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Rule #1 and Market Fluctuations

Phil Town
Phil Town

This question came in from Colleen last week: Dear Phil Town,

Thank you for RULE #1 and for writing an excellent book.  As a financial analyst I was never interested in stocks because of perceived risks, but thanks to your simplified approach, I am enjoying this new world.  I began investing last August and realized a 37% return (annualized) for the first 3 months, then got emotional and impatient and lost some of it.  But I am learning!

I am now investing about $8k in INFY, APOL, and LIFC, and got in based on buy signals, the MOS, the five #s, mgmt, etc.  (And yes, APOL is probably risky.)

I was wondering how you use the three tools in comparison to the market fluctuations.  I don't want to sell when the entire market goes down a little but there is no bad news on the companies.  I would rather buy then! Especially in the last few days when these 3 stocks keep going up and down.  Shouldn't I incorporate the fact that the DJIA, S&P, and Nasdaq are all down into my buying and selling decisions?

Maybe a better question is if there are any indicators for an overall stock market crash.  (I suppose that's a million dollar question.)


Colleen My response:

Hi Colleen,

Congratulations on joining the revolution and on your success.  You bring up an excellent issue.  Do we take into consideration normal market fluctuations?  Should we buy when those fluctuations give us our wonderful business at an even better price?

There is an old saying among traders: "The trend is your friend."

The 'trend' they are talking about includes the market trend (which direction is the market heading?), the industry trend (is the industry following or bucking the market trend?) and the price trend on your stock (is it bucking the industry trend or going with it?).

One friend of mine, another investor who uses these tools, likes to see the market trending up, the industry trending up and the 30 day moving average curving up before he feels like he really has strong buy signals.  Of course, what he's doing is pretty much the opposite of what you are asking about.  He's buying with the momentum of the market, industry and stock.  You are asking if we should be buying when the momentum has gone the other way.

There is a certain sense to that strategy.  In fact, isn't that pretty much what Warren Buffett says is the key to timing the market -- to buy when others are fearful (and selling) and sell when others are greedy (and buying)?  And indeed, Mr. Buffett has done very well by following that strategy.

But there is a problem that faces us little guys, particularly me. Last time I checked I wasn't a genius.  Which means that the other part of the equation that Buffett relies on -- knowing that the business is wonderful and that the price is below the value -- could easily elude my limited grasp of reality.

In other words, I might be buying a not so wonderful business at a not so wonderful price because I'm not so wonderfully smart as Mr. B.  If you are in my boat, this fact should give you pause when you start thinking about climbing aboard when everyone else in running for the life boats.

We have one advantage that the Buffetts of the world do not have. Those big guys are... well, big guys.  And we're not.  We are the little guys.  We don't have to buy $200,000,000 worth of this thing to even make it worth bothering about.  Which means that we don't have to worry about getting in early when there is fear and loathing.  We can hang out and wait for the fear and loathing to subside and for the big guys to start buying again, and then jump in there with all our bucks in about 8 seconds.  And if we're wrong and the bottom is still to be found, we can jump out again just as fast.

And this ability of us little guys to be nimble -- let's us wait to see what direction the elephants are headed and then go along for the ride instead of trying to guess that they are done stampeding.  There is no reason that a little guy should try to guess when the elephant stampede is over.   Just hang out and wait patiently until it is.  And when they turn around and start running the other way, we get in.

I want to emphasize how cool this is by referring to Whole Foods. In November (and for a while before that) I had it valued at about $90 based on 20% plus growth rates and a 40 PE.  It was selling for $47.

If you were following along, as it went green you bought it and rode it to $65.  Then it went sideways for 10 days and then the MACD went red and you started paying attention.  Then the Stochastic went red and you sold at $64.  Two days later it dropped overnight to $48.  And now it's selling for $44.  So why did it drop so suddenly?

John Mackey, the CEO, announced that instead of growing at 20% they would grow at 15%. That not only changed the expected growth rate, if you follow Rule #1, it also changed the PE ratio from 40 to 30 instantly.

And we're not the only folks who can do these calculations of value. Whole Foods' value changed suddenly on analysts' computers all over Wall Street, and that change made the stock go from undervalued at $64 to way overvalued at $64 instantly -- and those guys hit the panic button.

You know that OOOOGAAAHHHH sound that accompanies the "DIVE, DIVE, DIVE" order in submarine movies?  Like that.  OOOOGAAAAAHHHHH. And the elephants stampeded so strongly that there were NO buyers until it hit the new calculated value (depending on the analyst's system) of $48 -- and then some elephants stopped running and started to turn and go the other way.  (By the way, the technical term for this sort of a gap-down stomach wrenching stampede in price is "bad".  As in, "Oh oh.  That's bad.")

In case you had any doubts, we want to avoid this 'bad' thing.  We want outta there before this happens.  But, my dear Colleen, we can not avoid this big bad outta knowwhere how-did-that-happen sort of drop in price unless unless unless we are willing to get out lots of other times when it's just a normal price and or market flucuation.

You know why?  Because they look exactly the same until it's too late. Every crash, whether it's the market as a whole, the industry or the stock almost always starts the same way -- with the big guys sneaking out just like they do in a normal no-big-deal fluctuation.  The price goes sideways, you get two reds.  And it looks like that right up until it gaps down on some horrible news.

So if you aren't willing to get out on all the normal fluctuations, you won't be able to get out before the big kahuna crash.

And so we just don't try to guess.  We just assume every set of 'out' signals means get out now and we get out.  And once in a while, we get rewarded for our diligence by keeping a nice big profit and avoiding a nice big anti-Rule #1 loss.

But here's the downside.  If you get an actually wonderful business at an actually wonderful price, you won't do as well by getting in and out with the big guys as you would by buying on the downward fluctuations and holding all the way up.  Doing that on the right stock is the right way to knock it out of the park.  Absolutely.

So Warren Buffet is right.  IF IF IF you do have a wonderful business and IF IF IF the price is way below the real value, then the absolute best strategy is to never sell and to buy more on the dips.  IF IF IF you are smart enough to get the right biz at the right price.

Me?  I don't trust myself to be that smart, even now after 25 years of investing. I've gotten it wrong in some way so many times that I am humbled and willing to admit my intellectual limitations are somewhat severe.  So I do my best to get it right:  Wonderful biz, great price. But I cover my assets by getting in and out with the big guys.

Hope that helps, Colleen.

Now go play!

Phil Town