Thursday, August 9, 2007

How I'm Staying Calm during this Wild and Volatile Market Correction (Aug. 9, 2007)

I've seen investors go from euphoria as the the Dow passes 14,000 to panic and fear as the Dow has many down 300 days, and later get more excited as we have new rallies. As the market continues its correction (or bear market?), people are experiencing all sorts of emotions including fear. Even Jim Cramer on a "Stop Trading!" segment on CNBC shows his passion during a rant about the Fed.

Yet despite all this and the fact that I've lost some money recently, I've managed to keep my emotions in check. How am I doing this?

1. I believe in the long term power of stocks and the global growth story.

Over a long time period, investing in the stock market is a very good way to grow your money. Over the long term, stocks have returned around 10% per year. According to Schwab Center Research with data from Ibbotson Associates, the longer you hold stocks, the less chance you have of experiencing a negative return.

The table below represents the range of S&P 500 returns from 1926 to 2005. Total returns includes reinvestment of dividends. If you held the S&P 500 index for three years, your annualized return would range between 31.2% gain to a 27% loss. If you held the S&P 500 index for a period of 20 years, your annual return would range from a gain of 3.1% to a gain of 17.9%.

Chart Provided by Charles Schwab.

Stocks, over the long term, will do fine!

James Altucher writes about seven reasons to be bullish in this article, though some people would question if all those points remain true with the recent US credit crunch.

2. I've experienced many corrections before.

Having seen corrections before, I know that this too, will pass. If you look at charts from a longer time period, you'll notice that these corrections are just blips in a stock market whose very long term uptrend is up.

I've also incorrectly sold many of my stocks in my brokerage account during a market correction, only to see the market bounce back again and I had to repurchase a large portion of my portfolio. If I believe in the long term growth of the stock market, and the economy is not heading towards a recession or depression, why sell during a market correction?

3. I've experienced a Bear Market Before

I've experienced a Great Bubble and the Bear Market that followed it, and today's situation doesn't look like it at all. I remember the stock prices of many companies with NO EARNINGS went to the roof. I remember the PE ratios of companies like Yahoo (YHOO) go to astronomical heights during the Bubble.

Jeremy Siegel, in an article in the Wall Street Journal in March 2000 titled "Big-Cap Stocks are a Suckers Bet", says that of the 33 largest firms based on market capitalization (those with values greater than $85 billion), 18 of those were technology stocks, and their market weighted PE equaled 125.9. Mr. Siegel also notes that half of the large cap technology stocks had P/Es over 100.

Even if we look at the trailing PE of the more conservative of S&P 500 during the Bubble, we notice that the PE ratio went up to 35, when historical trailing PE is 14.1 and the trailing PE of the S&P 500 is 17.1 as of May 2007.

I also recently re-read an article about Michael Mauboussin in 1999, the head of value based research as C.S. First Boston. In this article, Louis Corrigan explains Mr. Mauboussin's position:

a. "We disagree with the consensus view that hype and hysteria drive the highflying valuations of Internet stocks," Mauboussin writes in the introduction. "Like all businesses, Internet companies are valued on their ability to generate cash."

b. "Mauboussin's work ultimately instructs investors to focus on FCF, to account for the whole cash economics picture."

c. In Louis Corrigan's introduction to Mr. Mauboussin's work, Mr. Corrigan says:
"Traditional metrics like book value, the price-to-earnings (P/E) ratio, or even the price-to-sales (P/S) ratio are of limited use in valuing start-ups. They are particularly worthless in examining Internet start-ups."

Does today's situation look anywhere close to the last Great Bubble and Bear Market?

4. I learned technical analysis.

If I didn't know technical analysis, I would be dependent on emotions and I would just go for an emotional rollercoaster.

Once I learned technical analysis, I'm able to take emotion out of the equation. I learned about trend lines, support levels, resistance levels, Fibonacci retracement, re-testing lows, and many other technical analysis concepts. Rather than just blindly follow the market and let my emotions contol me, I could analyze the chart and estimate how far a market could bounce and where potential bottoms may occur. When the market gaps down near a resistance area and then stages a late day massive rally, I know what that may mean.

With technical analysis, I could objectively look at the situation and not be a slave to my emotions.

5. I am hedging my portfolio using double short ETFs.

Recent innovations include Exchange Traded Funds (ETFs) that short or double short different market indices. Proshares offers ETFs that short or double short the market. For example, if you buy the ETF SDS, and if the S&P 500 goes down 5%, then SDS will gain 10%.

With this new hedging tool, and with my knowledge of techical analysis, I could implement a hedging strategy without having to use Put Options. This hedging strategy is also good because it prevents me from having to get whipsawed as I try to sell my stocks during wild and volatile corrections, only to have to rebuy my much of my portfolio as the market goes up again.

(Link to article by Roger Nusbaum on regarding hedging using double short ETFs.)

As an example, in June 2007, the S&P 500 ($SPX) had fallen hard three straight days. There was a possibility that the $SPX could fall even further below the 50 day moving average. So as a hedge, I automatically set an order that if the $SPX goes a certain percentage below the support level (in this case, the 50 day moving average), I would automatically buy SDS.

As it turns out, the $SPX bounced from this level and rallied for almost two months. Then, in late July 2007, the market started to correct. But since my automatic order to buy SDS (remember, this is a double short S&P 500, meaning I profit twice when the S&P 500 index goes down once) was still active, I ended up with a profit.

Near this point, I started seeing the $SPX was getting very oversold. It was time to sell my SDS for a profit.

I then formulated a possible scenario of a bottom, and I expected a Fibonacci retracement bounce ranging from 38.2% to 50% to 61.8%.

Based on the expected Fibonacci retracement oversold rally bounce and expected re-test of lows, I decided to automatically buy SDS if the $SPX reaches 1500 which was triggered at the end of August 8. On August 9, 2007, the $SPX dropped big all the way to 1453. Again, I have SDS for a profit.

That's where we are now. I could sell SDS for a profit, and then, set an automatic buy if the $SPX goes a percentage below the previous low of 1427.

Because of all the factors above, I'm keeping my emotions in check, and looking at the market more objectively despite the wild and volatile nature of this market.

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