You Don't Have to Guess the Low

 | Nov 13, 2012 | 7:49 AM EST
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"The supreme art of war is to subdue the enemy without fighting." -- Sun Tzu

There is quite a bit of fundamental news pressuring the market this morning.  The battle over the Greece bailout is intensifying, German sentiment readings were well below expectations and the fiscal cliff problem is dominating the news in the U.S. Throw in lousy third-quarter earnings and a deteriorating technical picture and you have a pretty miserable looking market.

There is no shortage of commentary about the many fundamental issues that we face, but little of it is very useful. We know the news flow stinks, but the key question is how do we deal with it? What is most important in this market isn't the news itself, but that we have an effective strategy for dealing with the price action.

There are two basic strategies for dealing with this sort of market. One strategy, which is well illustrated by Doug Kass, is to try to fight the momentum and try to anticipate when a turn will come. Doug has taken the position that "current fears are overblown" and is building his long exposure as a result. He has been averaging down for a few days now and has an opportunity to do so again this morning.

My strategy is pretty much the opposite of Doug's. Rather than try to fight the action and guess when the market will turn, I am going to wait to do any aggressive buying until the price action improves. I haven't been buying lately, which means I don't have to average down and try to make up losses. I can go in at any time and have no heavy baggage to carry when I do. The biggest danger of fighting the market action by using an anticipatory approach is that your timing may be off. If you are off just a day or two you can find yourself sitting on some pretty good losses if the market doesn't appreciate your logic and continues to trend the wrong way.

It has been my experience that most market players fail to appreciate the power of momentum. Market's typically run much higher or go much lower than seems reasonable if you use ordinary human logic. Trying to apply our personal thought process to the irrationality of the mob action and the machines that dominates the market just doesn't work too well. We just aren't dealing with a rational beast.

The biggst reasons I do not like the anticipatory approach to the market is that averaging down has probably killed more traders than any other mistake. If you talk to those who were hurt the worst in 2000 or in 2008-2009 they all made the same giant mistake of trying to guess when the market would make a low. Instead of selling and protecting capital as we trended lower and lower, they would buy more and more and find themselves sitting on bigger and bigger losses when the turn did not come. Invariabley, when you take that approach you will suffer too much pain and end up locking in huge losses with very poorly timed sales.

It is certainly possible that the present market will bounce soon. In fact I'd be surprised if we didn't have some relief rally soon, but that is for trading and not investing. The key to making the big money in the market is catching strong trends and riding them. The only trend we have right now is to the downside.

The most important thing you need to know right now is that you don't have to guess the ultimate market low to make money. What you need to do is to buy only when the action improves and it looks like a change in market character is developing.

Guessing the market bottom is a fun game and a good way to gain some attention, but it isn't the way to make big money. Respect the market action and let it be your guide. It will tell us what we need to know and when a major turn develops we won't have to make up losses and we'll have plenty of time to jump on board. Stay patient and vigilant and you'll do fine.

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