Good morning, today let’s welcome back again Troy!
In every investment, there are 2 critical parts
- An entry strategy
- An exit strategy
The individual cyclical bull and cyclical bear waves are easy to identify. And the beauty is (as I mentioned in the last post), you don’t have to predict the changes between cyclical bull and cyclical bears. All you have to do is recognize these changes in the economy’s fundamentals. The market (price) lags the real fundamentals.
So what do you do once you recognize that the fundamentals are changing from cyclical bear to cyclical bull?
“Catching the falling knife” is dangerous. This means that unless you are a professional trader, do not attempt to buy more into your investment as the market falls (or, as some people call it, “buy on the dip”). Why? Because in many cases, the “dip” isn’t a dip. It’s the beginning of the mother of all avalanches.
Here’s an example. In January 2009, the U.S. economy stopped getting worse (you would be able to see that just by looking at the economic data). Thus, the market started changing from cyclical bear to cyclical bull. However, had you started buying in January 2009 (catching the falling knife), the market would have fallen another 40%. You missed the bottom by 40%! That’s a 40% loss!
Instead, what you should do is wait for the bottom to “be in”. Wait until the market has already bottomed out, and then start buying. How do you know if the “bottom is in”? Simple. Every market bottom has a couple of characteristics:
- The economic fundamentals have to turn from “deteriorating” to “stop getting worse”. This is necessary for a bear market bottom, but it is not enough.
- The banks should start buying securities. In January 2009, the CEO’s of major Wall Street banks (e.g. Jamie Dimon from JP Morgan) said that the economy was turning around. He would only say that if JP Morgan had already covered their shorts (bearish positions) and gone long. Once they have completely switched from short to long, you know that the bottom isn’t far.
- The market needs to be in absolute panic. And by panic, I don’t just mean intensive selling (e.g. the market crashed 700 points today). I need to see media headlines that say “no one knows where the market bottom will be”. That’s what I’m looking for – absolute panic. When the average Joe has given up all hope, the bottom is very, very close.
Once the bottom is in, there should be a V shaped rally. Most strong rallies are V shaped. This is based on the simple theory of mean reversion. When the market panics (deviates from the mean), it should snap back using an equally great force.
But after every V shaped rally, there is always a retracement. This is where you want to buy. The market either retraces 50% or 61.8% of the rally. (The reason for this is unknown – it’s called the Fibonacci Retracements. Fibonacci Retracements like fibonacci numbers are just known to be valid. No one knows why the fibonacci numbers exist – they just do.)
By the end of the 4-6 year cyclical bull market, you need to initiate your exist strategy. Here’s how:
- Every cyclical bull market lasts at least 4 years. So unless the market has gone up (on average) for a minimum of 4 years, don’t even consider liquidating your long positions
- Increase of slope. The last wave of a bull market always involves the market increasing it’s rate of ascent. This means that if the market was previously increasing at 0.5% each day, increasing the rate of ascent (slope) would make the market increase 0.7% each day.
When the above 2 criteria are filled out, the proper way to exit a bullish long position is to scale out. No one can predict the market top (although it’s easier to predict the market bottom) – thus, it’s better to just scale out. If you sell all your holdings and the market goes up another 40%, you’ll be in a lot of pain. If you hold on to all your holdings and the market peak is already in, you’re going to sell when the market is falling.