To avoid risk, think like a trader, says Ken Norquay, a Hamilton, Ontario-based Chartered Market Technician (CMT) and author of Beyond the Bull, a book about behavioral finance and the impact of your personality on your long-term investments.
In the wake of the financial crisis, U.S. stock markets hit a low in March, 2009. But in the five and a half years since then, they have been going up. The S&P 500 composite index has gained almost exactly 200 per cent. Over the same period, the S&P/TSX-the main Toronto Stock Exchange composite index-has climbed 110 per cent. In short, the recession, the subprime mortgage debacle and the European banking crisis seem like distant memories.
But no market goes up forever. Every long-term up trend gives way to a downtrend.
In my previous two articles for The MoneyLetter, I pointed out some of the warning signs that the market may be topping. The momentum (i.e., the price change over time) is still up. Normally, before the market peaks, it goes sideways. But that sideways action has not started yet.
Our caution signs are coming from our study of market psychology, not momentum. The crowd has turned bullish.
What to expect
Now that investors have turned optimistic, how should we expect the stock market to behave?
First, the overall stock market averages should go sideways for a while. Second we should begin to see divergences.
A divergence occurs when some parts of the market continue up and others start to fall. For example, the S&P/TSX hit a record high in September, yet many gold mining stocks are making new lows. In other words, there was a divergence between the overall market and the gold mining sub-index.
Before the stock market up-trend ends, we should see many such divergences.
The power of thought
"Our life is what our thoughts make it," Roman emperor Marcus Aurelius said in 167 AD. In my book, Beyond the Bull, I point out how important our attitudes are in the investment business. If Marcus Aurelius were alive today, he might say, "Our stock market success is what our thoughts make it." What should our thoughts be at this stage in the market cycle?
What to think
Those who think they are long-term investors should ponder this question: "How long is the long-term?" Is the five-and-a-half-year stretch since the market hit bottom in March 2009 long enough?
Since 2000, the stock market has been falling and rising in a series of zigzags. The current five-and-a-half-year-long "up zig" has been the longest.
It's time to be cautious; to think about preserving capital and locking in gains. It's time to think like a trader.
Investor thinking versus trader thinking
And how does a trader think? Let's look at what is widely considered investor thinking and contrast this with trader thinking.
When making investment decisions, most investors rely on their advisors. When making trading decisions most traders rely on their trading plans. My grandfather once taught me: "It ain't what you know, it's who you know." Clearly my grandfather was an investor, not a trader.
The error most investors make stems from the fact all stock market advisors are salesman. Hence, their advice is never objective.
The error most traders make stems from the fact that they are human and proper trading sometimes goes against human nature. Human nature would have us be optimistic and buy at the top; it would also have us be pessimistic and sell at the bottom.
Most investors believe in the merits of their investments. Most traders believe in the merits of their trading system.
The merits of a good stock market investment are beyond the control of the investor. The merits of a good trading methodology are completely under the control of the trader.
As investors believe in the merits of their investments, they often ride the market's ups and downs in full faith their investments will work out in the long run.
Traders' strengths top investors'
Traders ride the up trends and avoid the downtrends. Their "long run" is a series of "short runs" added together.
Traders' plans help them decide when to sell and when to buy. (Note: There are trading plans designed to profit from downtrends too. We will not discuss them in this article.)
Investors' willingness to ride out "the downs" as well as "the ups" tells us they're willing to take risk. Traders' unwillingness to ride out "the downs" tells us they aren't as willing to take risk. Most are significantly more risk averse than most investors.
In order to manage their risk, most investors resort to diversification. Many traders use the opposite approach: they focus on only a few trades at a time. They control their risk by selling when their trades become too risky.
These are two quite different ways of thinking. For years, I've been advising ordinary investors to think like long-term traders: to develop long-term trading plans that help them decide what and when to buy and sell.
Who's giving you advice?
The most important problem faced by traditional investors is their source of information: their advisors are usually commission-driven sales people. All the information they receive is persuasive in nature. It is designed to persuade them to buy.
The second problem is that most of their advisors try to persuade them to buy managed investment products. "Managed products" means that you pay a management fee as long as you own the investment.
This means your advisor also wants to persuade you not to sell. Otherwise the adviser will no longer receive his or her share of that fee, as that revenue stream would stop. In short, a "buy and hold" strategy benefits the salesperson. Your trading plan is a strategy for your benefit.
Don't hold through downtrends
The lesson we should have learned at the stock market tops in 2000 and 2008 is that holding stocks through a downtrend is financial suicide. Stock market indices dropped in half after those tops. And most investors' equity portfolios dropped in half too. Don't let that happen again.
Instead, learn to think like a trader. Be cautious and risk-averse. Set up your selling plan now while you have a calm mind and a healthy portfolio. Then, when the downtrend begins, you won't lose money as economic history repeats itself.
Interesting times
We are living through a unique time. We can learn about psychology at a market top by studying the stock market. At the same time, we can learn about the psychology of a market bottom by studying gold.
Gold was in a downtrend from September, 2011 to June, 2013. Today it is at the same level as in June, 2013. In the same way that we expect the stock market to go sideways during the current period of stock market optimism, gold has already gone sideways for 15 months during this period of gold pessimism.
What to do
Wise long-term traders would have us sell our stocks in a period of optimism accompanied by sideways stock market action. They would have us buy gold during the period of pessimism accompanied by sideways gold market action. For me, it is interesting that these two contrasting market actions are happening simultaneously.
In the same way we should be thinking "sell" for the stock market, we should be thinking "buy" for gold. For those who like to indulge in stock market speculation, gold mining offers a smorgasbord of possibilities.
Review the charts of the many low-priced gold mining stocks that trade on the Toronto Stock Exchange. You will see that some are leading the way down. For example, Iamgold Corp. (TSX-IMG) and Kinross Gold Corp. (TSX-K) touched new lows earlier this month.
Other gold mining stocks appear to have bottomed and are starting to go up: for example, Kirkland Lake Gold Inc. (TSX-KGI) and Novagold Resources Inc. (TSX-NG) are well above their lows of 2013.
The point here is that when the time comes to buy Canadian gold mining stocks, those that have already bottomed will be the ones that are less risky.
When to buy
And how will we judge when it is the time to buy? Perhaps the secret is in following the stellar rise of the U.S. dollar versus other currencies.
When the greenback goes up, other currencies go down. Gold has some of the characteristics of a currency and for the past few months the yellow metal has been going down.
Since July, 2014 the U.S. dollar index has risen over eight per cent against a basket of international currencies. That's 15 consecutive positive weeks. It's been a spectacular rise.
And when it ends, we can speculate that gold's downtrend will end too.
That would be a good time for speculators to buy low-priced Canadian gold mining stocks.
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