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Musings Report #7 2-14-15 Why Is It So Difficult to Sell at the Top?
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Why Is It So Difficult to Sell at the Top?
This week I want to explore the reasons why it is so difficult for us to sell near the top of the market and preserve our capital and our gains.
In theory, it seems straightforward to follow this simple advice: buy at the bottom, sell at the top.
The problem, of course, is (as the investing truism has it), they don't ring a bell at the top. (They also don't bang a gong at the bottom.) In other words, in real-time, identifying the top and bottom is a guessing game fraught with uncertainty and ambiguity. The top and bottom only become clear in the rearview mirror.
This is why the professional money managers who tend to outperform the average focus less on identifying the tops and bottoms and more on reaping the low-risk gains in the middle--in other words, leave the bottom 20% and the top 20% of gains for others and take the middle 60%.
In effect, this means selling when the trend is getting tired or long in tooth, before anyone else even thinks of selling.
A powerful opponent stands in the way of this risk-management strategy: greed. When the market just keeps rising (in housing, stocks, bonds, collectibles, you name it), selling seems stupid: why leave easy money on the table by selling before the top is in?
There's an even more insidious enemy of reaping profits and preserving capital: liquidity. Alan Greenspan's long-winded mea culpa for why he (and the Federal Reserve) didn't see the 2008 meltdown coming boils down to the slipperiness of liquidity, i.e. a market with plenty of buyers and sellers.
When traders sense the jig is up, they sell. This causes prices to hit money managers' technical limits and the selling cascades as more and more "sell" signals get triggered.
On the other side of the trade, buyers have vanished, as it's clearly a losing trade to buy on a cascade down.
Once participants get skittish, credit to buy dries up: margin accounts are wiped out, lenders suddenly have no interest in giving $600,000 mortgages to janitors making $25,000 a year, and so on. The pool of cash/credit available to buyers dries up like a splash of water in Death Valley.
The speed of this collapse of liquidity supposedly surprised Greenspan, but liquidity is just a reflection of fear and greed: when panic replaces greed, buyers vanish. As the selling fires up moribund risk management, credit available to speculators and marginal buyers dries up. This too is a self-reinforcing cascade, as marginal buyers find they can't roll over their debts and have to default. The defaults spark more panic in credit markets, and so liquidity dries up.
Even if central bankers flood the financial system with credit, that doesn't make buying on the way down a wise move: downtrends after six years of expansion tend to last at least two to three years. From the peak in March 2000, the collapse in asset bubbles lasted until March 2003.
The top in 2007 (in housing, stocks, etc.) took another year-and-a-half to manifest in the freefall of late 2008 and early 2009, so top to trough was about two years.
Making money when you buy--and when you sell
Another investing truism is "you make money when you buy." In other words, if you buy correctly, i.e. at low valuations, you make money regardless of when you sell. (If you buy income-producing assets, then you lock in the income stream at a low initial cost.)
While there is great wisdom in this truism, you can't secure your gains unless you sell. So selling correctly is just as important as buying correctly.
In housing and real estate, the cliche is "housing always comes back." Many believe the same is true of stocks--and the postwar era from 1946 to the present supports this thesis.
But what few inside these industries are willing to admit (or even consider) is the increasing fragility of these asset classes: their increasing dependence on shrinking pools of qualified buyers, central bank policies that are losing their effectiveness, and the instability lurking just below the present level of liquidity.
All these asset bubbles depend on the riskiest, most marginal buyers having perfect financial lives going forward: no layoffs, no medical emergencies, no divorce, no capital controls in the countries officials are fleeing with their ill-gotten gains, and so on.
This is simply not realistic, yet financial perfection is the only way these bubbles can stay inflated. If nobody but a thin bleeding edge of wealthy corrupt officials from overseas and a few social-media millionaires can afford housing at the current level, how resilient is the market? Compare this to the housing market of decades past, when tens of millions of households could afford a house without stretching themselves to the limit.
We have difficulty selling at the top for another reason: our innate sense of risk management is not very sound when it comes to finance. We have to train ourselves to make good risk-management decisions.
Let's take an example: many people are sitting on 200% returns in mutual funds and 401K accounts from March 2009 to the present. The S&P 500 has climbed from 667 to 2096. Wow--that is a lot of gain to harvest--or lose by not selling near the top.
what would it be worth to secure your 200% gain? Would sacrificing a 5% gain in 2015 be worth it? In other words, if the best-case scenario is the market rises another 5% by the end of 2015, and the worst-case is a sharp 25% freefall, then is the gamble of hoping to secure a meager 5% gain after already securing a 200% gain really worth the risk of losing 25%? Clearly, the risk-return favors selling to secure the vast majority of your 200% gains in trade for giving up a potential 5% gain.
We might call this "stay fully invested" bias the Warren Buffett Syndrome. Buffett is a billionaire because he bought companies like Coke and never sold. Is this genius or just good timing? I think it's good timing: Buffett's strategy happened to coincide with one of the greatest stock market rallies in recorded history, from the early 1980s to the present.
Would Buffett be a billionaire if he'd bought Coke in 1968 and the next four decades were like the 1970s, up and down gyrations that yielded huge losses when adjusted for inflation/purchasing power? No, he wouldn't.
So a bet that never selling will work in the decades to come is betting that the era of good times that started in 1981 will last indefinitely.
If you look at the increasing fragility of all the props under skyhigh valuations (see "Market Musings" below for more), you have to factor in the possibility that the major trends are reversing or crumbling.
The ideal investor sold in the obvious bubble euphoria in early 2000 and bought back in when the market was all doom-and-gloom in early 2003. He/she also sold in early 2008, when the wheels fell off the subprime mortgage bubble and stocks were showing signs of impending cardiac arrest. He/she then bought back in after the spike down in March 2009.
This looks easy in hindsight, of course, but the warning signs were all highly visible in late 1999 and early 2008. It would not have been difficult for a software program to identify the risk-return had shifted decisively in favor of selling and going to cash.
My biggest mistakes financially have all been an inability/reluctance to sell. As a result, I have slowly trained myself to sell and take a profit, and not look back. If whatever I sold doubled later, good for those who bought it from me. But the main goal is preserving capital and reaping gains, not worrying about how much was left on the table, because that is unknowable.
What we know definitively is the world is increasingly at risk of another financial crisis and recession, and therefore all gains are at risk.
Most of us don't have the time to train ourselves to sell and not look back. Financial advisors are supposed to do that for us, but the number of advisors who recommend selling when few others are even considering it are rare, because selling when the bubble seems to still be inflating is an excellent way to lose clients and/or get fired.
It's dangerous for those inside the industry to buck the received wisdom that "staying fully invested" is the solution to all questions--even though three massive asset bubbles have popped in the past 15 years, destroying trillions of dollars of wealth.
The number of people working in the financial system who are guided by the knowledge that the old trend is either dying or reversing is low, for much the same reason: anyone with any doubts about "housing always comes back" and "stay fully invested" has been selected out of the industry, either by their own choice or via being fired/marginalized.
This is yet another reason why it's so difficult to sell at the top: seasoned advisors who support this strategy are few and far between.
I think this is an era that is increasingly likely to reward selling before everyone else, when the top is not yet visible, not when you have to sell after all the bubbles pop.
You can always buy back in, but you can't go back in time and sell at the top. If we have learned anything about massive bubbles popping in the past 15 years, it should be this.
Summary of the Blog This Past Week
The Cure for Discouragement: a Good Meal 2/14/15
Will China's Currency Peg Be the Next to Fall? 2/13/15
Empire of Lies 2/12/15
Some Thoughts on Greece's Exit from the Euro (Grexit) 2/11/15
The Top 1/10th of 1% Loves a Guaranteed Minimum Income: With One Caveat 2/10/15
What Looks Crazy at First Might Be the Ideal Solution: Meet Greece's New Currency, the U.S. Dollar 2/9/15
Best Thing That Happened To Me This Week
I completed the Executive Summary of my new book.
Market Musings: As Good As It Gets?
Evidence is piling up that the U.S. economy is in the final stage of the six-year expansion--the "as good as it gets" phase, where everything is topping out even as the mainstream financial punditry declares that the expansion has plenty of room left to run.
Consider everything that has reached the apex and is starting the long slide down:
1. Money supply: as explained in this excellent summary of the way we create and measure money supply, the expansion of money is now coming from bank credit, not the Federal Reserve. And where is money being created? In guaranteed-to-default auto loans, sketchy student loans and loans to developers to build office towers in Houston (as the oil patch lays off thousands of workers and tightens its belt) and large rental complexes--as if the 20-somethings working part-time at Stabucks can afford new flats in pricey parts of the city.
2. Unemployment: the unemployment rate is rigged, of course; the government has tossed tens of millions of people out of the labor force to manipulate the number of supposedly unemployed. But the technology of AI is advancing rapidly and remorselessly (see link below in "From Left Field"), and the number of jobs being created by automating software is tiny compared to the number of formerly middle-class jobs being eliminated.
3. Tax revenues: recent tax increases and the bubbles in housing, stocks and bonds have boosted tax revenues. Once the bubbles deflate and people get laid off/have their hours cut, tax revenues will follow suit.
4. Asset bubbles: fundamentally, asset bubbles are inflated by expanding the money supply and by increasing corporate profitability. The strong dollar has already sucker-punched global corporate profitability, and it's just getting started. As the link below in "From Left Field" explains, high-flying Google may soon deliver a shocker--a mass layoff as profitability doesn't just slow but reverses. Google is the tip of the iceberg of companies announcing decaying profitability.
In other words, the two drivers of rising stock market valuations have both reversed.
5. Interest rates. While the Europeans seem to be competing to push interest rates below zero, the low-hanging fruit of super-low interest rates have long been plucked. There's no place to go but sideways or up, and there's no boost from that.
6. Central banks are all-in. Virtually none of the six years of recovery have resulted from improving productivity or policies that fixed dysfunctional systems; it's all been driven by central bank money-pumping. The central banks have gone all-in, and the returns on their current policies are diminishing monthly. The monetary tools that they used to "fix" the last financial crisis/recession will not be available because they're what's propping up the current recovery/bubble.
People naturally assume the trend of the moment will continue essentially forever. Marginal returns dictate that this is "as good as it gets." Another way of saying this is that all the good news has been priced into the market, and so the market is not prepared for the end of positive trends and central bank policies that have lost their effectiveness.
The inescapable conclusion: preserve your capital and any gains you've amassed.
When will the bubbles deflate in earnest? Nobody knows, but the warning signs are visible to anyone who cares to look at the data.
From Left Field
Chinese herdsman stumbles onto a 17-pound gold nugget -- now there's a welcome surprise....
Health Care Cost Studies Pointedly Ignore Bad Incentives, Market Failure as Drivers (via Cheryl A.)
America's Most Loved and Most Hated Companies -- a few surprises...
The town where everyone got free money -- analysis of a pilot study of guaranteed minimum income; since the study didn't control for cultural differences, it cannot be taken as universal, i.e. equally applicable to humans in every culture....
The Current State of Machine Intelligence (via Lew G.) -- if you wonder why jobs are disappearing--here's why...
What Peak? Europe's energy consumption back to 1990 levels -- everyone drives less as they age...
the World Press Photo of the Year -- most relating to violence or oppression....
The invisible network that keeps the world running -- shipping and containerization...
Google Layoffs Inevitable -- now here's something you don't find very often: someone who actually looks at Google's financials...
Systematic inequality and hierarchy in faculty hiring networks -- a fancy way of saying only those who graduate from the very top tier of universities get academic jobs...
What do the bacteria living in your gut have to do with your immune system? (via John S.P.)
U.S. Rigs Are Being Idled, but the Oil Boom Is Not Ending (via Joel M.)
"Hide your capabilities and bide your time." Deng Xiopeng
Thanks for reading--
charles |
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