Aggressive/Defensive Investing And Market Timing: How To Profit From A Shift In Market Sentiment

by: Matthew Waterman

How to effectively time the market (Yes, really).

How to find the best opportunities in times of crisis.

How to rely on yourself by using introspection to become better at what you do.

(Image Source: still screens from "Trading Places")

Buy low. Sell High. Why is that so hard for most people?

Right off the bat, I guarantee that there are a whole horde of people who will want to tell me at this very moment that what I'm about to talk about doing is impossible. Something called the "efficient market theory" has changed the way how scholars, economists, doctorates, math geniuses, and virtually all major universities view and teach investing.

Fortunately for me, I haven't been to a university yet. I got lucky enough to learn the really good stuff before they ever had a chance to convince me that it couldn't be done.

You know what, market timing might actually be impossible to master, but that is entirely up to you. It is a function of whether you are willing to put in the effort to learn how to do things in a different, smarter way. If you are the kind of person who doesn't learn from their mistakes, then I recommend getting a copy of Burton G. Malkiel's "A Random Walk Down Wall Street". You can save yourself a lot of pain up front.


If you are the kind of person who burns their hand on the stove, and learns to put on an oven mitt instead of eating all their meals from a microwave, then I have good news for you. Being persistent is what makes you wealthy in stocks, not being a math genius. Losses will hit you in the future at some point. I promise you they will, and there is no way to prevent that; I'm sorry. What matters is how personally you take those losses, and what you do as a result. The book for you to read if you already haven't, is Benjamin Graham's "The Intelligent Investor". I like the 4th edition, I think the liner notes that Jason Zweig added are really great.

I don't buy stocks based on the patterns on charts. I buy them based on the patterns of human behavior, and what is well known about their psychology. Prey on their irrational fear. The kinds of mistakes that people make with stocks, that pattern is not new, and it's not ever going to change no matter how many robo-traders there are in the world.

There is a somewhat new type of study called "Behavioral Finance", and newer models of stock market trading have been built around it. The ironic thing is, now that those trading systems exist, people's behavior has changed as a result. Well, some people. There are plenty of people who still give up after their very first loss. As I talked about in this article, my behavior change was directly affected by the pain I felt from losses. I learned to overcome the fear of loss through self-examination of my own weaknesses.

First point: Expect change.

The market is dynamic, reactionary, and constantly evolving. However, do not expect rationality. The market cannot ever be truly efficient, because the people operating in it are not rational. There are very few deep thinkers in this game because time punishes you for not acting. People see a price drop, and they want to know why. The same people see the price going up, they want to know why. Everyone wants to find the catalyst, the news story, the reason behind why something has happened.

But sometimes there are no rational explanations for why something occurred. Don't dwell on it. Act on what you know will be more valuable in the future than it is today. Even if that means you might suffer a near term loss to receive that higher reward. It will be worth it.

Second: Buy common stocks as if you were the owner of the business.

There is no way you haven't heard of Warren Buffett. The guy gets mentioned in every good article here. He got to where he is by being greedy when others are fearful. It's not the news that tells you that opportunities are coming, it's the irrationality of the market that creates great long-term values. Ignore the buy/sell ratings of analysts, they are just like a herd of cows. They all follow each other's decisions and you can take advantage of that by getting the best businesses when they are hated.

To quote a bit of Dan Ackroyd:

"..Never show any sign of weakness, always go for the throat."

If the company you want to own is on sale, then buy it. Don't hesitate. To be prepared for these times, do as much as you can ahead of time to learn about business. Read annual reports, read accounting statements, understand what makes a good business good, and you will be ready for when the market finally does throw that fit about your stock. It will eventually happen. Keep your mindset on businesses that will be around a long time, that are profitable, and have barriers to competition.

Third: Go big, or don't go.

Don't diversify. Ok well, maybe diversify a little. Ten holdings is awesome, Thirty is too many. What the very large number of individual holdings in my portfolio (Over 180 at one point) have proven to me over time is that spreading out your bets mutes the potential growth of any one of them, and adds to your transaction costs.

I realize that the last paragraph at first seems like I am a hypocrite. What I have changed about my behavior since starting that portfolio is that when a good opportunity comes around, I concentrate a large percentage of assets into that single purchase. That strategy has earned me way more than I could have expected by "playing it safe". As a result, only a few core holdings take up more than 90% of my allocation. The rest I just leave in there so I can get various alerts from my tracking software.

Fourth: Don't chase yield, and don't rely on dividend growth alone.

This is a big one. Dividend growth investing is one of the most popular topics here on Seeking Alpha, but ignoring the price you pay is holding you back from your potential. Dividend growth in the absence of a corresponding growth in earnings per share is unsustainable, and will steal tomorrow's potential returns by paying you today. I've made some really great returns by buying right after dividend cuts.

Case in point: I buy more Prospect Capital (PSEC) each time they have a dividend cut because the market always overreacts, and I understand how Prospect operates.

Don't use options to hedge volatility. Use them to guarantee your future price.

If you are selling covered calls, you may also be sacrificing your growth by simply giving it away to people who understand the business better than you. With selling options you do have the house advantage, but understand what the business is really worth before deciding to risk it. A market can switch directions on a dime. I recently picked up long term calls on Mattel (MAT) that don't expire for two years for about $2 each.

I think the reason I got such a low price is because people were desperate to juice income from their holdings. The idea that Mattel can't rise $2/share from today's price seems very unlikely to me. (Author's note from the future: it's gone up about $6 so far.)

"..Fear, that's the other guy's problem."

And now the big one, what you came here for:

Fifth: How to time the market: Don't try.

I heard that record needle in your mind scratch across the surface of the album just now. It's not what you think. I mean the timing of the whole stock market, not the individual market for the company you like. Don't pay attention to the daily ups and downs of the S&P 500, the Dow, the Nasdaq, etc. You cannot control the behavior of those millions of people, you can only control yourself.

Good investing is like good karate. It is a mastery of the self you train towards, not just the ability to fight. That is the ultimate truth. Limit your watchlist to what you know are quality businesses, and you will gradually get a feel for what the market is willing to pay for those. As each bear and bull cycle passes, you'll learn even better about what a good P/E ratio is to pay for your business. You'll know when it's probably too high, and you'll know when nothing else is a better deal.

Sixth: Keep a critical eye, but not a pessimistic one.

Don't let politics influence your choices. Assume that everyone in the world has the individual goal of self-improvement. Don't be a skeptic, but don't be a blind follower either. If promises are made to shareholders, approach the situation logically. Use introspection- Ask yourself: Is what they are promising possible? How long would it take to implement? Have others achieved similar results in the past? What is this company doing right now that another company cannot easily duplicate?

Most importantly, ask: "If they fail, how much can I lose?".

The largest gains I've ever made were on businesses that were at great prices during a time that a fire sale was going on with the stock. They were at times the market was literally the most fearful, because people let other people tell them how to think instead of doing their own analysis:

  • In 2009 I was buying closed-end junk bond funds like the Pimco High Income Fund (PHK) and mortgage REITs that were full of mortgage-backed securities, such as Annaly Capital (NLY), Chimera Mortgage (CIM), and Armour Residential (ARR). These contained the "toxic assets" that the market was terrified of. I bought because I kept my head. These things were priced 90% off, and there was no way 9 out of 10 homeowners would just walk away from their mortgages. I figured the worst case scenario might be about 50%. It never even got close to that bad.
  • Following a string of bank failures from the great recession, I scooped up Wells Fargo (WFC) knowing that whatever was coming in the future, they had the strongest financial position. I have kept them to this day, and have also added Bank of America (BAC) when they started to show signs of improvement.
  • After the residential crisis was secured by the Fed, the news started reporting a slew of retailers were failing, and commercial REITs went on sale. The reporters said retail would be the "Second shoe to drop", so I bought Kimco REIT (KIM) and Realty Income Corp. (O). Kimco cut its dividends, but I knew that they were using that money to buy low priced properties instead, so I doubled down on what I put into it and walked away with an 80% gain in the span of just a few weeks time. By the time the markets had started to bottom out, I was already sitting on a total gain of more than 400%. I still hold Realty Income.
  • In 2010, I bought Canadian Royal Oil trusts Penn West (TSX: PWE) and MV Oil Trust (NYSE:MVO), as well as U.S. pipelines Linn Energy (LINE), Enterprise Products Partners (EPD), and Kinder Morgan Energy Partners (KMI). I bought those because of the infamous "Halloween Massacre" of CanRoys having their corporate taxes raised. Just those words sound scary enough. The market assumed that these tax changes were coming to everyone else, and all I did was figure out what the after-tax profits of those businesses would be. Knowing that, I worked out what to expect from earnings. I made ridiculous profits after the dust settled. I continue to add to Enterprise Products Partners today.
  • In 2011, When famed activist investor Carl Icahn made an offer to buy Clorox (CLX), I was already a holder. I bought more because I knew he wasn't offering enough. Then, when he raised his offer and the stock price climbed even higher, I sold because I knew they still wouldn't accept the deal. By that time the price had then become unrealistically high. Clorox never did take the offer, and after they said no for the final time, I bought back the shares about 20% cheaper.
  • During the Greek crisis in 2011, while there was rioting in the streets I bought the Greek shipping company Teekay Tankers (TNK). The price slid in that year, but I eventually cost averaged into a position size six times larger than what I started with, and sold for a total gain close to 50%. I started buying into Nintendo (NTDOY) around this time as well, which was admittedly early.
  • When Spain was facing bankruptcy in early 2012, I bought The Argentinean Banco Macro (BMA) because it was being dumped just like everything else with a Hispanic sounding name. I sold at the high with a 50% profit, and bought them back again in 2013 to go on to make another 100%.
  • In 2014, I bought into Target (TGT) after they had their credit card scandal. That stock made a very quick recovery and I have since sold.
  • And going into the 3rd quarter of 2014, I started buying shares of Mattel Corporation. To date I have put more than half of my entire net worth behind that stock, and have since boosted my Nintendo holding by more than ten times what I started with. If it's not clear by this point, I have a history of waiting for the bad news to buy.

As you may know, Mattel has not panned out yet. I was notoriously wrong when I made a very bullish short-term call about them. Nintendo also did not win over analysts with its year end results. However, my eye is on the long term, not the short. That's why my call options are for years into the future, not for a month. The great thing about buying stocks at low prices is that even if you don't win big, you usually don't lose very much either, and time tends to correct your mistake. I'll use the extra time I've been given to accumulate more shares, and by doing that, lower the average cost I've been paying.

Several of those other ticks are not the same kind of values today that they were before I sold them. The mortgage REITs for example, that sector is virtually untouchable today because of how much competition there is. The point of all of that was to show that you can make the best profits when the market believes things are bad, as long as you are persistent. Evaluate the long-term business possibilities, and if the market brings the price down, buy more knowing that you are owning the piece of a high quality business. Stocks are not just a piece of paper or a number on some trader's screen. As I said above, diversify to a certain extent, but don't ever sell just because the price of your stock went down.

Be confident. If your evaluation is solid, ignore what the market does.

Just because my outlook is long-term does not mean that it takes a lifetime to see profits. There are trades above that I opened and closed within the span of weeks, because the swing back to positive sentiment happened so rapidly. And when things are at their absolute bleakest, when you read the comments of frustrated traders, and other people say depressing, crazy things like the company's biggest brand is in a permanent downward spiral:

"..Think big, think positive"

Good management is dynamic, not static.

They will react when a problem comes up. We are seeing that with Mattel now. If management can, they will do what is needed to "right the ship". The key phrase here is "if they can". That requires tools like cash on the balance sheet, and customers who are loyal. That's precisely what happened with Coca-Cola (KO) in 1985 when New Coke was poorly received. That's a fascinating history lesson if you're not old enough to remember the Cola wars. Your understanding the businesses you want to own ahead of time is the key to quickly locating these opportunities. Buffett bought up two million shares when the markets were convinced that the company was headed for failure, and it's been one of the most profitable holdings ever for Berkshire Hathaway (BRK.A), (BRK.B).

Some ships never even need to be righted. I still believe that is happening with Mattel. There was an unexpected interruption in all toy sales for 2014 with the popularity of Disney's (DIS) "Frozen" products. In the longer term, I believe that the storm behind those characters will subside, and every toymaker's sales will rise to regain their places. All that has really happened with the stock price was that enough people believed to themselves that nothing could change.

Now go back and read the first point.

You just got smarter. Thanks for reading, I hope you enjoyed this article. I'll be back with something just as good soon.

Disclosure: The author is long WFC, MAT, PHK, BAC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Disclosure: I am/we are long BAC, BRK.B, DIS, EPD, KO, MAT, NTDOY, O, PHK, PSEC, WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.