Emotional vs strategic investing

‘Buy high, sell low, repeat until broke’ is an emotional investment strategy best left to lemmings. The MoneyLetter’s behavioural finance columnist Ken Norquay says feeling emotions is okay: reacting to those emotions is not okay.

Emotional_vs_Strategic_InvestingMost of the time, our investment minds do what they have always done and think what they have always been thinking. But every once in a while some unexpected financial jolt occurs. That jolt makes us wish we had seen it coming: “If I’d known that was coming, I would have done it differently!”

In stock market analysis, there are two main ways of ‘knowing it was coming’. One way involves predicting the future; the other involves looking for patterns in the past. Most of the literature we see from the investment industry involves some type of forecasting, some type of predicting the future.

As a market psychologist, my approach involves looking at data from the past, trying to recognize repetitive patterns. Then we look for those repetitive patterns in the stock market data of the present. When we observe a market pattern, we assume it will play out in the future as it has in the past.

You’re the Top

Because the US and Canadian stock markets bottomed over nine years ago, in March 2009, we are currently looking for patterns that accompany market tops. Those patterns are a warning that a bear market is coming and it’s time to sell.

The most common topping pattern is called ‘the umbrella top’.  First, the long-term up trend slows down, and then the market drifts sideways and slowly starts to sink, as the bearish part of the cycle begins. The chart is shaped like an umbrella. That pattern was in place over the period of October 2014 to February 2016.

A less common pattern is ‘the parabolic rise’, which occurred from February 2016 to January 2018. Sometimes referred to as ‘the spike top’, this pattern occurred in US stocks and in Canadian house prices. It indicates excessive speculation and is far more dramatic than the more common umbrella market top. For the record, the spike top in Canadian real estate was completed in June 2017. The spike top in the US stock market was in January 2018.

The umbrella top and the spike top are patterns in market prices over time. These topping patterns are always accompanied by a specific market mood, an attitude by investors about the market. At tops, the mood is optimistic. Investors expect to make money. Sometimes they worry that they will miss out on future profits. They tend to believe bullish market commentary and there is often evidence of extremes in speculation. In this current cycle, speculative excess is occurring in bitcoin/cyber-currencies and Canadian marijuana stocks. In real estate, it took the form of young speculators and foreign speculators buying several houses and renting them out, the renovation boom and ‘the condo flip’ phenomenon.

The psychology of this nine-year-old bull market has gone from worrying about bank failure to speculating in pot stocks and from worrying about the breakup of the European Common Market to a celebration of a re-surging American economic and military domination.

Is the Trend Your Friend?

Let’s review the long-term economic trends that most affect the financial fortunes of typical Canadian investors.

The US stock market: In January 2018, the US market peaked after a parabolic rise. The top is in. After a sharp short-term sell off, the market is stabilizing. A similar thing happened at the 2007 top: there was a sharp warning drop in August 2007, followed by a modest new high in October. The S&P500 dropped 57 per cent in the following 16 months.

The Canadian stock market is following its US counterpart and, after almost four years of underperformance, is starting to outperform again. The TSX Composite Index has gained back 80 per cent of its 2018 loss, the S&P500 only 66 per cent. We should expect the TSX to continue to outperform the NYSE throughout the whole bear market because speculative excess in the US was in the stock market, whereas the speculative excess in Canada was in real estate.

Long-term US interest rates as measured by the yield of US long-term treasury bonds: interest rates bottomed in the summer of 2016. The trend is now up.

Canadian long-term interest rates are moving in lock step with the US. These long-term up trends have been confirmed by up trending short-term interest rates.

The USD vs. the basket of non-US currencies has been in a downtrend since December 2016.

The CAD has been in an up trend vs. the USD since January 2016.

The price of gold in US dollars is in a weak long-term up trend, a weak medium-term down trend and a weak short-term up trend.

The price of oil in US dollars is up. Surprisingly, the price of natural gas is still in a long-term down trend. We normally expect these two commodities to trend in the same direction, confirming the overall trend of energy prices. Not so, this time. We interpret this divergence to be a caution flag for energy stock traders. It is likely that oil prices will peak soon and give way to a short-term down trend. Such an event would be bearish for energy stocks.

Strategy

For those who like to buy low and sell high, the market is high now. It’s time to sell.

For those who like to hold stocks through thick and thin, decrease your holdings of US and foreign stocks and increase your Canadian exposure: you will lose less this way. Note: if Canadian house prices start to fall dramatically, Canadian financial stocks will be affected negatively and the TSX may not outperform the NYSE in the bear market that lies ahead.

Traders in energy stocks should not take new long positions, and should review stop loss levels. Traders in gold mining stocks have noticed that there are very few stocks in short-term up trends. Nova Gold (TSX—NG), SSR Mining (TSX—SSRM; NASDAQ—SSRM) and Iamgold (TSX—IMG; NYSE—IAG) are worthy of attention.

Traders: shift your attention to exchange traded funds representing bearish positions in various stock markets. Read up on them: become familiar with them. Make sure your trading rules still work in these types of market instruments.

Speculators who enjoy the leverage of derivative instruments (options and futures), exciting times lie ahead. Keep your cool.

More Strategy: ‘Keeping your cool’ is not just a slogan: it’s an investment strategy. We all know that investors get greedy at market tops and fearful at market bottoms. ‘Keeping cool’ is another way of saying, ‘Don’t get greedy’ and ‘Don’t get fearful’. Easy to understand, but how do we do it?

Mindfulness

In my stock market book, Beyond the Bull, I write about the art of being mindful—the art of remaining objective about our investing. Mindfulness or objectivity is a learned skill. We learn to observe our own mind. In this case, we learn to observe our own emotions: Are we greedy? Are we fearful? Greedy means we worry that if we sell, we will miss out on some easy profit. Fearful means we are worried that we will lose everything. Or we are worried that we might sell at the exact bottom. We say things like: ‘I haven’t lost until I sell’. Or we say: ‘If I sell, I’ll have to pay taxes’.

Objectivity training involves observing ourselves as we make statements like these and checking the underlying emotion. If the market has gone down a long way, we are probably feeling fear of losing, regret of having lost or fear of missing the inevitable reversal from down to up. If the market has gone up a long way, we are likely feeling greed. Easy money makes us greedy. But who wants to admit they are greedy? Who wants to admit they are worried about losing? That’s why we rarely examine our own emotions.

How do we overcome this ironic investment problem? First, we allow ourselves to feel our emotions: fear and greed are normal emotional responses to profits and losses. Yes, feel our emotions of fear and greed. BUT—we do not take those emotions into account when making our investment decisions. We buy and sell based on a previously thought out investment plan. It’s a plan that includes both buying and selling. It observes specific data and responds to the buy or sell signals generated by that data. Investment decisions are not based on emotion: there is no need to deny our feelings about the ups and downs of the market. Feeling emotions is okay:  reacting to those emotions is not okay.

Ken Norquay, CMT, is the author of the book Beyond the Bull, which discusses the impact of your personality on your long-term investments: behavioural finance.

This is an edited version of an article that was originally published for subscribers in the May 2018/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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