About Me 0093: Stock Making Money

In the lower portion of this chart, there is a modified sine wave pattern to help visualize the behavior of the cycle in the SP500's price movements. The market was following this cycle pattern very nicely up until late 2005, and then it jumped onto a new schedule that just happened to be about a half cycle length off of the original schedule.

So with the knowledge that a phase shift was a possibility with this cycle, it was hard to understand what was happening in early 2008. And this illustrates one of the big pitfalls with doing any sort of cycle analysis: cycles can change, and so while they may give us nice predictions of what should happen at some point in the future, there is no guarantee that the past behavior will remain in effect in the future.

It just so happens that 2007 was when this cycle changed, and it was also the year that the uptick rule for shorting stocks went away. It is hard to understand why a rule change like this could make a difference on a market cycle, but I have an explanation that may help.

Imagine a wave pool in a laboratory, where scientists create waves to study how they travel through the water. Now imagine that you remove all of the water, and replace it with 30-weight motor oil. Because the oil is lighter but more viscous than the water, the behavior of waves in that wave pool would understandably be different.

So thinking of the financial markets, if the regulators were to do something that changes the "viscosity of money", making it flow more or less easily, then we would likely see changes in the way that waves propagate through that medium as well. Such changes might include restrictions on shorting stocks, the advent of money market funds, the introduction of stock index futures and options, leveraged ETFs, etc. All of these affect the ease with which money can flow into and through the stock market.

Now, if you look back at the top chart, you can see that the blue numbers are getting bigger again lately. Those numbers represent the time period between the major lows of this cycle (formerly known as 9-month). The lowest number was 159 trading days in early 2008, and it has climbed back all the way up to 177 as of the latest major cycle price low. It may be that after the initial shock, this cycle is working on getting back up to is "natural" frequency. Or it may be that 159 and 177 are just the widest extremes of a new range of cycle periods that average more like 168 trading days, and that this is the new natural frequency. We won't know for sure for several more cycles' worth of time, and that's the big problem with this analytical technique.

For what it's worth, and to help your planning, 159 to 177 trading days from the most recent major cycle low equates to a timeframe of Oct. 31 to Nov. 25, 2011.

The path of least resistance is the path of the loser.” H.G. Wells

Wells’ above quote could be applied to a multitude of things. For myself as an investment manager, the risk of falling prey to confirmation bias and shallow analysis can be dangerous. In the confirmation bias, people tend to favor/believe information that supports their current views & hypotheses.

Being intellectual honest about our thesis and rationale for investments is critical to success. How can we become better investors if our thought process isn’t consistently challenged? Are we taking the path of least resistance in our analysis and analytical rigor? Here are a few signs to watch out for:

Scouring for confirming views: Jason Zweig once wrote that, “…people are twice as likely to seek information that confirms their beliefs then they are to consider evidence that contradicts them.” Do you carefully considering opposing views?

Easily shaken out by fluctuations: How can you have faith to ride out short-term fluctuations without the confidence of a full vetted idea? While there is nothing wrong with having tight stops and loss disciplines, it is a whole lot easier to be shaken out if you don’t trust the idea.

Lack of conviction: What is the point of holding a stock that you don’t have high conviction in? I’d rather own an index fund than a stock I don’t love. Investors lukewarm on a holding end up becoming “long-term investors” as they are inevitably under water.

Loss Aversion: Does your original investment thesis still hold? If not are you only holding as you are reluctant to take a loss? Cut bait and get out. These situations lead to investors taking on more risk due to their loss aversion.

Obviously a well vetted idea doesn’t guarantee success, however a lack of reasonable diligence is inexcusable. Making money is too difficult to lose it on stupid decisions. Take a look at your holdings today and ask yourself why you are still holding it? Does it still meet your original criteria?

About Me 0093

Monday, August 1, 2011

Stock Making Money

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