A Digest-reader took issue with a recent market-call … and the investment lesson we can all take away from it
We love feedback from our Digest readers.
Sometimes, the feedback includes lengthy, well-reasoned challenges to our market calls. Other times, the Digest-reader prefers to write something a tad briefer and more passionate … such as the email we received about a month ago, which simply read:
What exactly was this Digest reader referring to?
A bit of context …
If you recall, May was a painful month for stocks. Here’s how the S&P looked …
On Monday, May 13th, the S&P suffered its biggest drop in the preceding four months. Meanwhile, the Dow shed more than 600 points, and the Nasdaq saw its biggest decline of 2019. Investors fled to safety, pushing Treasury yields to their lowest level since late March.
In short, investors were rattled.
***Given this, at that time, I reached out to John Jagerson of Strategic Trader for some insights
You see, John happens to be one of the smartest quantitative investors in the business.
Being a “quant” simply means John uses real, historical market data to identify patterns and trends. Then he uses that information to help make well-informed predictions as to what might happen in the markets going forward.
So, after the huge market drop that Monday in May, I asked John to run an historical backtest to give us some idea as to what we might expect over the next month.
John provided lots of great details, including the following chart …
… then he stated his bottom-line takeaway:
Over the last 10-years, a big daily-loss that moved the S&P 500 to a previous support level has signaled a positive return of +5% or more over the next 30-days nearly 90% of the time.
So, despite how harrowing the market appeared in the moment, odds were in favor of the market climbing from its support level. Given this, I titled that day’s Digest “Why It’s Rally Time.”
The Digest-reader who emailed us the following day apparently disagreed with John’s analysis and my title, resulting in …
***So, how did it all turn out?
I checked the numbers this past Friday. Here’s how the S&P has performed over the past month:
How do the specific numbers shape up? Well, the S&P support level identified by John on his chart (above) was 2798.54.
This past Friday, the S&P closed at 2955.24.
The S&P was up 5.6% from the support level as of last Friday.
To be fair, last Friday marked 37 days after our May 15th Digest rather than 30 days. That said, though I could be wrong, I suspect those seven days wouldn’t have made a difference in the Digest-reader’s opinion at the time he wrote his email.
***The investing mistake we all make far too often
First, please understand that I don’t bring up this email from the Digest-reader to gloat. In fact, if you want to get technical, the S&P didn’t climb the full 5% within the stated 30-day period. That extra seven days did make a difference.
But there’s a more important point here that would be equally-valuable regardless of whether the S&P had gone up, down, or sideways after May 15th …
In short, when it comes to investing, are you really open to all the facts — or just the ones that support what you already believe?
It’s no surprise that humans don’t make great investors. We’re just not wired for it. Greed, fear, and extrapolation tend to trip us up over-and-over again.
One of the biggest mistakes we make refers to something called “confirmation bias.” The stated definition is: the tendency to interpret new evidence as confirmation of one’s existing beliefs or theories.
Basically, we just search out information to support our existing opinion, while ignoring or discrediting everything else.
In the Digest-reader’s case, since he was unable to interpret John’s data in a way that supported his existing belief (apparently, that the market was going to continue selling off), he decided to reject the data entirely … in poetic fashion.
I can empathize with the reader because I’ve done this on countless occasions. When a stock I own begins going in the wrong direction, I often find myself scouring the internet for reasons why the sell-off is unwarranted and will soon reverse, rather than seeking explanations for why it’s happening and may even get worse.
Most of us act in this manner from time-to-time. But it doesn’t make for good investing.
The trader, Mark Harila, puts it this way:
What’s the difference between a pro and an amateur? Professionals look for what’s wrong with a setup. Amateurs only look for what’s right.
***So, what can you do about this?
Well, it starts by asking yourself a question — what’s your sacred cow? What are you certain is going to happen in the market, whether that involves the market as a whole, or a specific stock you own?
Whatever that ironclad belief is, that’s your blind-spot. Challenge it.
For example, last week, we featured an essay from Eric Fry, which included lots of data pointing toward why beloved McDonald’s may not be a great investment right now — and might even make a good candidate for a short-sale.
The day after we published that essay, we received this email from a Digest-reader:
“Anyone claiming MCD is a sell has either the timeframe of a fly or sawdust for brains.”
This reader has an ironclad belief about McDonald’s. But is MCD infallible as a stock?
Of course not.
You only have to go back to the beginning of last year to see McDonald’s falling more than 15% — which would have made a well-timed short-sale nicely profitable.
And keep in mind, nowhere in Eric’s essay did he claim McDonald’s was toxic and should never be touched again.
Nowhere did he claim that McDonald’s might not be the pillar of a great stock portfolio if purchased at a more reasonable valuation with a lightened debt load.
All Eric did was present a well-reasoned, fact-based argument suggesting that McDonald’s is trading 33% above its 30-year average valuation, which makes it vulnerable to a significant pullback.
The reader, who likely owns McDonald’s in his portfolio and doesn’t want to hear this, decided to attack Eric’s position from emotion, rather than evaluate it from reason.
But let’s take it a step further. Do you firmly disagree with an analyst’s position? Great! You might be 100% correct. So, rip it apart. Deconstruct it. Use fact, logic, and data to absolutely decimate the faulty argument.
But don’t blindly disagree simply because it doesn’t fit your preferred narrative. That’s how investors lose money.
***Coming full circle, let’s return to John and his call from back in May
When I told John I was considering writing this Digest, he sent me the following, which I believe is an interesting take on the topic we’ve been discussing today:
I want to remind readers what I knew in May versus what I didn’t know (or what any trader can’t “know”).
I did not “know” that the market would reverse on June 3rd and immediately make a new all-time high price. What I knew was that historical backtesting showed the head and shoulders pattern has a high failure rate, and those failures had a substantial expected return.
If I had 100 patterns like this all lined up, I would take the same bullish action every time. However, I could be reasonably confident the strategy would produce a loss in around 25% of the trades. The reason we do research is to help us to make an informed decision about the market, but it isn’t a crystal ball.
In other words, John was basing his market call on research and statistics, not an existing narrative. Whether or not he personally believed the market was going to rise or fall was irrelevant — the data informed his opinion … rather than his opinion determining his data.
***While I had John’s attention, I asked him what historical backtests suggest may happen in the markets going forward
In short, he told me that the dispersion rate of returns at this point is quite wide. So wide, in fact, that he wouldn’t necessarily recommend anyone try to bank on another 2% upside. From John:
I am still personally very concerned with the S&P 500’s ability to sustain its break through the resistance range of 2,930-2,940 without some improvement in the underlying fundamentals. I don’t recommend any bearish trades yet, but I think a small reversal to the downside or a flat consolidation is likely while investors wait for earnings data to start rolling in at the beginning of July. Hedging strategies like covered calls or some careful entries into dividend-paying stocks make more sense now than really aggressive positions.
Is there anyone out there who feels differently about this resistance point? If so, great — you might be correct, so we’d love to read your thoughts. But before writing in, ask yourself …
Do you disagree based on objective facts or personal feelings?
By the way, I have to brag on John and his partner, Wade. Their Strategic Trader trading service has now posted 91 consecutive closed, profitable put-write trades, with an average annualized yield of roughly 48%. To read more about their strategy, click here.
I’d be remiss to end this Digest without thanking all the readers who do write in, whether agreeing with us or not. We appreciate your time, value your feedback, and love a good exchange, so keep it coming!
Have a good evening,