Nothing Happened - Or Everything

I have been away for the last couple of days, I see the S&P 500 closed Tuesday at 1213 and then closed Thursday at 1206. Up a little today. So I guess it was a pretty boring couple of days? Not much news? Thank goodness the craziness ended, what a relief. Hearty chuckle.

This will be a tricky post; hopefully I can articulate this clearly--not joking around.

The biggest decision in top-down management is whether to be in the market or be out. If you have been reading this site for more than 20 minutes you know that my take on that is defensively postured versus fully invested, hinging on the market being below the 200 DMA (demand unhealthy) or above the 200 DMA (demand healthy). No matter what you think of that, it is simple.

Sector decisions and country decisions are not quite as simple as being in or being out, but certain sectors do well early cycle and other do well late cycle. I've written about the inverted yield curve's important probably 100 times. Regardless of how complex (or not) you perceive the things I write about to be, I stick to them.

I have no plans to change the big picture aspect of how I do things. No matter what is going on, if demand is healthy I will be much closer to fully invested, if demand is poor I will be defensive. Feast, famine, pestilence, boom, raining gold coins, whatever; demand is either healthy or it is not.

Taking this approach means it doesn't really matter whether you are right about too many things going on in the world. This leads me to what is happening right now.

Part of this entire mess before us may have come from unintended consequences of past actions (some think this, some do not, I think there is something to this line of thought). There is also an element of the store not having been properly minded that is contributing also. The store not being minded is due in part to either incompetence or negligence.

If any of the last paragraph seems within the realm of reason to you, then it makes sense to think about the unintended consequences of the efforts being made to fix our grand mess. At some point do we jeopardize our credit rating? Would there be political pressure to maintain the AAA rating? If so, isn't part of the current problem that paper that was not really AAA was rated that way anyway?

Just how much will the RTC-like solution cost? How will they value what they buy? How will they dispose of the assets? Who will buy them? What about moral hazard?

Doesn't the idea of banning short sales have unintended consequence written all over it? Anything that impedes two-way markets is scary territory.

Anyone who says we had to have these things put in probably has a point;  I certainly don't have a great argument beyond Ithinking that there will be bad consequences. Part of the issue is that the excesses that built, that so threaten the US financial system were allowed to develop under the set of rules that existed. If the rules had been better constructed things would have been different. Of course, that is utterly useless to say because things were how they were and then blew up like they did.

The stock market is obviously behaving strangely. It is difficult to conceive that the type of action we have seen can be thought of as healthy. It is certainly not normal. Do you own individual stocks? If so, how many were up double digits? I had a bunch - which is not a brag, it shows just how odd things are right now. This move up certainly could last a few days, but who would be shocked if there was another four-point-something-percent drop one day very soon?

I certainly do not have all the answers. I may not have any answers. But the S&P 500 is below its 200 DMA so I am defensive. When it goes back above the 200 DMA I will move toward reequitizing.

Comments

[JasonC:]

200 MA is a nice simple trading rule. I've incorporated it into models I've made of how traders with different strategies in different weights influence how markets behave. The 200 MA is the standard way of incorporating a *trend follower* into such models. The effect of trend followers being heavily weighted is a positive feedback, increasing serial correlation, the size of bubbles, and the violence and extendedness of reversals.

Here are other stylized simple trade strategies that have quite different effects. A level trader plots an exponential line (straight line on a log graph) through the market's long term history, and gets defensive *above* that line, and aggressive below it. This is a negative feedback instead of a positive one, and it tends to make price series mean-reverting (negative serial correlation, or the scale of moves growing less than square root with time).

And a new trader who just looks at the headlines and buys when they are good and sells when they are bad, adds mere noise and randomly walks.

Put a bunch of all of them together, and the level traders make out like bandits. The trend followers occasionally have large gains and often have large losses. They build large positions on the upper side of the market's fluctuations. And they miss the reversal moves from the bottoms.

Any strategy can work if you operate it intelligently enough. And simplicity is a virtue. But it is a good idea to understand where your rules sit in a sort of strategy space, to know what some of the alternatives are, and to be aware of the potential dangers in one's preferred approach.

Still a basically sober article, thanks for it.

2008 Sep 19 12:23 PM

[SW Richmond:]

"The stock market is obviously behaving strangely. It is difficult to conceive that the type of action we have seen can be thought of as healthy. It is certainly not normal."

Strangely? I am thinking 'psychotic.' And that's why I'm out. Too many huge and unpredictable swings, too much intervention, too much pressure both ways. Outcome unpredictable, outlook unstable, legal realm shifting rapidly, currency swinging wildly, constant upside intervention obviously necessary, hidden agendas. This isn't investing, it's gambling. It's not rational, it defies rational analysis.

How can one "invest" in such an unstable environment? If you go long you are merely betting on the interventionists and their ability / willingness to reinflate. If you buy, will you be allowed to sell next week? What will happen to the tax code, after all we have an election in 6 weeks?

Is it even possible to evaluate business fundamentals and outlook for future earnings in this environment? Can we even define the environment? Will the company we buy be nationalized (and our equity be wiped out) because some government official says the company is undercapitalized? How can we know?

What's the next 'emergency action' going to be? What will be the impact of Homeland Security's entrance into the financial markets? What's the next trap waiting to be sprung on "investors"?

2008 Sep 19 12:54 PM

[Larry House:]

You are right, SW. I feel like I am caught on a battlefield, but I did not sign up to be a soldier. Some of the folks on CNBC have stated that over 50% of each day's stock transactions are done by quants and other programmed trading. We are at the mercy of the big guys every day. To buy and hold something for a year or so seems ridiculous in this market. The market is trying to make traders of all of us, and I am not good at it. The vultures will pick our bones.

2008 Sep 19 04:12 PM

[Chris B:]

SW & Larry,

Fortunes are made at the highly volatile tops and the highly volatile bottoms. If the stock you bought yesterday drops to half its previous value, it shouldn't matter to you. It was worth yesterday's price or you wouldn't have paid it. You don't have to sell at that price (unless you're leveraged) so you haven't lost anything. Somebody else getting an even better deal is irrelevant. In fact, you gain the option of doing some tax-loss-harvesting and jumping right into another cheap investment.

If you are an investor who has done their homework and not a gambler, you should have the luxury of waiting years for the market to work out its inefficient pricing and reward you. Falling stock markets are good for investors, because they allow us to buy earnings for cheaper than before. Because earnings underly all long term stock appreciation and dividends, we get to buy more future earnings for less money at times like these.

The choice to invest in cash instead of equities is an investment decision too. You're not out. If you sell and the market pops 10% next week, you'll just have to get in at 10% higher. That's a loss. If you never get back in, it's opportunity cost.

Now if you've 63 years old and invested mostly in stocks, perhaps you should have considered your asset balance.

2008 Sep 19 04:34 PM

[1worldcurrency:]

Nothing extraordinary happened this week. The Feds spent another trillion. The Chinese patiently grow. Next week, though, oil hits $200.

2008 Sep 19 06:37 PM

[Adam First:]

JasonC,

Could you please elaborate on the "level trading" stategy?

2008 Sep 19 07:18 PM

[JustTrading:]

Yea, the market sux for investing, but for trading options, it is fantastic!

2008 Sep 19 07:23 PM

[investor88:]

I like Rogers take that this upmove could last a few days [only few days? not even a few weeks like the Bear Stearns bottom? who really knows?] and that we wouldn't be shocked if VERY SOON we see a 4% + drop.

His following the 200d moving average is a great idea, but I might add it matters whether the SLOPE of the 200d is up or down. Also if the shorter term averages like the 20d and 50d are above the 200d or below the 200d.

Following trends using moving averages has its draw backs. JasonC says trend following would miss the reversal moves from the bottom like the 1000 pts Dow reversal we see in the last two days. To catch such rare bottom reversals, maybe analysing market perception is better, what George Soros called "reflexivity".

2008 Sep 19 09:13 PM

[ashadu:]

Chris B. If I buy stocks when they sell at 19 times and over the next ten years they sell down to 12 times earnings because of boomers demand for retirement cash, how much are the earnings going to have to increase for me to break even? simply put, do you have a recipe which will allow me to eat off of my investment. 63 and in bonds- not good either. thanks for your article

2008 Sep 19 10:39 PM