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(Lessons From) A Trader’s Diary

Dear Diary,

Last week’s Market Commentary to members concluded:

"Technical analysts will cite bullish breakouts and push retail traders into bullish trades now.  We spoke in recent weeks of the potential for the stock market to remain bullish through early May, which would lull investors into complacency, believing that "Sell in May and Stay Away" would not materialize.  Everything is going according to plan in that regard.  The markets remained bullish through last week and optimism is high again that 13,500 will be just around the corner…..we are highly skeptical of any meaningfull bullish follow-through.  By week’s end we will be very surprised if the strength has been maintained and, as a result, are entering bearish positions"

As it turned out, the Dow Jones Industrial Average ended 3 of last week’s 5 trading days lower and ended the week substantially lower. 

On April 14th we wrote in our Monday blog that we expected "strength over the next couple of weeks in the markets assuming the 1325 level can hold…we’re looking for anything above that key threshold level to signal high likelihood of a bullish follow through to the end of the month."

 

As expected, the bullish follow through materialized once the critical 1,325 level held firm.

One of the factors we consider heavily when trading is general sentiment in the market.  In early May, optimism was high.  The Volatility Index, for example, had not been quite as low since the December and October peaks in the market.  Had all the pessimism of recent months really been eroded?  Had we forgotten so quickly the problems of the past?  We didn’t think so. 

 

While many were optimistic about the Dow crossing 13,000, we exercised extreme caution and refused to abandon discipline, preferring to stay safe than risk a big correction.  And the correction from approximately 13,100 to 12,745 soon followed. 

Although the correction so far has been just under 3%, it is still almost 3% in 1 week!  If all you could do was improve your virtual portfolio performance by 3% at the end of the year, the effect on compounded gains would be substantial over time. 

For example, $100,000 compounded at 10% over 20 years amounts to just over $670,000 (assuming a qualifed account) while $100,000 compounded at 13% over 20 years amounts to over $1,150,000, almost twice the amount! 

When making big money in the market, the devil is in the details and saving 3% here and there makes a huge difference at the end of a year when comparing actual and potential virtual portfolio gains.

Moreover, when the stock market rises or falls 2-3%, traders seeking greater returns often experience greater account value declines as their individual stocks suffer even more.  So, by-passing a 2-3% stock market decline can mean avoiding a 5%,6% or higher account value decline!  In short, when optimism reaches extreme levels, it’s very dangerous to follow the crowd because the crowd is often wrong at the tops and the bottoms!

Rather than discovering by trial and error with one’s own capital how to master sentiment extremes, it’s often much easier to look back in history.  For example, famed value investor Benjamin Graham suffered at the hands of sentiment when he and his partner Jerry Newman ran a joint account in 1929.

With capital of $2.9M on which $4.5M of outright long positions were balanced and an additional $2.5M of long positions were offset by $2.5M of short positions, the duo believed the matched set of long and short positions presented negligible risk.

At the time, the heavily margined long positions were used to purchase convertible preferred stock or convertible bonds while the common stock was shorted.  As the 1929 crash took full force, the duo reverted to valuation models and believed too soon that it was appropriate to cover short sales yet still hold preferred stock positions.

Graham recalled that his reasoning was "the prices seemed too low".  At the bottom of the market in 1932, the $2.5M capital account was reduced by 70%. 

What were Benjamin’s Graham’s sins?  He had failed to adequately account for the power of sentiment and he had used excessive leverage.

For most of us, it is so easy to feel an opportunity is being missed when a stock is up day after day.  Yet waiting for the pullback and refusing to buy into extreme optimism often serves us much better! 

Next time, you are about to pull the trigger on purchasing stock AFTER a big uptrend, re-evaluate whether it is purely greed driving you to buy.  And next time, you want to panic AFTER a big downtrend, re-evaluate whether it is fear driving you to sell. 

In early April, fear was paramount in the markets, but we refused to give in to it and made some very attractive gains on the uptrend.  In early May, optimism was high, but we refused to buy into the uptrend and kept our powder dry.  We hope you too have navigated this choppy year successfully!

Optionsage @ StockandOptionTrades


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