Mechanical Investing
Historical Perspective of the Market

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By Talofa
October 1, 2001

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As a child I grew up with daily discussions of the direction of the stock market. This was no doubt due to the fact that my grandmother was the daughter of the principle lab assistant who helped Guglielmo Marconi, Nobel Prize winner in physics in 1909, invent the radio. When Marconi was broke my great grandfather, who was Marconi's only helper at the time, gave his life savings to him in exchange for then worthless Marconi stock. 1000s of shares were sold to him by Marconi for 25c/each and these shares were eventually to be worth $260 each when Marconi became an international sensation. Nevertheless, most of this fortune was lost during the great depression but enough was left to his 6 daughters for them to become stock market devotees for the rest of their lives. As a result, whenever I visited my grandmother, I was required to watch the ticker tape on TV 6 hours a day with her recording every transaction of all her stocks in her black ledger book. She made fortunes watching her stocks rise from $5 share to $160 but also lost fortunes seeing them crash to $6/share when the so-called go-go sixties ended. She died in her late eighties having found great enjoyment in the stock market and watching it to her very last day.

The period from 1996 to March 2000 was a period of phenomenal stock appreciation but not a unique period in stock market history. The investor Richard Rhodes observed that the final 10% of the time of a bull run will usually encompass 50% or more of the price movement. Thus, the first 50% of the price movement will take 90% of the time and will require the most backing and filling and will be far more difficult to trade than the last 50%. We all remember being told by numerous analysts and commentators on TV 18 months ago that earnings don't matter because we were in a new era.

Similar comments were common in the late 1920s and late 1960s. We know now that earnings do matter and most of the stocks have totally collapsed in value causing enormous losses to their stock holders. We know now that stock markets don't always keep going up after brief bull market corrections but can go down for prolonged periods of time in a bear market.

What has bothered me about MI Investing is that Jamie Gritton's back test only goes back to 1986 and as a result doesn't include any major bear markets similar to that we are currently experiencing. I believe that there is a generally held belief on this board that MI Investing can be successfully practiced in all market environments. Periodically individuals attempt to make a case for market timing but receive a less than receptive response due to their inability to backtest their theories. This is only fair since this board is devoted to mechanical investing. My own experience with technical analysis has not been very successful although using trend lines using specific criteria I believe have value in investing with the trend.

In the past several months a number of OT discussions totally unrelated to investing have consumed much of this board. A hobby of mine has been to purchase books written by great stock investors of bygone periods for insight that might assist me in understanding better the cycles that markets always periodically experience. A quote by Fred C. Kelly in 1930 has always interested me, "The game is old- but the players are always new." When the 1973-74 bear market ended, there were net mutual fund redemptions for the next five years of the new bull market. At a time when the individual investor should have been investing, they were still bailing out with every rally. It took a whole new generation of investors in the 80s and 90s to see the market averages rise to new unbelievable levels.

If history repeats itself, most of the investors of this board will unfortunately probably bail out when the market decline is near its ultimate bottom never to return to investing again because of a belief that mechanical investing doesn't work. This would be unfortunate because I am totally convinced that the MI screens are a proven method to far exceed market returns in bull markets but I remain to be convinced that momentum investing can be successful in a bear market. Even the non-relative strength screens that had a positive return earlier this year have started to develop losses as the value stocks begin to follow the technology stocks down. Because of the large losses suffered by many on this board, including myself, I sense a determination to remain committed to the screens for the time being but a growing doubt to their value as the bear market continues. If my belief that there is still a major leg down to go in the bear market turns out to be true, many investors won't have enough money left in the screens to invest when the new bull market begins. For those who were fully invested in 1929, the averages didn't regain those levels again until 1954. David Feldman in 1997 at the age of 86 wrote down his reflections of his experience in the stock market beginning in 1925. "I am sure that those who were not alive during the 1930s do not have the slightest conception of the devastation resulting from the thirty-month stock market decline. To say that the market "dropped" is an understatement- it was just about obliterated!" In 1938, "The Trader" noted that "Nothing is more vital, except good health, than the preservation of capital. The history of fortunes shows that it is more difficult to conserve than to accumulate." I believe those words have stood the test of time.

Last week it was reported that 7 stocks on the NASDAQ 100 (the 100 largest NASDAQ stocks) were selling for < $1.00 We all know $150 stocks that were supposed to be a great buy at $100 and then $50 and then $10 and now at $5. Years ago an investor checked a random list of stocks from the 1929-1932 period to check their price declines. Below is part of that list:

1929 highs vs. 1932 lows

General Electric 403 ~ 8 1/2
Republic Steel 146 1/4 ~ 1 7/8
Johns-Manville 242 3/4 ~ 10
R.H. Macy 255 ~ 17
Wabash Railroad 81 3/8 ~ 7/8
Am. Machine & Foundry 279 3/4 ~ 7 1/2
Auburn Automobile 514 ~ 3

History today appears to be repeating itself. Thomas Gibson wrote in 1906 in "The Pitfalls of Speculation" that a review of 4000 investing accounts covering a period of 10 years showed that 80% of the accounts showed a final loss and that there was a tendency to buy at the top and sell at the bottom. And this was during a period of rising stock market prices. I suspect that the current market decline has produces net losses for at least 80% of investors so far.

A basic premise of MI investing is to remain invested in the screens at all times. However, this is at odds with extensive published writings from investors who were successful in a series of bull and bear markets. R.W. McNeil in 1921 wrote "One reason so few speculators sell their stocks and take their profits when prices are high, is that they spend too much time hoping and not enough time thinking; too much time dreaming of future profits, and too little time mediating on the probabilities of losing the money they already have at risk. They forget one very important thing in speculation- that it is just as important not to lose money, as it is to make it. One might as well never have any paper profits as to have them and let them slip away again."

I finally sold all my stocks 6 months ago when I reread the writings of my childhood hero, Jesse Livermore, who was the most famous investor of the 1920s and 1930s. He was falsely believed at the time to have caused the 1929 crash by shorting the market. Shortly before his death around 1940 he wrote, "Markets are never wrong. Opinions often are. I have long since learned, as all should learn, not to make excuses when wrong. Just admit it and try to profit from it. We all know when we are wrong. The market will tell the speculator when he is wrong, because he is losing money. When he first realizes he is wrong is the time to clear out, take his losses, try to keep smiling, study the record to determine the cause of his error, and await the next big opportunity." I foolishly ignored the evidence that a bear market had finally started after the first big market drop in March-April 2000 and that one should not invest long in the market when the trend is down but should step aside. A hope to regain my losses was the hook that kept me in too long. I forgot that market are never wrong but my opinion regarding the direction of the market could be. I am relearning his advice that the "Essentials to stock market success are knowledge and patience. So few people succeed in the market because they have no patience. They want to get rich quickly. In the long run, patience counts more than any other element except knowledge." and the more earthy advice from Frank Williams in 1930, "If you are intelligent the market will teach you caution and fortitude, sharpen your wits, and reduce your pride. If you are foolish and refuse to learn a lesson, it will ridicule you, laugh you to scorn, break you, and toss you on the rubbish-heap."

My goal now is to prove R.W. McNeil wrong when he said in 1921: "Few gain sufficient experience in Wall Street to command success until they reach that period of life when they have one foot in the grave." To quote my childhood hero, Jesse Livermore, again, "If there is any axiom which should be borne in mind in speculation, it is this: Don't be afraid to sell, after prices have had a big rise and you have a good profit. Let the fellow who buys from you have a chance. And when you do sell, do not rush into the market to buy some other stock equally high with the funds. Take the profits and get out of the market and stay out until there is an opportunity to buy stocks again at prices admittedly cheap. Anyone who thinks he must be in the market all the time can never make any money."

The first step for me was to restudy past bear markets so as to better understand when I could anticipate the end of this current bear market. The fact that we are now entering an official recession at the same time the rest of the world is undergoing financial distress, the first time since the early 1970s, is not a promising near- to intermediate-term prospect for the market and hasn't been fully reflected in the market I believe. Historically, bear markets follow a certain pattern. Certainly, a speculative mania ended in March 2000. Thomas Gibson in 1906 note that at the peak of a bull market "Excited groups gather about the tickers and predict future events founded principally on illusions or hope, and stories of quickly acquired gains are heard on every hand. A fever of speculation fills the air and men who had no thought of venturing during the time of depression and low prices, now purchase anything and everything at prices that are very high." It could easily be a description of the 1999-2000 period.

Accepting that fact that we are in a new investing environment is difficult even after the events of the past 18 months. "The Trader" wrote in 1938 that "The result of excessive, ingrained optimism is that a change from good times to bad is so great a shock as usually to paralyze investment decision. The chief characteristic of a bear market is its swiftness. Like a bolt from the blue comes the first waive of selling that launches a genuine or major liquidating market. One day all is serene; a week or two later panic may rage. That was the story in 1929 and it was duplicated in 1937. The other salient characteristic of a bear market is its encompassing breadth. First one groups descends perpendicularly as the general market tumbles. Then, as prices rally and steady after a panic, certain groups appear to be impregnable. As the months drag on, however, and the grim realities of what the initial break was discounting emerge, the apparently impregnable sections of the list give ground. Necessitous selling is no respecter of stocks and price stability simply invites liquidation. Therefore, because bear markets are so swift and, before their completion, so all-encompassing, the first rule in a bear market is to discard manuals, reports and data of all description. Only by subscribing to the thesis that all stocks fall together in a bear market can serious losses be avoided. Few individuals there are who do not in a bear market cling, to their sorrow, to some 'pets' in the mistaken notion that their particular issues can escape the effects of the whole liquidation. It is an ironical fact, probably based on the law of action and reaction, that the leaders of a bull market turn out to be the leaders of the ensuing bear market." He added that "Once a bear market gets underway it is necessary, above all, to remember that previous prices count for nothing. The stock market is always discounting an entirely new set of circumstances."

I may be wrong but I believe we are at least 2/3 of the way to reaching a bottom in the stock market. Recent headlines suggested we are early in the third phase of a bear market. "The Trader" briefly summarized: "There are three stages to a bear market. The first is the initial stunning decline in quotations. The second is the steady sag induced by the exposure of poor business and poor earnings. The final leg is the grueling process wherein stocks are sold to meet pressing cash needs and where the stark nakedness of depression (recession) is exposed in the form of bankruptcies, receiverships, suspended dividends, and the like." News of possible airline bankruptcies due to poor economic conditions etc. suggests we are finally beginning phase.

It is very difficult to make money when the market trend is down. In such times the prudent thing may be to step aside and wait for the trend to be positive since it is often reported that 50-70% of success in the market is achieved by merely following the general trend of the market. Since the major trend is current down it is difficult for MI screens to show a positive return under those conditions. Justin Mamis wrote that "The market will do whatever it takes for the most number of people to lose the most money" and that "The odds are against a stock going up if the market is going down. Never, never, never invest in stocks until you have established that the market direction is up." Brilliant minds on the MI Board have develop outstanding screens for stock selection. Perhaps some effort should be expended in developing a simple mechanical approach to trend identification that will augment the success of the screens in a bull market while minimizing losses when the intermediate- long-term trend is down.



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