Thoughts for This Friday

Over the past year, I've tried to cull through some of my information channels. There are so many opinions in the market place, when one gets bombarded with too many, it is unproductive. It's not that the opinions are bizarre or unfounded--most are quite compelling and well argued. But two diametrically opposed opinions cannot both be right in the same time frame.

The ultimate filter for divergent opinions is experience and the good judgment that follows. Unfortunately, I don't have that experience having spent most of my adult life indifferent to the market. I never followed it. Couldn't tell you any of the daily, weekly, monthly or YTD moves. I looked at my mutual fund balances. If they were up, that meant I had chosen well. If they were down, well....that was just normal. Today, I can tell you every day's market outcome. The price of gold and oil. I know them. Leading and lagging sectors. I generally know them. However, I have to ask myself, "Am I a better investor for having these facts?" I'm going to say, "Somewhat," if only in being able to draw some conclusions about the nature of market information which I will share with you here.

Essentially "market information" is resident in two venues, both readily available:

• Price and volume action in individual stocks that are constituents of sectors and indices.

• Opinions (whether publicly stated or through subscription) about the meaning of the aforementioned price and volume information. Within this category I'll throw in opinions about the economy, politics, technical analyis, position of the sun, moon stars and one's mood on any particular day!.

At any point in time, there might be divergences within those groups--and I want to speak to that. But first, I want to make a statement. The adages that the stock market is always right and that it is a perfect discounting mechanism are not notions that I embrace. If my last year plus of individual observation and study have taught me anything, it is this: The stock market is nothing more pricing mechanism good for that snapshot of time. No more, no less. It represents the incontrovertible judgment that the market has made today on the price of that stock.

Ultimately, our job as investors (or traders or speculators) is to determine whether there is a misalignment between the current perception of an investment's price and the future value (which could be a long or short time frame) of that investment based on qualitative (emotional such as pessimism/optimism, fear, greed) and/or quantitative (valuation metrics such a earnings growth, financial strength, and overall economic factors such as interest rates, availability of credit, expanding/contracting market for goods sold) factors that will influence both the direction and magnitude of future price change.

Technicians used technical analysis to look at price/volume action to make judgments about future price action. They are measuring the delta between current and future price relative to past patterns and relationships. Say what you will about technical analysis, there are certain points that every trader is looking at on the floor--and those points represent very important psychological stops (as well as stop loss stops). Technical traders might buy a stock that has nothing more going for it than price momentum. Based on the momentum moves that I've seen, these momentum plays are not for most investors, but rather are trading vehicles that require vigilance. My sense of it is that if you happen to already be invested in a stock that suddenly becomes a momentum play, it is prudent to take profits. These stocks can double and then crash.

Fundamentals investors are looking digging through current and past financial information, product offerings, product position in the market, market share, cost of inputs, distribution of US v. non-US sales, management team, technology and a host of other 'stuff' to determine if there is a misalignment of current value to future value. I believe that determining where the stock's industry home lies in the current economic cycle is key as well. Money moves in and out of sectors--sometimes with such volume and rapidity--that it sinks a few ships. No one wishes to have shipwrecks in their portfolio.

I know that I'm not saying anything new or insightful. Nor am I trying to provide a comprehensive view of either technical or fundamental investing. Rather, I'm reinforcing the point that no matter what your investment style or your tools, ultimately the same target is being sited: increasing one's capital.

Despite one's prowess in technical and/or fundamental analysis, one can still get it wrong--materially wrong. In such cases, the investor/trader must have capital preservation tools in hand. As this market has undergone this transition from bull to bear, there are remarkably few people talking about the importance of capital preservation. I'm sure that you've seen these tables before, but I'm going to provide it here. Below is a table of investment loss sustained and the resulting investment gain needed to restore capital. An admitted short-coming is that this is not tax-effected. When I've more coffee and more time, I'll produce a table that shows that.



Wall Street admonishes investors to always stay invested. You cannot time the market, they say. I agree that short term timing of the market is difficult--and that is for traders, not investors. But there are some pretty reliable 4-6 year patterns that by paying attention you can capture a good part of the gain and avoid a good part of the loss. You can see how much Gary Kaltbaum has evangelized this point so well. Rev Shark on Real Money has too (in fact, both have been in lockstep in their opinions about the market. Rev Shark requires a subscription; Gary K is free).

When choosing an investment, then, an investor has four things to consider, really:

• Thing 1: There is a future positive divergence in the investment's current price and it's future value, (If one is shorting, then flip it to a negative divergence!);
  

• Thing 2: The reasons why there will be a divergence;
  

• Thing 3: The time frame in which the divergence will take place; and
  

• Thing 4: The risk reward ratio: How much capital is the investor willing to risk while awaiting the unfolding of his/her price divergence scenario to unfold.

Ultimately, the successful investor will not be one who is right all the time. No one is. A successful investor is one who quantifies his/her risk in terms of time frame and permitted loss before re-evaluating the thesis. It doesn't mean that the thesis is wrong, necessarily, but rather the time frame is wrong. Best to preserve capital and await a more advantageous entry unless there is new information that increases the probability of the investment succeeding.

When I look at the Nikkei's performance since the early 80's I cannot help but consider the US's situation. Japan had a real estate boom that went bust. Even today, their market is not even 1/3 of the highs in 1989. For a buy and hold investor--as many of us are admonished to do by the investment community--would not have fared well, and no amount of rebalancing of sectors or diversification would have saved him/her. I'd like to read more about their situation and any intersects with the US.

I'm not saying that the US market will fall into such an abyss. But if it could happen in Japan, why couldn't it happen to the US? The Japanese economy was one of the strongest in the world. It is clear to me that our economic and political hegemony have peaked. In the aftermath of their economic decline, I guess the Japanese chose deflation rather than inflation. Plus, they were a country of savers, not debtors. I don't know the effects of that, as I've not studied it at all. You can tell that Russell's paper recommendation, "Irrational Optimism" seared my soul! But I do think that it is important to understand that conventional wisdom can be neither conventional or wise. Nevertheless, it is always convenient and comfortable--and convenience and comfort can lull us into underestimating risk.

As I post this, the jobs numbers and addition Fed infusion news has been released. The Fed infusion is a 28-day get out of jail free card--it is not liquidity that will make it to Main Street. It is liquidity that will literally keep the wheels from falling off of the carts that have been wobbling under the overload of structured debt that was too freely loaded.