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August 22, 2007 — Issue #335

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Tharp's Thoughts Weekly Newsletter #335

In this Issue...

Article

What’s Going on in the Markets?, Van K. Tharp Interviewed by Melita Hunt

September Workshops

$500 Discount on Day Trading Workshop Expires Soon

Trading Tip

Markets Are Still Deciding Their Direction – It’s Okay to Stand Aside, by D.R. Barton, Jr.

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Melita's Corner

Back to Basics, by Melita Hunt

 

Feature

What’s Going on in the Markets?

Melita Hunt interviewing Van Tharp

Last week before Van started teaching our Peak 101 and 202 workshops, he was asked to do an interview for an Austrian magazine about his take on the current markets and the impact that the media has on investor psychology. I thought that the topic was interesting, and many of the answers represent the core of Van’s teachings, so we tweaked a couple of questions and added some of our own for our readers. The interview is below. --Melita Hunt

Mel: What are the some of the psychological pitfalls that traders encounter when the markets fall? 

Van: First, traders shouldn’t have any problems in down markets if they are prepared.  Falling markets are no different than rising markets because they represent an opportunity for profit.  In fact, it’s possible to make more money in the short term in falling markets.  In addition, you should be able to gauge when the markets are falling and react appropriately, which means 1) exiting the long positions when your system tells you to do so and 2) entering short positions because they represent good profit opportunities.

Psychological pitfalls occur when people don’t have a system or, even if they do, they don’t know how it will perform in various kinds of markets.  For example, if you just buy stocks and expect to hold them forever, then down markets could give you a problem because you have not planned how to react in this situation.  But not having a system is a psychological pitfall in any kind of market.

It’s interesting that the market needs to fall 10% to be considered a correction.  Most markets haven’t even had a correction, although we came close a week ago with Monday’s lows, and the media has already contacted me twice, wanting to know about the psychology of the markets.  So perhaps there are also some problems in that the media helps to cause people to panic.

However, the problems people have in down markets are pretty much the same as they have in up markets.

1.  They don’t have a system, so they have nothing to guide their behavior

2.  They don’t have a business plan, so they don’t have a big picture perspective. For example, in the U.S. I believe we are in a secular bear market that began in 2000 and could easily last 20 years. A secular bear market doesn’t necessarily mean that prices will fall. It simply means that valuations will go down and that’s been happening. For example, the PE ratio of the S&P 500 has been in a nice downtrend since 2000 with only a slight upward correction in the last year or so. When you realize that we are in a secular bear market, then questions about how traders react to a few weeks of downward movement in the market become somewhat funny. Nevertheless, people react more to bad news, such as the subprime mortgage situation, in secular bear markets.

3.  They have no objectives.

4.  They don’t understand that position sizing is designed to meet their objectives and they might not even understand what position sizing is.

5.  They have no bailout point to help them get out of positions when they might be wrong about them (and that’s really part of a system).

6.  They haven’t even thought about worst-case contingency planning.

7. They have no discipline to follow their rules even if 1 through 6 were in place.

Mel:  How can people avoid falling into these traps?

Van: I wrote in the new edition of Trade Your Way to Financial Freedom that there are six different kinds of markets: 1) up volatile; 2) up quiet; 3) down volatile; 4) down quiet; 5) sideways volatile; and 6) sideways quiet.  When you develop a system you should have some definition of what constitutes each type of market for your system and you should also have a good idea how your system will perform in each type of market.  For example, if you bought high tech stocks during the late 1990s, you only understood the first two types of markets (the UP markets).  You probably didn’t even think about the other types of markets, so you really were not prepared.  You don’t have a system until you 1) have a definition of those six kinds of markets that fits your trading style and 2) have an excellent idea of how your system will perform in each of those conditions.

For example, if you are a buy and hold type of person, then I recommend that you have 25% trailing stops in most of your positions.  This means that when it drops 25% from your entry price or from the most recent high (whichever is higher), then you’d get out of your positions.  In most instances, the little reactions we have had in the market probably would not have triggered any of those stops.  Thus the buy and hold type person, with those types of stops, should have done nothing and by now you’d probably be stopped out of a third to a half of your positions.  If the market moves up, you have a lot of cash to find good bargains and if the market moves down, you have reduced your exposure.

Short-term traders on the other hand, probably should have been out of all of their long positions long ago.  They’d now be in a short mode or perhaps a "wait and see" mode. 

It really boils down to trading fundamentals.  First, you have to know yourself and your objectives.  Then you have to design a methodology that fits you and your objectives.  Part of that means knowing how your method will perform in various kinds of markets and being able to take appropriate action if the market changes.  And lastly, it amounts to having the discipline to follow your plan once it is in place.

Mel:  How can they make the best out of falling markets?

Van: Again, this depends upon your perspective and objectives.  If your system is only designed for long positions, then you need to know when market conditions change and be able to get out.  However, your system parameters should take care of that.  If your system took care of it and got you out, then it did what it was supposed to and you have nothing to worry about.

On the other hand, if you have a faster mentality and don’t mind going short, then the profit potential of falling markets is even better than that of rising markets.  Why?  Because falling markets tend to be fast and quick.

Mel:  So back to the media, what is the typical reaction of a reader/viewer of something like the CNN article: Five Ways to Know the Bull is Over?

Click here to see that article.

Van: I think that watching or reading the news is an exercise in getting your buttons pressed.  News is typically bad news because stations that tried to give “good news” go out of business because no one watches them.  This is probably why the media wants to interview me about the psychology of the markets – to stir up people.  People want to see/read bad news because it pushes their buttons and gives them drama.  If you then react to the bad news and let it affect your investment decisions, then you get even more drama because you will lose money.  I really think it is as simple as that.  Typically, the only people who make money from the news are the people who watch it, watch the market reaction, and then do the opposite on a short term basis.  We described how to do this in Financial Freedom through Electronic Day Trading.

For example, the article, Five Ways to Know the Bull is Over, should only impact people who don’t have a system.  I got out of most of the positions we had on in IITM’s retirement portfolio in July when it was clear that trend lines were broken.  I don’t care about the other things that they mention because they are not part of my system.  However, if you don’t have a system, then an article like this could be both fascinating  and dangerous for you.

Mel:  What is your opinion about the Federal Reserve Cutting the Discount Rate? Will this end the down move?

Van: It’s interesting because last Tuesday I discovered some bear market funds (which go up when the market goes down) that my brokerage company would actually allow me to trade in IITM’s retirement account.  I put in the order and they were filled.  A day later, we get a Federal Reserve interest rate cut, and the market is up 1-2% as a result.  These things seem to happen that way.  But is that enough to get me out of those bear positions?  No, not yet.

Let me point out some facts about what is going on and about Federal Reserve discount rate cuts.  First, we are in a secular bear market and there are a lot of down moves in a secular bear market, we are probably due for a second down wave and that should be a lot more than just 10%.

Second, this particular crisis was fueled by the subprime debt crisis in America that we’ve managed to export all over the world.  Bill Gross, the Bond King, has pointed out that the crisis has just scratched the surface.  There are $500 billion in ARMs that are due to be adjusted by 2% or more in 2007 and another $700 billion in 2008 (3/4ths of which are subprime) in 2008.  Currently, 7% of subprime mortgages are in default and more than double that rate is delinquent.  It’s not a pretty picture and I doubt that one interest rate decrease will change things.  But the interest rate cut should cause the dollar to fall more and we should see even bigger inflation.

Third, remember the last bear market decline from 2000-2002?  Throughout most of the decline, the Federal Reserve was lowering interest rates.  And throughout most of the bull market in 2003, the Federal Reserve was raising interest rates.  So does one interest rate cut forecast an up market?  Answer: Probably just on the day of the cut.

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

 

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Trading Tip

Markets Are Still Deciding Their Direction – It’s Okay to Stand Aside

by D.R. Barton, Jr.

We’ll return to our series on no-cost internet sites.  But market news and volatility are still major issues and there are some interesting points to cover today.

Today (Wednesday August 22, 2007) is the second straight tighter intraday range that we’ve seen (both today’s and yesterday’s ranges are ~15 points).

Don’t be fooled by this tightening volatility just yet.  The market has just put in its first 10% retracement in over four years - and for some key fundamental reasons – so its very unlikely that the battle between the bulls and bears is done yet.

But let me be clear that I don’t think the volatility will stay this crazy – it will certainly revert toward the mean.  But for me and many of the technical analysts I talk with, it doesn’t seem like the market has made its defining move. Here are some of the key reasons why I think we have a bit more volatility ahead:

•  I have read several credible reports that are claim we must test the old July highs before we can make new downside lows.

•  I have ALSO read equally credible analysis that firmly states that we have to go back and test last week’s low before we can spring forward and resume the bull run.

•  The market is in a real battle around the key 1460 level in the S&P 500 that I wrote about on August 1st in this column and also talked about  all the way back in April of this year.  This number is a battle ground – not a stopping off point!

•  MOST IMPORTANTLY:  Institutional leverage is at historic levels and has still not been unwound.  The leverage has been most talked about in the mortgage markets, especially around the well-flogged sub-prime area (and the flogging there isn’t finished).  But the leverage used by myriad hedge fund and proprietary trading houses has only begun to be uncovered.  And why is this a problem?  Because when highly leveraged positions go bad, they have to be unwound quickly and at almost any price.  And this greatly increases volatility.

I think it’s premature to do a bunch of bargain hunting with a large part of your portfolio.  Warren Buffet can start bottom picking early – but he most likely has deeper pockets than you or me. 

It’s okay to be on the sidelines now.  If top analysts are in stark disagreement, and the market is not giving us any good hints as to direction, then it’s okay to stand aside.  When there’s no discernable edge – its time to play golf or do what you enjoy and let your money take a rest as well.

My good friend and co-teacher Brad Martin says that there are times when you want to “pay for confirmation,” meaning that you will let the market move in your direction before jumping in.  This is most likely one of those times.  And remember that with the expanded ranges, a bigger move than normal is needed to confirm that the market has headed in a definitive direction out this volatile but definitely sideways consolidation.

Keep sending in your favorite web sites to drbarton@iitm.com.  And let me know if you’ve found this discussion useful! Until next week…

Great Trading!

D. R.

About D. R. Barton: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena where he is one of the most widely read and followed traders and analysts in the world.

He is a regularly featured guest analyst on both Report on Business TV,  and WTOP News Radio in Washington, D. C., and has been a guest analyst on Bloomberg Radio.  His articles have appeared on SmartMoney.com and Financial Advisor magazine.

 

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Melita's Inspirational Corner

Back to Basics

by Melita Hunt

Do you believe that your beliefs play a big role in every aspect of your life?

The last time that I was in Australia, I got into a conversation with my mother about beliefs and the work that we do here at the Van Tharp Institute. She wasn’t quite grasping what I was talking about, so we decided to go through examples. I simply asked her: What are your beliefs about the stock market and trading? She said, “Ask me something else because:

1. I don’t have any beliefs about the markets (so I asked her to tell me what she knew about trading). Her answer: 

2. I don’t know anything about trading (okay then – tell me what you think about trading)  

3. Well, I think that too many people lose money trading and that’s why it doesn’t interest me.

4. And I would never trade the markets because I like to save my money and keep it safe.”

What she had done, without even realizing it, was rattle off four very distinct beliefs about the markets (and there are actually many more beliefs in those statements if you read through them closely). Is there any wonder why she doesn’t trade and doesn’t want to trade?

When I brought all of this to her attention, she had a small “aha” moment and her interest was definitely piqued so we kept going and the conversation led to a further discussion about where she had formed those beliefs, and I just listened to age old adages about “well they tell you this on the news,” “everyone knows that,” “haven’t you seen the stock market crash?” and as we dug deeper into money stuff it became very interesting to hear her beliefs about “how important it is to save for a rainy day,” “how we were brought up,” “silver spoon in their mouth,” “what we learned living on a farm,” “making ends meet,” “your father was a spender” and of course, something to do with root and evil…but we will not go there.

Now I have no intention of sharing this with you to analyze, question or judge my mother’s beliefs, nor do I have any need for her to change them, it is her choice to believe them or not. Many of these beliefs have obviously been extremely useful for her because they have afforded her a nice, comfortable retirement lifestyle, but I also know that she had her share of rocky times to get there.

When Mom (spelled “Mum” in Australia) started to recognize what she was saying, she was also able to see that many of those beliefs had never been questioned or even thought about, they had just guided her behavior unconsciously. Some were useful, whereas others may not have been particularly useful to have. We just enjoyed our conversation (until she had had enough), and I was also able to look at which beliefs of my mother’s I had adopted for myself.

“So what has this got to do with me?” you may ask.

If you really “get” the importance of beliefs, then all of this work becomes so much easier, but if you don’t believe in the importance of your beliefs (which is a belief anyway), then the self-work journey could become a difficult one, especially Van’s work.

The basis of Van’s work and all of this self-work “stuff” is in understanding and recognizing the importance of our belief structure and what our beliefs are on every level (environmentally, behaviorally, capabilities, values, identity, spiritual). That is why we are constantly asking you to look at things such as “Who am I?” and “What do I believe about XYZ?” (whether it be trading, money, finance, markets, my abilities, success etc…). He covers beliefs extensively in the Peak Performance Home Study course (and that’s why I’ll recommend it until I’m blue in the face).

The more we do this, the easier it becomes to see where these beliefs conflict or sabotage us, guide our behavior, protect us, support us, etc…

When we change our beliefs, our lives change accordingly. But we can only change them if we’ve identified them and are willing to change the ones that aren’t working. Most people are so invested in their beliefs that they will die to defend them and be right about them.

And the next question that I am often asked is, “How do I change them?” Well, there are many ways and we’ll start to cover them next week.

However, if all of this belief stuff doesn’t work for you, then perhaps you are best studying something else that will support the current beliefs that you do have (i.e., I don’t believe all of this belief stuff).

On an upbeat note, here’s something that you can do with your own family. Ask them what they know, think or believe about your hobby, vocation or career of trading and the markets, then don’t judge, analyze or question what they say. Your job is not to change THEIR beliefs, it is to recognize and work on your own. Just recognize that you are hearing their beliefs (do you think you can do it without having to correct them?) and you may learn something new about the people closest to you…

And one belief that my mother and I definitely have in common: 

Shopping is fun.

And the jury is still out on whether it has been a useful belief or not… our shoe closets seem to say “Yes”… 

You can contact Melita at mel@iitm.com

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