Why I Am Always a Market Optimist, Even in Tough Times
It is unrealistic to expect the market to go straight up, so why invest that way?
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The general view of the stock market is simple. Up is good and down is bad. It is understandable thinking, but it creates a mindset that has you fighting market action rather than navigating it to optimize your returns.
Recent market action has been a good example. There has been broad selling and substantial losses in many names. This action triggers strong emotions in almost everyone who owns stocks, and those emotions stem from simplistic thinking: If down is bad, then a down week is a bad week, a loss is a failure, and the only thing to do is hope it ends quickly.
But what if you view downside moves and a weak market differently? What if you think of down cycles as the time when great opportunities are created? In a poor market, good stocks are likely to be sold along with bad ones. Prices become disconnected from fundamentals, and the resulting mispricing is where a stock picker can earn substantial returns.
The up cycle of the market is where you press your bets, grow your profits, and eventually harvest them. That provides you with the capital for the down cycle, when new opportunities emerge again.
Neither phase of the market is “good” or “bad.” They are just two parts of one process. You cannot have the profits without the setup that produces them. The cycles are going to happen, so why not embrace what each one offers?
An investor who thinks up is good and down is bad spends the up cycle fully invested and then does nothing but hope for an end to the pain in a down cycle. An investor who understands that both halves are necessary spends the up cycle building profits and protecting them, then spends the down cycle building a shopping list of great new buys. It is the same market, but one investor spends his time and capital fighting the down cycle while the other embraces it.
Where Hope Goes Wrong
The belief that down is bad produces three specific and common mistakes.
The first is holding on to stocks that are breaking key technical levels. The stock was a good one, the story has not changed, and surely it will recover. So we hold tightly to the position while the support gives way and the loss compounds. There is fear that we will miss out when conditions improve, but rebuying something you sold when the cycle shifts is easy to do. The problem is that people become emotionally attached to their stocks and it is hard to sell them. My advice is to think of selling as just a temporary form of insurance. You are protected when you don’t own the stock, and you can buy it back any time you want. If you have to pay a higher price, then it was just an insurance premium. If you get back in at a lower price, then you got a bargain.
The second mistake is rushing to buy stocks that have dropped substantially. The name that was $80 last month is now at $50. That $80 becomes the anchor even though it may have no relationship to what the business is worth. The stock feels like a bargain simply because the price is lower. That thinking works well with commodities or groceries, but not so well with operating businesses.
The third mistake is selling the best-performing stocks rather than the laggards. In behavioral economics, this is known as the disposition effect. Economists Hersh Shefrin and Meir Statman named it in 1985, building on Daniel Kahneman and Amos Tversky’s finding that a loss hurts about twice as much as an equal gain feels good, so there is a natural reluctance to take the loss.
A study of 10,000 brokerage accounts found investors were about 50% more likely to sell a stock that was up than one that was down, and the winners they sold went on to outperform the losers they kept.
The tendency intensifies in a correction. A study of German investors across three bear markets found they were about 25% more likely to sell a winner in a down market than in an up market, while their willingness to sell a loser did not change at all.
A 2015 study found that on the day an investor sells something, there is a 31% chance it is the best-performing position in the account and a 26% chance it is the worst. Positions in the middle are sold only about 11% of the time. That is a good clue that the sellers are acting emotionally rather than analytically.
All three mistakes come from hoping that the down cycle is not justified and will not last. If it is an aberration that will correct itself quickly, why not hold the broken stock, buy the biggest losers, and sell the best stocks to raise cash? Every one of those decisions can be rational, but they are much more likely to be emotional.
Cycles Are Not the Interruption
Market cycles are inevitable, and they should not be viewed as a negative. They are the nature of the market beast. Ups and downs are one of the great certainties of all markets, and treating the down leg as a mistake that the market is making is what produces the three errors above.
The reason the emotion of hope is so persistent in the stock market is that most of our experience is in rising markets. Up cycles last longer than down cycles, so the majority of the time we spend watching stocks is spent watching them go up. That conditions us to expect a constantly rising market. We have all heard that over the long run stocks always go up. When a down cycle does occur, it feels like a departure from normal rather than half of what normal is.
Once you accept that the down cycle is as much a part of the market as the up cycle, the shift in your behavior takes on a life of its own. The stock breaking support gets sold, because a broken chart in a downtrend won’t fix itself just because you think the market is wrong. The stock that fell 40% goes on the watch list rather than into the account, because there is no rush when the cycle has further to run. The winner gets held because it is working, and the laggards get cut because they are not.
None of that requires predicting where the cycle will turn. It requires accepting that it exists.
What Embracing It Actually Means
Embracing the cycle is not an attitude. It is a set of things you do with your capital. During the up cycle, it means recognizing profits rather than assuming they will always be there. Positions get trimmed into strength, not because the stock is about to fall, but because the cash will be needed for the next down cycle and it has to come from somewhere. The trader who is fully invested at the top has no way to take advantage of the bottom.
During the down cycle, it means preparation rather than participation. The shopping list gets built. The names being sold for reasons unrelated to their businesses get identified. The method for buying them is determined in advance, incrementally and on weakness, so that when the time comes, there is no decision to make under pressure. The capital sits and waits.
The hardest part of a down cycle is that it exhausts your patience. Bad markets do not scare you out, they wear you out. Every failed bounce takes another group of buyers with it, and the people who keep trying to call the bottom fuel the decline. The person who has embraced the cycle is not trying to call anything. He is watching the process run and waiting for it to finish.
Where the Optimism Comes From
I am always an optimist about the stock market. Not because I think it goes straight up forever, and not because I think the current decline is about to end. I am an optimist because the cycles are inevitable, and I know without a doubt that they will produce an endless flow of opportunities for anyone positioned to take them.
The down cycle is where the next set of winners gets created. Good companies get sold along with bad ones. Thin stocks go bidless. Fundamentals stop mattering for a while, and the resulting mispricing is exactly what I am looking for. That opportunity exists only because market cycles occur, and it is only available to people who didn’t fight the cycle on the way down.
So the current market struggles are not the story. The story is what you do with the cash you protected and the shopping list you built while everyone else was hoping for a return to normal. Once you embrace the inevitability of market cycles, you will welcome the downside rather than dread it.
At the time of publication, DePorre had no position in any security mentioned.
