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November 20, 2002 — Issue #92

IITM, Inc.

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In this Issue:

Feature Article The Only Way To Survive Market Chaos, By Steve Sjuggerud
Trading Tips By Dr. Van K. Tharp

  

 

Quote of the Week:

Sooner or later, those who win are those who think they can.

~Richard Bach~

Feature Article:

The Only Way To Survive Market Chaos, By Steve Sjuggerud

"People are in a hole and they just keep digging," my dad said on the phone this morning. Leave it to my dad to sum up the message of last week's Investment U E-Letter (#156: Getting Back What's Gone) in one sentence. 

I remember when I was last in a real hole. If I'd kept "digging" I would have died. It was my only near-death experience... 

I was pinned to the bottom of the ocean under a large sail. I was only in about two feet of water, but waves were breaking over the top of this windsurfing sail, pinning me flat. Even worse, I was connected to the sail by the hook of a seat harness, and in a twist of bad luck, this harness was caught. I couldn't get myself unhooked from the sail to try to swim out from under it.

I started panicking. I was out of breath and out of options. I remembered that someone had drowned in this exact spot, in the exact same way, a few months earlier. Now I'd probably been under the sail for over a minute. As I was scrambling and it was looking pretty bad, something came over me. All of a sudden I told myself to relax...and THINK! There has to be a way out of this...

And there was... Believe it or not, I stopped what I was doing. I (reasonably) calmly assessed the situation. The hook was stuck. I couldn't get it undone. But I COULD undo the ENTIRE seat harness, taking it off my body. It was a few buckles and straps, so it would take a little while, but it was a sure thing. And it worked.

I crawled up the beach and sat. It took a long time to catch my breath. Then I went home and slept. For hours. But at least I'm here to tell about it. And it's all because while I was in a serious hole, I made a lifesaving decision - to stop digging. To stop scrambling. To stop panicking and calmly assess the situation. It was the only way out.

STEP BACK AND ASSESS THE SITUATION

Most investors are in a hole right now. And most will choose to keep digging, which will quite likely ruin them. But the few that can step back - and assess the situation as calmly as possible - will be just fine.

Assessing the current situation in the stock market calmly, we find three things...

1) Stocks are still somewhat expensive by historical standards.
2) Stocks have fallen 40% -- the biggest fall since 1929. 
3) Investors are spooked.

From these three things, we can draw a few simple conclusions. Let's take them one-by-one: 

1) Since stocks are still expensive, chances are, we won't see extraordinary returns from stocks over the next decade. That doesn't mean returns will be bad, it just means they probably won't be fabulous. How about a little lower than the long-run average return of stocks? That would mean returns in the high single digits.

2) The 40% fall in share prices IS significant. In today's "Wall Street Journal," Jeremy Siegel reminds us of the following:

"There have been six major stock market peaks in the past 100 years. After the market dropped by 40%, subsequent five-year returns have averaged 8.6% per year ABOVE INFLATION and none has been negative. And all subsequent 15-, 20-, and 30-year returns have not only been positive, but have also been above the 7% long-run average real return on stocks."

Now that's the best reason for cheer I've heard in some time. If the "real" return is 8%, and inflation is 2%, then 10% average annual returns in stocks from this point forward are not out of the question at all.

But while what Siegel says may be reason for cheer...I'm still not buying. Assessing the situation calmly, I see that the stock market had become more expensive than it's ever been this time around, by a long shot. Sure...a 40% fall is important. And Siegel's facts are noted. But there are only six historical    examples of this. No first-year student of statistics would deem Siegel's research as usable. It's interesting. Something to talk about. But not something to hang your hat on.

3) Now...as for the third point I mentioned earlier - the fact that investors are spooked - that is reason to cheer also, actually. 

"THE MARKET IS MOST DANGEROUS WHEN IT LOOKS BEST; IT IS MOST INVITING WHEN IT LOOKS WORST." - Frank J. Williams, a great stock trader of 100 years ago, quoted from Siegel's article today.

There was no fear in the market in March of 2000, when the NASDAQ was at 5,000. Now the market looks terrible, everyone is scared, and the NASDAQ is at 1,200.

Funny how it looks risk free at 5,000, and risky at 1,200.

WHAT WE "KNOW" RIGHT NOW

There is a gauge of fear in the market. It's called the Volatility Index, or the VIX, for short. And when it peaks, stocks rally (often 20% in three months). Believe it or not, the VIX hit levels not seen since September 11th this week. And sure enough, we had a huge rally on Thursday. It could be the start of good things to come, in the short run at least.

So based on these three "knowns," we know this:

-The market is expensive and may not produce extraordinary returns over the long run.
-The market has fallen 40% and the little historical evidence suggests that you might do okay from here on out.
-The high level of fear right now out there may allow the market a quick 20% upward burst in the short term.

Well now...this is a little frustrating. These three indicators are indicating somewhat different things. Weak long run, decent long run, and strong short run. All maybes, mind you. So how should you approach this?

THE APPROACH I'M RECOMMENDING

The approach I'm recommending to readers of my newsletter - "Steve Sjuggerud's True Wealth" - right now is as follows: subtract your age from 100. Then cut that number in half. That's how much you should have in stocks right now.

So if you're 60-years-old, you should have 20% in stocks right now. That's 100 - 60 = 40. Cut 40 in half and you get 20. There you go.

When conditions become more favorable (say, when stocks are cheaper, or the indexes start to turn around), you'll want to return to my basic 100 minus your age rule. When we get back to that point, 60-year-olds could have up to 40% in stocks. But we're definitely not there yet. Stay with me here in these Investment U E-Letters, and I'll let you know when that day comes.

Until then, keep your head screwed on straight. Make sure you cut your losses as always. Adjust your allocations to 100 minus your age divided by two. 

And stay cool... You can't control the stock market, so don't lose any more sleep about it. You can't lose sleep over things that are out of your control.

Rise above the chaos. Stick with your plan. Cut your losses so you're never in the position to have a catastrophic loss. And have your first good night's sleep in a while.


Good investing,

Steve

Steve Sjuggerud has a doctorate in finance and is regarded as one of the best researchers on the stock market around. He regularly offers sound contrarian investing advice as the editor of "Steve Sjuggerud's True Wealth," has been a member of the Oxford Club's Investment Advisory Panel for more than five years, and is the co-founder and President of Investment U. Steve is co-author of Safe Strategies for Financial Freedom and a frequent guest speaker at Van Tharp Institute workshops.

This article, is reprinted with permission from The Investment U E-Letter. To learn more about Investment U and Steve Sjuggerud visit their website

Trading Tips: 

Peak Performance Trading Tips from Dr. Van K. Tharp. 

This section features Peak Performance Trading Tips. These won’t be tips on some hot new investment. Instead, they’ll be tips on how you get yourself in the best possible condition mentally to perform at a peak level. You may have heard some of them in one form or another before, but you can never apply them enough. As a result, these tips should become second nature to you.

Tip# 40 
The Art of Journaling, Part One

by Brian June and Van K. Tharp

At the end of the trading day, your first impulse is probably to shut down all your equipment and get far away from trading. Trading is a strenuous activity, much like taking an exam. If you can remember the feeling of a very strenuous all-day test, like taking the SAT college entrance exams, the trading process is the same — it drains you. The reason it drains you is because you are using large amounts of your brain processing capacity while you trade. 


Even though you may feel drained at the end of the day, you need to either discipline yourself to continue on with a daily debriefing process or to discipline yourself to come back and do it at a set time that evening. The daily debriefing is a critical part of your trading success. This process will have a critical impact on your bottom line—a positive one if you do it and a negative one if you skip it.


There are several steps to this debriefing process, including: 
1) reviewing your trades; 
2) determining whether or not you made mistakes during the day; 
3) learning from your mistakes when you do make them;
4) doing periodic reviews; and 
5) refining the process of trading.

Review Your Trades: Live and Learn
When you use today’s direct access trading software, you will have a record of every trade you make during the day. We strongly suggest that you take that raw data and put it into a database of some sort that will make it useful for you in the future, so that you can understand your trading patterns. The simplest suggestion would be to use an Excel spreadsheet. That spreadsheet is divided into nine columns, with each row being an individual trade.


The most critical elements to include in your spreadsheet (as column headings) are the following: 

1) Date and time
2) Symbol for what you traded
3) Your entry price
4) Your initial risk (i.e., your stop price)
5) How many shares you traded
6) Your total risk exposure in that trade (which we call R) 
7) Your total gain or loss
8) Your R-multiple
9) Your commission amount. [This technique is described in detail in the Market Mastery, February 2000 issue.]


Your Level II software will write the price for the entry and exit and the number of shares traded to your hard drive, but you will have to copy this information to your spreadsheet and fill in the blank columns. In addition, we also suggest that you make notes at the end on why you entered and exited that particular trade (if you can remember) and any emotional reactions you had to the trade. Since important psychological information is both subjective and qualitative, the sooner you do it after you finish trading, the more likely you are to remember what happened.


Environmental Influences: When you’re doing your journal, capture as much information as possible. Did environmental influences have any impact? Note the lighting, outside distractions such as children or spouses talking to you, distractions such as telephone ringing, anything having to do with the environment external to yourself. What will happen over time is if you pay attention to these things, you’ll learn to set your environment up in a way to reduce or eliminate their impact on your trading. Minimize your negative environmental factors and enhance the positive ones. 


Personal Thoughts: Your thoughts have a great effect on your trading. So keep a journal of your thoughts when you are not under intense pressure from trading with a time stamp for each thought. Notice how you are thinking during the day and how those thoughts are impacting your trading. For instance, when you lose money on a trade, what do you say to yourself? If you’re using words like stupid, ignorant, loser, or using phrases like “I can never do anything right” or “I always do everything wrong”, you’re using very disempowering language. You’re teaching your brain to actually attract the negative as opposed to attracting the positive.

 
To see if that’s true, try the following experiment. Right now, do not think about the color blue. Concentrate on not thinking about the color blue as long as you can. Are you ready? Try it right now. Do not concentrate on the color blue. What happens? What happens is, the only thing you can think about is the color blue. We have talked before about the influence of positive self-talk, so here, when we’re talking about our personal thoughts, we’re really talking about the thoughts and the words that we’re using to say to ourselves. 


If you catch yourself using negative self-talk, concentrate on positive issues. Reward yourself verbally and mentally when you keep your trading rules, meaning you made a good trade. Do not punish yourself when you do not keep your trading rules. Instead, use something more empowering. For instance, if you break one of your trading rules by failing to stop out when your rules dictate, don’t say to yourself, “Dummy, you didn’t stop out!” It’s better to use language such as this: “I recognize that I broke my trading rule. I assume personal responsibility for that. Next time, in order to enhance my self-worth, I will adhere to my trading rule.” These seemingly small things make a big difference. And you are not likely to recognize these changes unless you’ve taken the time to make a journal. Because once you’ve taken hundreds or thousands of trades, you simply won’t remember anymore. That’s when you can get yourself into trouble as a trader.


Market Influences: As much as you can during your journaling, notice the market influences for each trade. I go back to my five indices that I keep all the time, the Tick, the TRIN, the S&P futures (first forward contract), the Nasdaq composite and the Dow Jones. I write the trades down, then I write down in the condition of these key indices, so that I would know whether the market was positive, negative, up-trend, down-trend, or consolidating. You will also want to include in this spreadsheet the impact of news, positive or negative, and any sector news. For example, if you’re trading biotech stocks, it’s important to know how the other biotechs are trading at the time. If you’re trading Internet stocks, then note what the Internet Index is doing.


Equipment and Support: You should note these types of problems in your journal. For example, note when your data feed, software, or your ISP go down and how you dealt with it. What happens when you have computer problems? If they are impacting your day, then make a note of that in your journal. As an extra benefit, with your connectivity and computing history captured in your journal, you’ll be able to troubleshoot problems much more effectively.

In Part Two of this tip we will continue with the key to debriefing, the importance of following your trading rules, and the four categories of mistakes. 

Editor’s note: This article is excerpted from “Financial Freedom Through Electronic Day Trading” by Van Tharp and Brian June.