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Lesson 2: How I View the Markets

In order to understand the point of the Market Comment, you really must understand what the author believes about the market. These I believe are the fundamental truths. More importantly, they are the creed of my investing philosophy. To put it another way, this is how I think it all works.

Basic Belief 1: The Stock Market is the Best Investment
Over the long run, you can make more money investing in the stock market than any other investment. There is a basic reason for this, business equals wealth. The largest economies in the world are the wealthiest and the crown jewel of the economy is production. Regardless if you make computer chips or potato chips, if you don't make things people want or need, you don't create wealth. Business pays all the employees, all the rent and in a way all the taxes. Therefore owning a business is the true source of wealth and the stock market lets you buy a slice of that.

Here is what $100 in 1926 would grow to:

Basic Belief 2: The Power of Compounding
There a fable story of a king who was taught to play chess by his scribe. He was so delighted he told the scribe to pick the reward of his choice. The humble scribe said he wanted a grain of rice.  The king urged him to think bigger. So the scribe said that the king owed him one grain of rice on the first square of the chess board, two on the second square, four on the next square and so on doubling again and again until all 64 squares of the chessboard were accounted for. The King was not very versed in math so he agreed. Unfortunately that turns out to be a mountain of rice, in fact, more rice than the whole world produces in a decade. Our fictional king was broke before he could deliver.

You might think that the underworld thugs got rich selling drugs or stolen goods, but in fact it was interest on gambling debts that fueled the mob. Famous loan sharks would wait until a drunk gambler was in trouble and then make loans with a 2% a week "VIG". It does not sound like much, but if they only pay the interest portion, it doubles the debt in just one year. That 2% a week is in fact 104% annual interest. However, if the interest does not get paid, and the debt is allowed to compound, the debt instead of doubling now triples. A $10,000 debt becomes a $28,000 debt in a single year.

You can use a handy calculator to figure out how fast money doubles, it is called the rule of 72. 72 divided by the interest rate gives you the approximate doubling time. At 10% interest money doubles about every 7.2 years (72/10=7.2). So if you earn 3% interest your money doubles about every 24 years.

Let's look at three, investors each earning 7% interest:

  • Michael (blue line) saved $1,000 per month from when he turned 25 until he turned 35. Then he stopped saving but left his money in his investment account where it continued to accrue at a seven percent rate until he retired at age 65.
  • Jennifer (green line) held off and didn’t start saving until age 35. She put away $1,000 per month from her 35th birthday until she turned 45. Like Michael, she left the balance in her investment account, where it continued to accrue at a rate of seven percent until age 65.
  • Sam (yellow line) didn’t get around to investing until age 45. Still, he invested $1,000 per month for 10 years, halting his savings at age 55. Then he also left his money to accrue at a seven percent rate until his 65th birthday.

The lesson is time matters and always use the power of compounding.

Basic Belief 3: Invest don't gamble.
When I tell people I make my living off my investments in the stock market they say, "oh you are a day trader". They have a Hollywood image of a guy who sits at some super terminal like this and rings billions out of the market:

I got news for you.... Not only am I not a day trader, I actually get very upset when I see a picture like this one.   I have seen too many good people sucked into day trading to only have it all end in going broke and in a few cases, death.
Day trading = gambling
Gambling = broke.

If you want to gamble, go to Las Vegas, at least when they take your money you get a free drink.

There is a book, Reminiscence of A Stock Operator. It is the story of Jessy Livermore, a real man who made a bundle on wall street through his own wits. I don't know how many day traders have told me that this is their favorite trading book. 

Jessy Livermore was quite a trader, he built several fortunes and also lost them. He was a master of trading inside information, spreading rumors and cornering commodities. Cotton, grains and so on. Today many things he did before 1928, are illegal or impossible. 

On November 28, 1940, Livermore fatally shot himself in the cloakroom of the Sherry Netherland Hotel in Manhattan. Police found a suicide note addressed to Livermore's wife, it read, “My dear Nina: Can’t help it. Things have been bad with me. I am tired of fighting. Can’t carry on any longer. This is the only way out. I am unworthy of your love. I am a failure. I am truly sorry, but this is the only way out for me. Love Laurie”.

Frankly, suicide is what happens to a lot of gamblers and it is a fate I have no interest in. 

Of course there is money in trading. I do consult with some very successful traders at some major banks. Their offices look like this:

These banks and brokers make a lot of money trading. So what is the difference? Here is the big difference, the traders on a floor are seldom trading their money or the banks money, they are trading CLIENT money. They make a fortune on the spread or commission or some fee. Winning trade, client happy broker is happy. Bad trade client unhappy, broker still happy. Yup all those busy traders you see on CNBC are taking ZERO risks. Peter Tuchman, the kooky looking famous floor trader on the NYSE once admitted, he has never owned a share of stock in his life.

In the few case where banks are trading for their own account it is to offload risk. To many Japanese Yen in our vaults? Then put on a hedge Yen/Dollar to lower risk.  That is very different than speculating.

"Mark Hanna: The name of the game, moving the money from the client's pocket to your pocket."  - From the Movie "The Wolf of Wall Street"

There is also a variant of day trading, I call sniping. A good friend of mine loves to do this at work when the boss is not watching him. He will log on to his account and buy a few thousand dollars worth of some stock or ETF, then sneak peeks at it all day and sell it a few hours later. If the trade works, he will email me and say, in at 10AM on XYZ and sold it by 2PM for a fast $300 --- Yeah!  That's peachy, he put up $10,000 in risk and made $300 in a few hours. That's a really good return. However if the trade goes the other way and he loses, I don't get an email.

Sniping is a cousin of what I call cocktail party investments. Go to a cocktail party and some guy corners you and brags about some stock they bought. By the way, I am guilty of this too. Of course, people brag about the investment that is up 300% but the question I ask them, "do you have 100% of your money in that one investment?" The answer is always no, so their portfolio is not up 300%, one stock is, and the rest might be underwater. If you don't understand this these people can make you feel like you are missing the big secret, that others know.

In fact, Mornigstar points out that the number one reason individual investors under-performed is they are bad at timing the market. They sell at the bottom and buy at the top because of greed and fear. Also, because they don't trust their system of investing, they jump around too much.

Here is the problem with day trading, sniping and cocktail party investments. They are too dangerous to throw all your money at.  If you are not investing all your capital, you are not using the power of interest compounding.  For example; My sniping buddy who made a fast $300 did that on Monday, then gets too busy at work, so did not trade the rest of the week. That same week I might have many times that amount of money in a boring index ETF and make way more than $300 by the end of the week. Also I don't need to keep darting in and out creating stress for me and commission for my broker.

Basic Belief 4: Experts Can't Beat the Index - Eugene Fama was right.
In my post "A Warning About Experts" I point out that most fancy mutual fund managers seldom outperform the S&P500, despite the impressive educations and over $200,000 a year salaries they command. Even odder, the few who do outperform seldom are on top more than a few consecutive years. So if you back last year's winning manager you often under-perform next year.

If you click this link, you will download the 2017 SPIVA report. On page 6 you will see that over a 15 year period, investing in indexes like ETFs outperforms over 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers. Almost all actively managed funds failed to outperform on a relative basis.

There is a joke it goes like this:
"Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it."
    Will Rogers
    US humorist & showman (1879 - 1935)

But that is the core of the issue, which ones "go up". 
In my post "A Warning About Experts" I point that many very smart people end up giving the wrong advice in the market. Ultimately thousands of academics and experts have come up with thousands of ways to beat the market. In most cases they are proven wrong. On any day you can go to web sites like Bloomberg, Market Watch, CNBC or pickup a publication like the Wall Street Journal or Barron and there you will see people saying both positive and negative things about the market. You also can subscribe to newsletters and even use hundreds of kinds of computer charts to look at the market. Ultimately the price of a security is set by bets made across thousands transactions, so by definition the price now is the right prices. Those publications give you opinions, but obviously since so many contradict each other, they are only a guess.

In fact many financial  publications simple have two lists of guests and ideas for articles, one positive and one negative. If the market goes up they present more of the positive views if the market goes down they bring out the other story. 

No wonder you will get very confused listening to the news. The financial news is an emotional roller coaster and it will only leave you confused.


The truth is it is fun to pick a winning stock but over the long run your winners and losers often cancel out. This is just as true for experts, professional money managers and us people who "play the game at home".

Eugene Fama is the author of the Efficient Markets Hypothesis. For many his work came to light in a book called a Random Walk Down Wall Street.   I received my copy at business school, in my finance class. Basically, the book says it is very hard to consistently pick stocks that will do well. In most cases people seldom outperform the index. So the book says -- just buy a cross-section of major company stocks and forget about it. Ideally diversified over a lot of companies, like say the 500 biggest (the S&P 500). Of course, that is not easy for a home investor.

This led to the idea of indexing, buying an index of several large stocks. But to make it practical for most investors, a large organization had to buy them in aggregate and sell them as a package.  This was the creation of computer-driven investments called ETFs the first one gave investors a slice of the 500 biggest firms in America, the S&P 500 (Ticker:SPY). ETFs are like mutual funds, except they are not run by a manager, just a computer program and you buy and sell them more like stocks.

You recall I said individual stocks are hard to predict, but index ETFs are diversified and move in a more predictable trend.

I always have a few "cocktail party investments", these are a few shares of some high-risk stocks, whatever stock does best, I brag about at cocktail parties -- like everyone else. But I seldom mention the one that tanked when it went wrong! Over time, most of my money was made in very stable index ETFs, index futures or cash cow monopoly companies like Canadian Banks and Pipelines, yawn.  So it is true, it is hard to increase return, on individual stocks, without a lot more risk.

A very important take away is that diversification is important. I can name lots of companies that at one time were sure-fire money makers and today are out of business. Example; Pennsylvania Railroad, Burroughs, TWA, Pan-Am, AMC motors, My Space, Lycos and now Sears. I myself have been a shareholder in Nortel, Enron, and Real Networks (technically still in business). Today Real Networks is worth nothing compared to the price in 1998, of course, I bought in late 1999. That is why index ETFs help spread the single company risk.

However, I am not a strict index investor, in fact, there is a core idea Fama missed and these next ideas will show how that works.

Basic Belief 5: Market Cycles and Trends
The Market is of course, subject to trends and cycles. The biggest trend in the market is its general upward movement.

First off let's look at the Dow Jones Industrial Average -- the top 30 stocks in the market, from 1920 to now.

This is not a random walk, this is a trend, anyone can see it. One famous stock trader in the 1970's said he put his long term chart on the floor and stood on a chair to view it so he could "see the big picture". It will not last forever, even this trend, in a thousand years, probably will return to zero, but in your lifetime, probably this upward march of the stock market will continue, as it has for all my lifetime.

The smaller cycles you see are human emotions, fear and greed. Economic cycles are a bit like biological cycles. If you leave 4 rabbits on a remote island, without a predator in sight, 4 become 10, those 10 become 50, 50 become a thousand. Then they eat all the plants, most starve and die as the cycle begins again.

The first players in a new market cycle are die-hard market believers, like my family. In 2010 I wrote Why I Believe in America -- because so few people would listen to me as I was telling them this was an amazing time to invest in the markets.

The next investors are institutions and the last in are the general uninformed public. It is not a conspiracy, it is just levels of experience.

In the Stock Market this manifests itself in Warren Buffets quote:
"Be greedy when others are fearful and fearful when others are greedy."
-Warren Buffet
In other words, when no one else wants to be in the stock market, it is a great time to buy and be very aggressive. 

There are also trends within trends. The hot stocks of 1928 were RCA, Railroads and Investment Trusts. All were in disgrace by 1930. In the 1970's it was the "Nifty 50" conglomerates, from 1985 to 1999 it was technology stocks. Catching on to the next trend early is a great way to be aggressive but dangerous when the mania ends.

There are of course panics and crashes in the market. That is a good thing, if there were not, we would just keep paying more and more for stocks. With no down side risk, the price would go straight up. Fear is the gravity that keeps speculators in line. In each market cycle, we enter a period of extreme greed, where fear is forgotten. Remember this -- after you run out of buyers, all that are left are the sellers. Thus you have a correction, either a small pull-back or an outright crash. You can manage the cycles understanding the next two beliefs.

Basic Belief 6: Crashes are Very Painful.
It is easy to look at that 100-year chart of the markets and think you could hang on through a big crash, but when you watch your favorite stock go to half its value it is not so simple.

For example, let's say you owned in the summer of 2007 1,000 shares of the Prudential Insurance company. That's about $100,000 of real money invested in one of the oldest and best run insurance companies in the world. By the winter of 2008, your stock would trade as low as $8 turning your investment of $100,000 into $8,000.

Or let's look at it another way, $100 investment dropping 30% in value is $70. Now on the way back up $70 raising by 30% is $91. If you are down 30% and then up 30% you are still out $9. Recovering from losses is very difficult.

On my trading monitor is only one motto. "Preserve Precious Capital".

Also similar to this popular quote:
"Rule No. 1: Never lose money. 
Rule No. 2: Never forget rule No. 1."
- Warren Buffet

I speak at some private trader conferences and I consult to a few investment banks. There is really only one distinctly different attitude the pros have over the armatures. You will see me quote this over and over again in my blog.  Amateurs worry about returns, professionals worry about risk. In my experience that is the only edge the pros have over the amateurs, but it is a very big edge.

Basic Belief 7: Fortune Favors the Bold
Now you might get the idea that what I was just talking about is that by being a cynic or a "perma-bear" you can stay safe or thrive -- you can't.

I know a broker who once told me his clients with the biggest losses were the ones who would overly afraid. I also have seen this over and over. As a mater of fact most people can think of someone they met who made a lot of money through naivety. I felt the Vancouver real estate market was over valued in 1992 and missed many chance to invest, yet my less "sophisticated" friends plunged ahead and made fortunes. Remember :

"Fortune Favors the Bold"

When I began playing poker, I was over cautious and better players  would often win against me by simply betting heavy. A big bet in poker should be a warning, but if you fold six good hands in a row, to the same player and never see that players cards, perhaps it should occur to you that this player might be bluffing. Statistically no one should get the very best hand at the table 6 hands in a row. As in Poker, the markets take advantage of the "weak hands" the people who give up to easily or worse those that jump around with no plan just emotions.

Obviously the last belief section says manage your risk and this belief section says be bold. So about now you should be frustrated and thinking you need to be clairvoyant or lucky to know when to be bold and when to fear. But you don't, the market will tell you when to be afraid and when to be bold. In fact that is the whole point of chart 100 the Bull Bear Lines. It is no mistake that is why it is the first chart in my analysis.

You will notice also in my comments if the green lines are over the red I say "Bull Market expect bullish outcomes". That is a reminder, be optimistic in a Bull Market.

I even keep on my desk a miniature bull or a miniature bear, at all times. One on display and the other stored away. I use the bull bear lines to decide who is on display and they set my mood. They tell me when to be in the market and when not.  

I would strongly recommend at some time you reread lesson one of the CME4PIF school and be bold during times when the Bull Bear lines are green over red. 

Basic Belief 9: Your "Uncle" Point
When I was a kid, if you were wrestling and if you could not win because your opponent dominated you or had you in a painful position, you could yell Uncle! thus give up and admit defeat.  This idea of an Uncle Point was a key trading concept of 'Buzzy' Schwartz in his book about trading called Pit Bull.  Any good poker player will tell you there is a time when you should know to "fold-em", that is an uncle point. Even in loving relationships, there can be a breaking point in your partner's mind (one you hope you never cross).

There are many ways to set an uncle point, some could be preset stops on your positions, (I have whole CME4PIF School lesson on stops) others are "rules of thumb". The important thing is, you have some trigger that you absolutely will not ignore that says it's time to cash out.

I use the Bull Bear lines as detailed in lesson one. In other words, my uncle point is the 50 day EMA crossing below the 200 EMA of the equal weight S&P500.

For example look at this grid produced by Art Hill;

It shows in the first like what a 25-year investment would return with buy and hold. The Bull Bear Lines is a 50-day / 200-day cross system, although it uses the Equal Weight RSP ETF and it uses exponential moving averages, not simple moving averages. But the result will be similar. Notice the return goes up using the Bull Bear Lines (last line) by a small amount... but the worst case draw-down drops from buy and hold losing 59% of your portfolio to only 19% using the Bull Bear Lines. I would like to point out 1993 as start year means the investment begins during a long period of gains, before the first draw-down. I think if you look at a more volatile start time, all the returns would be lower but the Bull Bear lines would stand out as even more advantageous.

Notice also the win-loss area. Using the Bull Bear Lines over 25 years you would have had 11 winning trades and one money-losing whipsaw trade. Also, your money would only be at risk 74% of the time.

But here is the most important part about uncle points. In Basic Belief 6: Crashes are Very Painful, I explain that you don't want to be anywhere near the market in a major downdraft. It is true if you use the Bull Bear Lines, occasionally you will sell out of the market just as it will turn around, that is called a whipsaw. However these are rare, and very short times. Whole years can go by with the no cross in the Bull Bear lines. In those rare big sell offs that decimate a trading account, the Bull Bear lines will keep you safe and out of the way.

Basic Belief 10: You Can Beat the Index - Eugene Fama Was Wrong.


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