13 Lessons Learnt From This Stock Market Rally

I think most market participants would agree that even if we are yet to see the real lows in this markets, the rally since March 2009 needs to be properly assessed and conclusions made. No matter how bearish you are, missing this rally is not good. For young investors like myself it should be clear by now that you make money in a bear market not only by shorting stocks (or currencies, commodities etc.), but also by riding such rallies.

So, I tried to make a list of the lessons one could have learnt from this rally since March. Some of the points below are well-known and often quoted, I still included them because to find a proof for an argument is equally important. Some points may look fresh, I hope. Its also useful to analyse a longer period and make broader conclusions from market movements since 2007. I will try to do it some time later.

1. You cannot predict turning points in a market. Even you make correct predictions 10 times out of 50 it still does not mean you got the skill. This is so often a mistake made by so many young investors. I was under the impression that market was on a downward trend since January 2009 and thus, the market rise post 9 March seemed to be just a short-term spike. How much money could one have made.

2. After accepting Point 1, one has to decide if he is a speculator or a fundamentalist. Try not to mix two separate strategies. You either ride the the trends or you pick stocks that are mostly undervalued and have sound fundamentals. In the first case you will always be focusing on what market we are in (bull’s, bear’s, range bounds etc.). In the second case, the fundamentals of your company and its valuation relevant to its peers is your main concern, You need to focus on how close is market assessing/reflecting the underlying value of the company, and market timing skills are relevant to decide when to open a position in a stock you like fundamentally. If you are a speculator the next three points are worth remembering.

3. Using old adage, the trend is your friend. Identify direction and don’t focus on market fluctuations. In this case you would have missed some part of the recent market rally, but clearly you would have jumped onto it at some stage.

4. Some exceptional investors are often the first to identify the new direction and this can be done following another maxim that its darkest before the dawn. You don’t need good news to start coming for the market to change. Its when everything is just bad and everyone is prepared, another piece of equally bad (not worse) news would likely lead to a short-term bullish move. Another similar way of putting it buy on the rumor and sell on the news. Its more important what is in the price already, how much of the new information has the market already discounted. Throughout last 9 months we often saw market rising when really bad macro or company data was released. Well, investors have already expected this.

5. Sentiment is very important. No matter if fundamentals are bad, you need general sentiment to be bullish to start a massive market rally. Sentiment can even sometimes destroy good companies (when they cannot access financing, for example). I think it has much to do with the theory of reflexivity developed by the legendary George Soros. This often leads to a disconnect between the stock market and the real economy. Some are arguing we are are witnessing this disconnect currently, especially in the oil market. There are several ways of assessing what sentiment you are dealing with.

• Credit spreads. If they are widening, its a bearish signal (TED spread is most common)
• T-bills yields. If they are high, people prefer cash and so they are cautious
• VIX levels, if its below 30, sentiment is bullish
• Put-Call ratio
• Net flows into mutual funds
• Cash position of mutual funds
• Various investor surveys and confidence indices (eg Barron’s Confidence Index)

6. If you prefer to stay away from speculation, you need to have a system of fundamental analysis. Normally its done in three stages: screening, working-out investment thesis for individual stocks, testing. I am not going to spend time on fundamental security analysis, however I find its useful to mention quick points that are relevant for fundamental investors in relation to the recent rally. You must have an investment thesis in writing where you would explain why you think the stock is undervalued, what could change this undervaluation. You also need to have entry and exit levels set up initially.

7. Its crucial to develop some risk management system. Decide what is the maximum exposure to a single stock in your portfolio, what is the highest loss per position (in % and absolute terms), what hedges you want to use (blue-chips, bonds, gold, options, shorts).

8. When working on investment thesis, find at least five (better ten) reasons why this investment is bad. Focus on the downside, on what can go wrong. Overconfidence is very common and its the one that kills so many so often. Also important to remember is to always look at both sides of the arguments, never take one side of the trade for a long time, like ‘I am a big bull in trading’.

9. My experience tells me that the key to success in investing is finding a perfect balance between having confidence and sticking to your views even when everyone around you tells you the opposite (being contrarian in a sense), on the one hand, and on the other - remaining open-minded, flexible and being able to accept making mistakes and adjusting your views when evidence suggests you are wrong.

10. Avoid being sucked in by rising prices for various assets. I noticed that I too often change or take a view based on rising / falling prices. Very experienced and smart investors use this bubbles to make money either by riding them or by using weaknesses to buy stocks for the long-term. If you prefer the last option, make sure that the situation always remains under control and stay doubtful (about the bubble and your view on this bubble).

11. You don’t have to always have a view on every asset and market. Some moves are just random, they can be unexplainable. Avoid trading when you don’t have enough confidence, let the situation clear-out first.

12. There is no authority in the market, no one knows enough to be correct in his predictions, so never trade just because some expert you trust shared his trading idea. There are more smart people out there then you think, your expert is just one out of many.

13. Do not miss the next correction if it ever happens to buy on the lows. Do buy when there is too much pessimism around. Also, have your investment horizon clearly stated. If you speculate its probable short-term (days or several months), but if you are fundamentalist be prepared to take long-term views (could be for several years) and remember that every recession ends in the end.

PS: I know most of the points above are too common and obvious, however I decided to list them because its my own real market experience. You can only become better by constantly reviewing your mistakes, analysing your weaknesses and correcting them. Constant improving is crucial to one’s success in investing.