Pessimism Sounds Smart, but Optimism Pays
Here’s why financial media is built on bad news and why being positive is the best way to succeed in trading.
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Most people think about the stock market in very simple terms. Up is good. Down is bad. Bull markets are a time to celebrate, and bear markets are a period of doom and gloom. That seems logical and intuitive, but this pattern of thinking creates a mindset that will cost you money in both directions.
The issue that matters most is not direction. It is the level of opportunity. The number of “good” setups at any given moment is the best way to evaluate a market. That number varies enormously over time, and it has surprisingly little to do with whether the indexes are making new highs or new lows.
The Bull Market Trap
What almost nobody talks about is that when everyone is celebrating a roaring bull market, the number of great opportunities is often contracting.
Think about what a mature bull market actually looks like. The charts are extended. Everything you want to own has already run. The entries are bad because the charts are overbought and risk-reward on a new entry is suboptimal. The trades that looked promising six months ago are now crowded with everyone who noticed them late. The screens produce plenty of names that are going up and almost nothing you would actually want to chase at current levels.
Meanwhile, the mood is euphoric. The media is gushing about the number of new highs. The analysts are raising their targets. Everyone at the party is having a wonderful time.
That is the environment where the biggest danger lurks. It isn’t a sudden crash that will do the damage. It is from chasing FOMO and forcing mediocre trades because the market feels like it is offering something when it is not. The late cycle trading is when you rack up the biggest losses.
How I Time Turns Without Predicting Them
The best way to gauge a market’s health is by counting the number of setups being developed. It is the only market timing tool I trust.
When I cannot find favorable setups, I put less money to work, and when I take profits in existing positions, cash builds up automatically. I become more defensive, even though I’ve never made a decision about where the market is going.
I am not making a market prediction. I have no idea what the indexes will do next month. I am simply reacting to the level of opportunity available to me right now, and that level is forcing me to put less cash at risk.
The key is that the quality of setups deteriorates before price does. The charts extend, the entries get worse, and the risk-reward turns unfavorable, while the indexes are still making new highs and everyone is still celebrating. The number of setups drops before the market reverses. If you are paying attention to what your screening process is producing rather than to what the headlines are saying, you get defensive early, and it costs you nothing to be there.
The inverse works the same way. After a brutal stretch, when the media is generating maximum misery and every commentator is explaining why it gets worse from here, the screens and the number of setups start to jump. Stocks that were sold indiscriminately because someone needed liquidity. Charts that have finally found good support with attractive valuations. Entries with real risk-reward are now available.
I get aggressive then. Not because I have called the bottom. Because opportunity has become abundant, my job is to respond to that.
Buffett Says the Same Thing
Warren Buffett has been making this argument for 50 years and almost nobody actually listens to it. His seven-word version, from a New York Times op-ed: “Bad news is an investor’s best friend.”
He went further in his 1997 letter to shareholders. He pointed out that investors who plan to keep buying stocks throughout their lives should welcome lower prices, and that they show no such confusion when it comes to food. Everyone knows they will be buying groceries for the rest of their life, so they are happy when prices fall and annoyed when they rise. It is the seller of food who dislikes declining prices, not the buyer. Yet the same person becomes euphoric when stocks go up and miserable when they go down.
In the same letter he offered a simple mental edit. When you read a headline that says investors lose as the market falls, rewrite it in your head. Disinvestors lose as the market falls. Investors gain.
Buffett is not being clever. He is describing exactly what I am describing. He complains constantly about how difficult it is to find anything worth buying when markets are strong. He sits on enormous cash piles for years at a time, not because he has predicted a crash, but because nothing on his screen meets his standard. And then when everyone else is panicking and the media has decided the world is ending, his phone starts ringing with the best deals of the decade.
He also said this, and it belongs on a sticky note on your monitor: cash combined with courage in a crisis is priceless.
The cash is the easy part. Courage is what most people cannot manage, and courage comes from having spent the bad stretch looking for opportunity instead of drowning in the misery.
The Mindset That Makes It Possible
When the market is struggling, the emotional gravity is enormous. Every headline is about the danger and how things are sure to get worse. You don’t even want to look at the stocks you are holding, because it will force you to question your poor judgment. The natural question that comes to mind is: how bad is this going to get?
That is the wrong question, and it is a trap. It puts you in the position of forecasting, which nobody can do, and it locks you into a defensive position precisely when opportunity is expanding. The question you should be asking is, what new opportunity is this creating, and how do I position for it?
That question is available only to the person who has not been sucked into the negativity. It isn’t just mindless optimism. It is a working question. The selling that just occurred created dislocations. The money that left one group went somewhere. Something is being set up right now that nobody is looking at because everyone is staring at the wreckage.
Why Nobody Wants to Hear It
Bearish views almost always sound more thoughtful than bullish ones. Warning people about danger carries a gravity that enthusiasm does not. The bear claims to see the risks the silly bulls are ignoring. The grizzled veteran of the market wars has done the homework and he is protecting you with his talk of disaster.
And the asymmetry protects him. If the market drops, he was right and he says so for years. If the market rises, nobody lost money by being careful. The bull has no such cushion. If he is right, everyone made money and he gets no credit. If he is wrong, he looks like a fool who ignored the obvious warnings.
The financial media understands this arithmetic perfectly. Bears get booked because they attract attention. If you spend enough time consuming market commentary you are being trained to embrace this thinking without noticing. Caution is sophistication and optimism is a lack of intellectual rigor.
This dynamic pulls you away from looking for opportunity and puts you in a position where you can’t make any money.
The Stubborn Optimist
In Gregory Zuckerman’s book about Jim Simons, “The Man Who Solved the Market,” what I found most striking was that Simons, the king of quants, was a stubborn optimist.
Simons built the most rigorous quantitative operation in the history of finance. Renaissance Technologies had mathematicians and physicists and models measuring risk from every angle. Nobody would accuse him of naivety about what could go wrong. He had the data.
And the trait that carried him through the years when nothing worked was stubborn optimism. He wasn’t optimistic about market direction. He was optimistic that his systems would work and he never gave up. Optimism is not the opposite of rigor. It coexists with it. The most systematic trader who ever lived was one of those dumb optimists that the bears always warn us about.
The Reframe
The market does not owe you an uptrend. What it offers, in every condition, in every year, in bull markets and bear markets and the long stretches of nothing in between, is opportunity. Sometimes a great deal of it. Sometimes almost none. The greatest thing about the market is the flow of opportunities. No other business offers you that much potential.
Your job is not to forecast the direction of the market. Your job is to count the opportunities and respond to what you find. The optimist finds them, because he is still looking. The pessimist misses them because he is busy being right about the danger.
At the time of publication, DePorre had no position in any security mentioned.
