed to help you time this market bear.

If you’re still holding onto positions that have lost money, your signals are broken, and you have nothing but hope then you should get rid of them, go back to the drawingboard and start planning again. As traders we must look to the future and discard trades and ideas which do not work. Remember that you do not need to be able to time the market to make money. You just need to have a good system that you can execute well. The question you should be asking is: do you have such a system?

2) Are you are a long term investor (as in, were you a long term investor 6 months ago and not someone who used to be a short term trader but have since become a long term trader because your trades have not worked but you are reluctant to realise losses and sell - yes, you know who you are!!)? And do you have a regular income and have you been regularly investing in stocks which are fundamentally sound? If so, then then you should stick to your plan and continue to buy. This will average down the cost at which you acquired your shares over time and benefit you in the long run. Remember, the best time to buy is when everyone is selling.

Let’s take Tradingmalaysia’s portfolio as an example. This is a portfolio which consists mainly of companies which I consider to be good and either cheap or pay good dividends, and which I am regularly investing my income into (on a monthly basis). And because I have been bearish the market, only 65% of the money has been invested. Over the next year, I will gradually increase my equity allocation to 100% and continue to invest my regular income into the portfolio, bringing the average cost per share right down so that I am positioned to benefit from the next boom. For more detail on this I will post again tonight with some concrete numbers regarding the portfolio so that you get a better idea of how a long term portfolio should be managed and how it performs especially under duress. I think you will be surprised at the result!

Came across this article in the papers today which provides an interesting case study. I quote:

“Four months ago, judging myself to be the next Warren Buffett, I logged on to my Charles Schwab account and did something that in hindsight was astonishingly stupid, even for my own very long roster of financial screw-ups. I clicked over to the trading page and bought shares of Citigroup.

The company, like most of the big Wall Street banks then staring down the subprime meltdown, was limping along. The headlines were bad. The chatter on CNBC was pessimistic. I saw a bargain. I saw a company whose credit card bills and offers show up in millions of mailboxes every day. Just as soon as the banks got their write-offs out of the way, optimism would return to the sector. There would be more buyers of the stock than sellers. I would profit.

Now here I am today: My investment is down 22 percent. And I’m still holding on to the stock. Am I, as my wife and closest friends sometimes insist, the dumbest man walking the Earth?”

What went wrong?

The crux of the problem is that the trader used the wrong strategy for his expected reward. If short term profits are to the object here, the right strategy would be to buy into a company on its way up and not down. Buying on the way down is a contrarian strategy adopted by investors who believe that the company has been unfairly punished and will bounce back. Since there is no way of knowing when the shares will recover, contrarian strategies such as this are only advised by investors who have a medium to long term view and are willing to average down / hold for the requisite amount of time.

This is one falling knife that short term technical trader have no business trying to catch. Logic, which plays a big part in picking strategies, is the best advisor in these circumstances. It’s okay to compare yourself to Warren Buffett, provided that you also think and trade like him.

Also, short term trades must necessarily have short term profits and short term stops. It is possible to survive bad trades like this, provided that targets and stops were set, which they weren’t. Being able to fly from one point to another requires you not only to know where you are going, but to possess an properly functioning aircraft that can takeoff, fly and land without crashing. You must check its wheels, landing gears, navigational instruments, radio etc. In trading terms, these are the targets, stops, bet sizes and formulas for knowing when to increase or decrease positions. Entering into a trade without considering all these things is like taking off in a plane and then worrying about whether it can make it to the other side in mid-air.

When analysing financial markets, it’s important to also keep one eye on the economy, because financial markets are not the same as economic markets. In financial markets, there is only one consistent measure of value: price. However, in economic markets the measure of value is more subjective, and is contained in the question “How well is the economy doing?”. To answer it, analysts use a variety of indicators such as GDP, exports, industrial production, consumer price index etc. etc.

At uncertain times like this, being able to analyse the economy can sometimes provide a sane benchmark against which to asses whether things are overvalued or undervalued. This is because a large component within financial markets is “expectation”. Put simply, investors will pay more for a company if they expect it to do well in the future regardless of what it currently says in the company’s financial statement. There is no such thing for economic indicators, which only look backwards.

So if you look at our current economic indicators, there is actually quite a lot to feel comfortable about, because both Industrial Production and International Trade has been growing steadily in 2007 (thanks to our palm oil), and at the global level even though the US may be in a recession, high commodity prices and exports are providing evidence that emerging markets are slowly starting to consume more and more goods, thereby taking up the responsibility of becoming the world’s consumer and keeping demand alive.

The question we have to ask then, is if that is the case then why are financial markets in distress? Well, it began with the credit crisis - a phenomenon which would theoretically have been confined to financial markets, were it not for the fact that it happened on such a grand scale that it is affecting the ability of banks and creditors to lend money to mom and pop - retailers and other bricks and mortar businesses.

On top of that there is also the (separate and more worrying) fear of inflation, caused by high commodity prices driven partly by a weak dollar and partly by surging demand in the emerging markets. The fear here is that inflation will cripple the ability of the emerging economies to continue demanding more goods, thereby causing more businesses to suffer and result in a depression.

As a result, investors are staying away from the financial markets and causing weaknesses in share prices, and thus the conclusion is that even though the economy can be said to be chugging along just fine, fear has caused financial markets to disconnect from the economy, because it expects the economy to suffer and for economic indicators to turn down in 2008.

What I have just described are the first phases in a bear market cycle, which has several phases each characterised by its own specific brand of fear. The first type of fear is a knee-jerk reaction, usually starting from a single event (such as the the poor results from banks resulting in writedowns and the sub prime fiasco) which then spreads to a second type of fear of something more fundamental (such as fears of liquidity and inflation worries). As traders, we will start to consider whether the end of the cycle of near when market fears which reach such deep levels.

But be careful, because it’s important to understand what we mean when we say that the end is near because firstly just because the end is near doesn’t mean that there will be a bull anytime soon. And secondly just because we are near doesn’t mean that there can not be a further drop in prices. As traders we need to wait for evidence of a turnaround - which will be the subject of another post.

So my opinion is that there is one more fear to come, and that is when we look at the most recent evidence that emerging market economies are slowing along with exports (China’s industrial production figures and imports are already down in 2008) and people start to expect both the US and China’s economies to stall. But, that won’t come quickly because there will be bear market rallies every now and then as the Fed and other central banks and governments take whatever measures they can to avoid this possibility and making it extremely difficult to pinpoint the exact moment when the market bottoms.

So, I still intend to gradually start accumulating shares over the entire period of the market bottom, and eventually going into 100% equities.