The Winning Trade is the Tough Trade

Submitted by A Dash of Insight

One of our favorite daily reads is The Kirk Report. Charles Kirk shares his success, listens to his readers, and provides long lists of links that find articles often missed by others. For the full benefit, readers should make the requested donation and become members. You’ll probably recover your cost on the first trade.

In an article today Charles provides a lot of great advice from legendary trader William Eckhardt. We recommend reading all of the great quotes, but wish to highlight two particularly relevant insights (emphasis added):

“If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you’ll gravitate toward the majority and inevitably lose.” - William Eckhardt

“One common adage on this subject that is completely wrongheaded is: you can’t go broke taking profits. That’s precisely how many traders do go broke. While amateurs go broke by taking large losses, professionals go broke by taking small profits. The problem in a nutshell is that human nature does not operate to maximize gain but rather to maximize the chance of gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance.” - William Eckhardt

The Tough Trade

The toughest concept right now is dealing with the incessant emphasis on recession prospects. Our viewpoint is that the market prices have already built in the recession and some are even looking at early cyclicals for a rebound. We have the interesting prospect that the market may discount a recession and follow the playbook for emerging from one — whether or not the recession actually occurs!

It all depends upon earnings. Turley Muller does an excellent job of describing the difference between forecasted earnings and the current market attitude. His conclusion, like many others, is that earnings forecasts will move lower to match the market. This is the prevailing viewpoint of “top-down” strategists as noted in a good New York Times article.

A good question is whether the top-down analysts, whose methods are not very well described, are actually better than those following the companies. It would be nice to have more hard data. Our own reading of many analyst reports is that many are already building in a downbeat economy, as are the companies. We wonder whether the market has too much fixation on the 2000 era, when analysts and companies alike really hyped their prospects.

Some Facts

Current earnings ex-financials are about about 14% year-over year. Generally, we do not like throwing out a particular sector, but it provides food for thought in this case. Financial companies have been forced by accounting rules to mark down illiquid positions which might (or might not) do better than the marks. They have expanded balance sheets rather than selling assets into an illiquid market. The Fed is helping with the TAF facility. The market is expecting more losses from financials, at least in the first half of the year. The second-half comparisons will be much better.

Is there a Contrarian Play? Does it have good risk/reward?

Everyone knows that interest rate cuts work with a lag. Some of the impact comes right away, or even in anticipatory fashion. Much of the impact comes later.

Despite this knowledge, market participants are fixated on the recession question. Partly this is due to the financial media’s preoccupation with asking anyone, regardless of forecasting ability, their opinion on the subject. There are some important consequences, as follows:

Individual investors bail out. Mutual fund outflows show it happening. Some great stocks get sold along the way.
Since the stock market is seen as a leading indicator, traders view stock prices as confirming economic consequences.
CEO’s read the news. Even when their current business conditions are solid, many are cautious in offering guidance. The market punishes any company that does not offer solid guidance, so there is a self-fulfilling prophecy at work. Notable exceptions today included TEX and RIMM — both worth attention.

Some Cool Heads at Work

Let us consider the thoughts from some quite disparate sources.

David Malpass. Regular readers of “A Dash” know that we admire Malpass’s work, mostly because he has a multi-year record of excellent predictions about the economy. His most recent writing, The Punchbowl is Back, shows a major shift in his thinking. He now places recession chances at about 10% and expects a rebound in corporate earnings. His work on the consumer, the wealth effect, and misleading savings data deserves more attention. A key point is that consumers doing smart things, like taking cheap loans for good assets, are summarized as piling up debt. In fact, their assets have grown significantly, even allowing for housing declines. Only the debt shows up in government stats. See your Bear Stearns rep to read more of Malpass, or watch for his frequent WSJ articles.

Dick Green at Briefing.com is another of our favorite sources. His overall read and market assessment have been strong for several years. His most recent commentary includes the following:

Monetary and fiscal stimulus has been much more aggressive this business cycle than in the previous two recessions. A comparison with 1991 and 2001 suggests that the market is vastly underestimating the economic impact for 2008 from lower rates and tax rebates.

Last, but surely not least, is the level-headed Muckdog. One reason that we feature his thoughts is that he has an uncanny feel for parsing a lot of disparate information and seeing a winning course. He writes as follows:

Bottom line is that I think the Fed rate cuts will work. The tax rebates will help. And folks who are doing their 2007 taxes may also receive refunds, and that’ll help.

Conclusion

Investors succeed by taking contrary positions, realizing when stocks are wildly overvalued, as they were in 2000, and when they are on sale. Right now, this means understanding the negative market psychology and finding the right opportunities.

One needs to anticipate where the economy, earnings, and stocks will be in a few months. Understanding the impact of policies — measures already taken by the Fed and the Congress — is part of that process.

Technical indicators, like our Gong Model (still showing that a good risk/reward bottom is in place) and our TCA-ETF method (showing numerous attractive sectors) can help provide the needed discipline and confidence.

Those who are under-invested in equities might well consider beginning with a partial position, something that we accurately recommended at other times of stress.

TCA-ETF Update

As usual on Thursday, we show the latest output from Vince Castelli’s successful model for sector investing. Despite a tough market environment, the system, which includes trends, cycles, and anticipation, has identified a number of successful sectors. It also shows that there can be a bull market in some sectors, even in a time of market stress.

We show this mainly to help other ETF traders and to illustrate how a system can help. Some readers have expressed interest in a full performance report, which is available upon request.