by Doug Wakefield with Ben Hill

The most interesting combination of speakers, at the Conference of Monetary Research and Education, held in New York this May, had to be Glenn Hubbard, Dean of the Columbia School of Business, and Jim Grant, editor of the well-known Grant's Interest Rate Observer. As I listened to these two, their diametrically opposing views about the future of the U.S. economy became apparent. Yet, rather than give way to my obviously biased review of their presentation, I will defer to my wife. She is a great musician and an avid reader, but economics is not her cup of tea. As such, I was interested to get her opinion.

When I asked her what she thought, she said, "Well, Jim Grant just sounded more believable." Obviously, she's also less wordy than me, so I'll go ahead and elaborate. Grant sounded more believable because he went below the surface aggregates that so many speak of and he spoke in easily understandable terms about circumstances that we can see in our day-to-day lives, and he pointed out cause-and-effect relationships that were more realistically believable and, therefore, easy to follow. On the other hand, though Hubbard presented a "feel-good" message that we would rather believe, his presentation, heavily reliant on impressive sounding eco-speak, seemed to fit better in the ethereal halls of academia than the world in which you and I live.

It may be too late to say that my aim is not to bash Hubbard. His position and his intellect are certainly worthy of respect. My intentions are more as follows: I hope to present three propositions that are easy to understand that will benefit investors immediately and for years to come. Most of us have already formed strong opinions, and conclusions, as we come across others' ideas. Yet, if the reprieve of 2003 to the present is over and we are about to resume the strong bear market that began in 2000, careful consideration of the following will prove extremely helpful.

Proposition # 1 - Don't Buy the Hype

The easiest way to convince an investor to buy something is to show them an investment that has just gone up in price. As a matter of fact, the faster that product has climbed, the easier it is for Wall Street to tout and the more investors want to pile in. After all, for some legitimate sounding reason or another, "it's obvious that this thing's headed to the moon." Whether the argument is bullish or bearish, the faster the price changes the easier it is to rationalize why this must be right thing to do, and that "this is just the beginning."

No matter how many times science and history make it so seemingly apparent that parabolic rises are unsustainable, by its very existence, there will always be investors who buy the parabola. In all probability many of you have benefited from these various parabolic spikes and are now concerned about the recent malady in most of these same markets. Still, I don't doubt that some are not concerned. When prices start moving rapidly and change from moving upwardly horizontal to moving more vertically, bullish sentiment always seems to move to extremes as well. While the noise of the crowd, saying, "You missed out again," can trigger our adrenal impulses, we'd best quell this natural response. Gravity eventually takes over, and unsustainable price movements up give way to steep corrections that become the spikes on which the latecomers land. We need look no further than the last few weeks to illustrate this painful lesson.

Though we could as easily look at emerging markets, gold, oil stocks, or small caps, let me illustrate with the recent activity in silver.

This chart above, courtesy of Elliotwave International, was featured in our June 2004 newsletter, Special Edition: Parabolic Rises. Clearly, silver was going parabolic, and as such a blow off was in the offing, and yet if you had sold silver at $7.62 in March of 2004, you would have questioned your decision, or that of your manager. Silver prices continued to climb until April of 2004, when they reached an intraday high of $8.50 (as seen below). Now, if you were among those who purchased silver at, or near, $7.62, it would have been difficult to continue to hold while it declined more than 35 percent, to $5.45, in a little over a month. If you had the uncommon fortitude to hold on after buying into a parabolic spike, you would have spent very little time in the black until November of 2005.

Logically speaking, the way we are wired, as human beings, makes it far more likely that we would buy into a sharp price increase rather than sit on a "loser" for over 2 ½ years in hopes of returning to profitability.

The chart above and the one below, look to be showing the same lesson, yet again, for investors. In the late fall of 2005, as liquidity continued to pick up speed, the few investors, who had bought silver at the previous high and managed to hold on, were rewarded. Once again, investors are reading all the reasons why this most recent parabolic rise is sustainable and why silver is early in its next upward move, and again, with a 27 percent decline (so far) in less than a month, science and history are showing latecomers a more painful reality.

This is not an academic discussion in an investment textbook. Rather, it is a current holding in many investors' portfolios - maybe even your own. As such, we must now ask ourselves some hard questions. At what price did we enter silver? How long will we need to stay? Will it be a year or two, or more before we revisit these recent tops, or do the recent sharp declines reflect a longer fall to much lower lows?

None of us will know the answer definitively until the future has passed and the time to act will have come and gone. Still, we need to ask ourselves, "Am I a silver investor, ready to "hold on for the long term," or do I have more of a trading mindset? If we are investors, then we need to remember that there are other markets to trade and taking losses is part of life. If we are married to silver, our choices are more limited, and we may have to endure greater losses and longer timeframes before we'll profit. While we may get a fast rebound to new highs, the lessons from the March 2004 top, as well as other parabolic spikes, does not support that probability.

All of this, of course, leads us to our second proposition.

Proposition # 2 - Have an Exit Strategy

In the Bible, the author of Ecclesiastes states, "There is a time to plant and a time to uproot...a time to search and a time to give up, a time to keep and a time to throw away." Clearly, to those who aim to profit in the markets, entry and exit points matter. With so many investors holding to a "buy-and-hold strategy," we will focus on the need to sell. Having an exit strategy means that we buy with selling in mind. Hopefully, we arrive at the party early with a mind toward leaving, and as such, we continuously keep our eyes on the door.

The best trading managers have their exit strategies set up well in advance of a given trade. This is nothing new. In his book, Hedgehogging, Barton Biggs notes the exit strategies of legendary traders Bernard Baruch and Jesse Livermore.

In his book, My Own Story, Baruch notes:

"In the stock market the first loss is usually the smallest. One of the worst mistakes anyone can make is to hold on blindly and refuse to admit that his judgment has been wrong." ¹

In Trend Following, Michael Covel echoes Baruch. Covel states, "The problem we have with accepting a loss is that it forces us to admit we are wrong. We human beings just don't naturally like to be wrong." ²

In Edwin Lefevre's book, Reminiscences of a Stock Operator, Jesse Livermore says, "Never make a second transaction in a stock unless the first shows you a profit. Always sell what shows you a loss. Only suckers buy on declines." ³

Biggs continues,

"Livermore did not have a hard-and-fast rule on when to eliminate a losing position, arguing instead that the timing depends on the feel of the stock and the market. However, he was an unusually gifted, intuitive trader. Thus Livermore was more flexible in his thinking, and he was a dedicated believer in owning strong stocks that were in clearly defined, long-term trends." ⁴

As usual, the traditional approach to the markets, with the "buy-and-hold" approach, got it partially right. We, on the other hand, suggest that a "buy, hold, and sell" approach would be more financially profitable.

Consider this: we've just experienced the largest expansion of credit and liquidity in history (which has led to the belief that liquidity never contracts), and that enormous amount of money has been chasing returns with reckless abandon and no concern for risk. The sharp moves lower of the last few weeks have brought us to a watershed moment. If the ever-expanding credit continues unabated, then the markets should move back to newer highs, and once again, the resumption of the bear market will have been averted. If credit contracts, then the losses will likely match, or exceed, the effects of the excesses it has created. As such, if there were ever a time to have exit strategies in place, it would be now.

Proposition # 3 - Volatility Can Be Your Friend

Still, we must be cautious not to sell solely because we are experiencing some downside volatility because volatility can be very beneficial. While this statement may appear to be at odds with what I just wrote, the fact is, recognizing and harnessing the benefits of volatility (easily the most difficult emotional and intellectual challenge investors face) is the only way that any investor can grow their capital over time.

The conventional school of thought, in which I was trained, teaches that higher volatility means higher risk. Biggs points out that institutional investors are no exception. In speaking about a specific money manager, Biggs states:

"Institutional investors apparently can't tolerate his volatility, which is crazy because what they should care about is long-term performance." ⁵

In our April newsletter, we referenced Michael Covel's book, Trend Following, a resource containing Covel's research and observations on some of the most successful hedge funds managers of our time. Regarding the issue of volatility, his comments continue to reflect my own.

"Volatility (what standard deviation really measures) is a four-letter word for most market participants. Volatility scares them silly, even though a freshman algebra student could quickly analyze historical data series of any market or trend follower and see that volatility is to be expected, plenty of investors run away from even a hint of volatility. Of course, some markets and traders are more volatile than others, but degrees of volatility are a basic fact of life. To Trend followers, volatility is the precursor to profit. No volatility equals no profit." ⁶ (Parenthesis his)

Many, who manage money from a strictly technical view, may exit a position too quickly because it has reached a predetermined percentage loss. While speaking of managers who advocate this practice and defending his 1973 purchase of The Washington Post, Warren Buffet quipped that if the stock had fallen by half before his purchase of it, it would have been considered more risky, but that he had never figured out "why it's riskier to buy something at $40 million than $80 million." ⁷

On the other hand, there are times when prices have not declined much at all, that we would have good reason to sell. Livermore observes,

"When the market leaders begin to lose relative strength even though the news is still very good, and buying strength and selling weakness no longer works, get out of stocks in general because the game is over.

It is enough for the experienced trader to perceive that something is wrong. He must not expect the tape to become a lecturer. His job is to listen for is to say 'Get Out!' and not wait for it to submit a legal brief for his approval." ⁸

As you can see, blindly equivocating risk and volatility can be very misleading. We must look at the herd and decide where we are in regard to the trend. If we are in front of the trend and we are experiencing losses, we need to study to make sure that we are positioned well and anticipate the possibility of losses. If we are with the trend and are late in it, we should tighten the parameters on how much loss we are willing to take.

Ironically, our April newsletter, "Losers: Why We Invest With Them," shows that managers who position themselves in front of the next trend, often lose clients for being perceived as too cautious or, more often, too aggressive. In the long run, these managers have often significantly outperformed the markets. Clients, who wish to avoid a premature and costly departure, will only achieve this by asking questions that do not pertain to current prices.

We must learn to ask questions that will give us clearer insights. This is not easy. We must be able to make counter-intuitive decisions and balance resolve to stick with our decisions enough open-mindedness to consider opinions that conflict with our own. All of this, of course, requires a great deal of research and reading. If you are an average investor and the time requirements are beyond what you are able to expend, then I strongly encourage you to heed the words of Robert Prechter below:

"Well, my advice to the average investor is stop being an average investor. You cannot survive as an average investor. The pros will beat the pants off of you, and the markets will too, because what seems logical is exactly what will not happen. That is one of the first keys to understanding how not to lose money in markets. So step one is: stop being the average guy or gal. Get a foundation. And the only way to do that is to start reading." ⁹

The recent declines in dozens of markets the world over are signaling a trend change. Money managers, who have understood and practiced these proposals for decades, have not been surprised by the painful turn of the last several weeks. I implore you: give careful attention to the three propositions I have presented in this article. If your managers and investment tools reflect these ideals, then share you ideas with others. If they do not, consider stepping aside until you are more confident about the managers and investment tools you are using.

If you would like a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds, visit our website. This will also give you access to archives of the same monthly newsletter titled, The Investors Mind: Anticipating Trends through the Lens of History.

Sources:
1. Hedgehogging (2006), Barton Biggs, page 196
2. Trend Following: How Great Traders Make Millions in Up or Down Markets (2006), Michael W. Covel, page 165
3. Hedgehogging (2006), Barton Biggs, page 197
4. Ibid
5. Ibid, page 136
6. Trend Following (2006), Michael W. Covel, pages 91 & 92
7. Buffett: The Making of an American Capitalist (1995), Roger Lowenstein, page 316
8. Hedgehogging (2006), Barton Biggs, page 136
9. Prechter's Perspective (2004), Peter Kendall, Ed., page 93