Whenever markets pull back for a few days, fear sets in. You see plenty of stories about how to protect your portfolio, what stocks will fare the best in a decline, and a parade of pundits explaining what is going wrong.
In an election year, it is even worse.
If you are in the market, what should you do? It depends.....
Are you a trader or an investor?
Barry Ritholtz has a great article on this theme, emphasizing the importance of time frame and having discipline geared to your objectives. He includes a number of specific and helpful rules.
Readers of "A Dash" know that I endorse this distinction, making it carefully in my weekly WTWA articles. Despite this, and just as Barry mentions, people wonder why my recommendations may diverge from my market commentary. Since I am managing five different investment programs, geared to different investor needs, the right move depends upon the program objective and the time frame.
As Barry notes, investors should not try to "play the squiggles" based upon their preferred concept of long-term valuation. This is consistent with my recent article showing that none of the big-time pundits is very good at market timing, if you look at actual results.
Traders versus Investors
There are sharp distinctions right now, with differing conclusions. Here are some of the key topics:
The Fed and QE 3
Steve Liesman today offered this analogy. Suppose your doctor gave you a clean bill of health. Alternatively, suppose your doctor said that you were really sick, but he had a prescription for you. Which would you prefer?
For traders, the analogy breaks down because they are all smarter than the Fed. They know that the economy is in dire shape whether the Fed realizes it or not. For them it is all about more QE, since they have become convinced that central bank money printing flows directly into stocks. It is a simple focus on Fed policy.
Investors do better to stick with traditional economic policy and forecasts.
The Natural State of the Economy
Traders seem to believe that the normal state of the economy is recession and this will occur as soon as government stimulus programs end, the "sugar high" wears off, or the "training wheels are removed."
Investors should realize that the normal state of the US economy is is trend growth of about 3%. In the absence of any policy, that is where we will eventually wind up. Specific policy actions may make it happen sooner or later. Right now there is a huge performance gap, as illustrated by Scott Grannis:
Until the gap is closed, things will seem very negative.
How to React to Selling
Traders need to game the system, anticipating how other hot money players will react and beating them to the punch. This can imply trading styles that either anticipate market tops or react quickly when they seem to occur.
Investors should see short-term selling as an opportunity to establish positions at favorable prices. This is a fundamental lesson from the Buffett school -- use your own valuation, not the current market price.
Interpreting Sentiment Indicators
Traders are intensely focused on sentiment, trying to identify "dumb money" (everyone other than them!) and take the opposite side.
Investors seeking to establish new positions hope to find periods of irrational sentiment.
Traders are in love with cycles and the calendar. They have scenarios and retracements and sometimes even astrology. If something has worked for the last year or two, it is expected to happen again unless there is evidence to the contrary.
Investors make decisions on fundamental values. The perceived seasonal effects merely provide opportunities to establish new positions or lighten up on those that require rebalancing or selling.
The mistakes come when traders and investors get confused about their roles.
Traders should reduce positions in recognition of the message of the current tape. I agree. In trading accounts we are not guessing exactly how deep a correction might be. Instead we watch the evidence. Some traders may get impatient to "call a bottom" in a normal market correction.
For investors it is quite different. Many have been frustrated for months by a market that moved relentlessly higher, providing no obvious points of entry. Now that there is some selling, these same investors may be unable to pull the trigger for fresh buys.
In our investment accounts we have been waiting to add to positions and we have a shopping list. There are many candidates. Since we think that the short term perspective is wrong on Europe and the economy, we have been buying positions in energy stocks, strong cyclicals like Caterpillar (CAT), leading technology like Oracle (ORCL), and US banks poised to exploit selling by European banks -- JP Morgan Chase (JPM). We also see Aflac (AFL) as a nice back door play in Europe --- good earnings, great business, good dividend, but some holdings of European bonds. This is safer than buying Europe since there is less downside, and yet plenty of upside.
Understanding your objectives and time frame is essential to market success. We often have completely different postures for our investment and trading programs.
If you do not distinguish between trading and investing, it is easy to get caught in a Twilight Zone where you are always doing the wrong thing!