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A book which examines the psychology of market cycles.

The Craft of Investing
by John Train

( available from Amazon)



See if you can spot where we are...

The Washout: "All Is Lost!"

A convenient place to begin our circular tour is bobbing around in the
pool at the base of the waterfall: In the depths of despair in a bear
market-1957, 1962, 1966, 1970, 1974, 1978, 1982, or 1987. Stocks
have just declined 35 percent, say, sliding several percentage points a
week for months on end. Near the end of the slide many famous issues
have been cut in half with terrifying speed.
At a major bottom, current business news is usually terrible, and
many authorities feel that things are likely to get even worse. There are
several spectacular bankruptcies, of international importance. Unem-
ployment is usually up. There is usually some grave unresolved na-
tional problem that is bothering everybody.
The brokerage business itself is likely to be in the dumps, with
many bankruptcies. Big "producers" of the up years have to cut back
on their lifestyles. Wall Street's own desperation reinforces the syn-
drome.

When in a market collapse everything finally caves in during a few
catastrophic days and weeks, there is an almost audible flushing effect.
Stocks are hurled into the abyss, like the cargo of a sinking ship that
the crew is desperately trying to save. Value means nothing.
About this time, if you go to a cocktail party, you will meet that ir-
ritating figure Faunty Smugg, who smoothly assures you that he hasn't
owned a share for six months. A social broker you sometimes encoun-
ter, Pete Pusher, claims that he has gone short in all his accounts.
Eventually, though, a point is reached where everybody who can be
scared into selling has sold. The professionals, who have been hovering
overhead, so to speak, and the institutions, who always have a few
billion dollars to spend, accelerate their buying, and finally an equilibrium is reached between the buyers and the sellers. Usually, the final battle occurs in a few days of extremely high volume - a selling climax. The ordinary investor, who has gone over the waterfall, is groggy, bruised, and sick, his ears ringing. He does not want to hear
about stocks, never again. The few professionals and institutions have the field pretty much to themselves. What they buy goes up, since there are almost no sellers left.
Then, some weeks later, the old lows are quietly tested on modest volume, but it doesn't attract much attention. Experienced investors are confident that that better weather lies ahead.

It's odd, but major bottoms are almost never a spike. They have two roots, like a tooth.

Surge: "It's Too Early to Buy. . ."

We are at the beginning of the dynamic phase of the bull
Market, the optimum buying "window' will last for only a few months,
But it is prudent to hold off most of your buying until the market has
clearly turned, and is full and by on the new course. You can usually
recognize when the upward trend has been solidly established. The
professional investor does not mind paying 20 percent more for a stock
that has been cut by two-thirds, to be quite certain that it is not going
to go down a lot more.
The government-shocked by the decline, and as always beset by
clamour to "do something"-pumps liquidity into the economy,
which of course does not take effect instantly. The Wall Street pundits
declare that this time the stimulus isn't working. "It's like pushing
a rope," you hear. In fact, however, the government will get what it
wants, and as soon as its intentions are fully clear, it's time to act.
The months go by and prices rise. The misery of the recent past
is quickly forgotten, like a thorn extracted from your foot. A few mutual
funds will have been started during the bottom area, and articles
in the financial press begin pointing out that the Hercules Fund has
grown 75 percent in six months. One starts hearing extraordinary
stories of people who bought calls on Intertronics warrants and thus
transformed $100,000 into $800,000. The institutional issues, such as
the Dow stocks, make important moves. Volume, however, usually
continues low. The consensus of the advisory services remains cautious. The banks recommend staying in short-term, fixed-income instruments "until the situation has clarified." The brokers, who have to push what they can actually sell, suggest bonds, preferreds, and the like. That, however, is what I call the "yield trap." Most of the time, if bonds are going to do well, stocks will do much better. Indeed,
stocks well bought at such a time will double or triple in the next few
years.

The Surge Continues: "Prices Seem High. . . It's Too Late to Buy"

More months pass, and the market can now be seen to have estab-
lished a rising channel for itself, like a marble rolling from side to side
along a gutter. The Dow oscillates from the top of the channel to the
bottom, but continues in the same broad upward path. Pete Pusher is
quoted in a Wall Street newspaper as expecting one last major down
leg, which will be the time to buy. There will be few significant reactions during this phase of the new bull market.
The rising prices of the principal stocks attract more buying from
the professionals and from institutions who have been waiting on the
sidelines; this additional buying puts prices still higher. The higher
prices, in turn, give confidence to more buyers, who enter the market,
putting prices higher still. The whole system continues to feed upon
itself, to rise and build like a prairie twister.

The general public, during this phase, moves from feeling that it's
too early to buy to feeling that it's too late to buy.

The Second Stage of the Rocket: "Prices Are High, But Maybe It's Okay to Buy. ."

Time passes. Perhaps a year or a year and a half after the beginning,
the public, which has been apathetically watching from the sidelines,
starts to become interested. There are a number of downward legs, or
tests, against the bottom of the market's rising channel. Each time the
test is reversed at a higher level than before. The longer the channel
remains intact, the more it is considered invulnerable. But the more it
is considered invulnerable, the closer it is to a bust.
,Most times there is eventually a pronounced and unmistakable rise
in volume, which then falls off again. Later in the cycle one can usuall
look back and see that this volume bulge appeared approximately two x
thirds of the way up the whole eventual slope. The fervor and the
tempo of the dance continue to mount. The music plays louder and
louder. More and more spectators join in.


Not a Cloud in the Sky: "Buy!"

More months go by, and the public is hooked. Business news is excel-
lent. The "standard forecast" of the economic outlook is optimistic.
Jazzy funds proliferate.
Some particular market area-the major industrials in 1961, the
over-the-counter speculations and hedge funds in 1966, the conglom-
erates in 1969, the sacred-cow growth issues in 1972, the energy group
in 1980, high-tech in 1983, emerging markets in 1993-surfaces as the
center of attention and the focus of a self-confirming myth as the
brokers and professionals bid up these "talisman" stocks to irrational
heights.

The Blowoff: "Stocks Can Only Go Up"

Hot managers become famous. Young, glib, impatient of conventional
wisdom, they collect huge sums from trustful and greedy investors
hoping for miracles. The volume of hot manager trading may become
a significant part of the whole market. They chase new themes as a
pack. It then becomes profitable to jump aboard a trend (in the early
1990s, a new emerging country) instantly, before the less hot managers get hold of it and run it up. This further undermines the quality of
the buying. Brokers get younger and younger, since fresh graduates
swarm into the business, chasing the flood of commissions. Speculations, illiquid securities, "collectibles," commodities, and ventures are
palmed off as "investments." Securities firms specializing in issues of
glamour companies, or hot hedge funds, have long waiting lists for
each underwriting. A broker specializing in froth can sell any stock by
letting it be known that he is in touch with a few big operators who are
getting behind it.
Most new issues, even of companies without a history, or even established management, rise to an immediate premium. At cocktail parties,
people talk excitedly about the latest prodigy. Faunty Smugg's wife ex-
plains they are buying a shorefront house in Newport with the profits
of his last six months' trading. Peter Pusher, the social broker, jumps
into the market with both feet, buying his customers low-quality volatile "story" stocks and as many new issues as he can get his hands on.*

The Nature of Markets

This is what is called a buying panic-the reverse of a selling panic.
It is, however, rarely profitable to jump on board a trend that has
moved more than 10 percent within three months. You are indeed
safer making short-term buys after the market has dropped 10 percent
in two to three months. This is one of the tiny handful of tactical rules
that seems to work quite well.
Why so? Because frenzy feeds on itself. The runaway horses get the
bit in their teeth and gallop faster and faster. However, the runaway
horses do not sprint all the way to Kansas City. At some point most
experienced market operators can feel the surge becoming exhausted,
and will do some buying (or selling) against the main trend, just when
the most inexperienced investors are hopping belatedly on board.


Coasting: "The Market's High, But This Time Is Different. . ."

As the months wear on, stocks hesitate; their upward pace slows, with
only a few leaders making new highs. The market analyst detects this
situation by the loss of "breadth." For instance, the ratio of advances to
declines usually starts falling, even though the leaders are still rising.
Speculative volume tapers off.
And there are also inherent restraining features in a business boom:

1.Inventories eventually reach the point of glut. In the early stages
of a business pickup the entire pipeline-from the mine through
the mill and metalworking plant, all the way to the warehouse
and hardware store-has to be replenished, so factories go on
overtime. (After the peak is passed, the whole pipeline empties
out again, so factories cut back.)

2. The price of raw materials is bid up as production increases.
3. Money costs go up. (In slack times, there are few borrowers, so
rates are low. In a boom, the manufacturer needs more working
capital to finance inventory, and wants money for plant expan-
sion, so interest rates rise. )
4. Labor costs soar as full employment is reached, and the unions,
profiting by manpower scarcity, inerease their demands and get
more overtime.

5.Efficiency drops as older facilities are brought back into produc-
tion and high profits mask operating sloppiness.

Thus, beyond a certain level, more business does not mean higher
profits; about at this point in the stock market cycle that economic fact
is remembered.
A few enthusiasts still claim that this time things are different. They
rationalize that the government has mastered the business cycle, so
that there need not be another downturn; or that there is an absolute
shortage of stocks because of an insatiable institutional or foreign
appetite for them, which will support prices at permanently higher
levels; or that stocks are the only refuge from inflation.

Nonetheless, in a bull market an unlimited volume of securities can
be "manufactured," enough to satisfy everyone's desire to invest, how-
ever strong. "When the ducks quack, feed 'em," said the old-timers.

The Top: "Hold"

At last the government, concerned about economic "overheating" and
stock market speculation, starts "leaning against the wind." The Fed-
eral Reserve raises bank reserve requirements; the discount rate goes
up a notch; margin requirements may be tightened. Here again, the
government gets what it wants, and in time this process always wres-
tles down a runaway bull market.
The insiders, suspicious of stock price levels, step up the sale of
their holdings in secondary issues.
Another few months pass, and we start to recognize the typical
top formation. It often comes in January, on good economic news. A
series of vicious reactions, or chops, begins, probably for the first
time since the cycle started. First, over a six-week period or so the
market falls rapidly, perhaps 10 percent. Then the arrival of belated
"second-chance" buyers halts the decline and puts the list, up to new
highs.
Some time later there is a second vicious chop, which usually bot-
toms at a higher level than the previous one. The recovery again car-
ries to a new high. Those who sold out at the bottom of either chop
feel foolish. Those who jumped in are jubilant. Peter Pusher, the so-
cial broker, says that the Dow is going up another 30 percent, "al-
though selectivity remains- important." If you sell out at about this
point, you probably won't regret it. To push the operation to its limit,
however, you only abandon ship when the successive chops reaching higher levels and start into a downward pattern, with each peak lower than the last one, and each drop going below the one before. The secondary stocks, those not in the leading averages, have been sluggish for months. This is the beginning of the end-a dangerous moment.


Over the Hump: "It's Too Soon to Sell"

The public remains heavily in the market, but the professional inves-
tors are edging out. They have known for some time that the most
conspicuous issues are too high, and are waiting to sell as soon as they
conclude that the game really is over and there is nowhere to go but
down.
It is like the ogre's dinner party, at which the last guests to leave are
eaten themselves. When chairs begin to be pushed back and napkins
placed on the table, the wise diner prepares to dash for the exit as soon
as there's any excuse to do it. This crush at the door is why the market
goes down much faster than it goes up. The lower-quality stocks start
declining significantly.


The Slide: "Prices Are Cheap, But It's Too Late to Sell. . ."

A few more months pass, and a number of issues, although not yet the
leaders, have fallen appreciably from their highs, perhaps 25 percent.
The mass of the market, as measured by a 2000-stock index, or, for
instance, as indicated by the advance-decline ratio, has been going
down for some time. Business news is now felt to be not too good. You
hear doubts about the economic outlook: Perhaps there will be a recession next year?
The market, like a tired horse that no longer feels the whip, drops
on bad news but fails to respond to good news, often governmental
stimulation measures and bullish announcements. Still, the major bro-
kers remain bullish on America. (They have to be, since, like companies in other industries, they have expanded their facilities, and thus
lifted their break-even point, in the preceding boom. )
Faunty Smugg quietly sells his Newport establishment. He lets it be
known that he has taken a few losses, but that things have come down
so far "there's no point in giving up now."

"It's Okay to Sell"

After a while we may see a severe decline, with perhaps 25 percent
marked off the prices of the more volatile issues. There is often a
deceptive recovery, which one might call the "trap rally." It often comes
in March and can last a number of weeks, producing a significant
bounceback in the battered leaders. Some public investors, who were
on the sidelines all the way up, are finally lured in by the lower prices.
The usual sequence is that the lowest-quality stocks collapse first, while
the top-quality issues struggle forward; then the general market starts giving
ground. Finally, the institutional growth stocks let go, and everying starts slipping faster and faster, and indeed many old issues are so far down that the
companies solicit tenders for their own shares, sometimes amounting
to hundreds of millions of dollars in a month.


The Cascade: "Sell!"

Now the river sweeps over the brink, carrying everything with it. A
cardinal point of market strategy, if you are a trader at all, is to get out
before this cascade, even if one has already lost 15 or 20 percent.

Business news is bad. The standard forecast is for more stormy
weather ahead. The hot fund managers have to meet redemptions, but
find out that illiquid securities cari t be sold and depart in disgrace. As
for the margin operators and leveraged funds, their borrowings turn
out only to have hurried them to disaster. (Aggressive managers as a
class lose more money than they make, because you can only raise
money for a ressive vehicles when the pot is bubbling, and the lessons of the previous collapse have been forgotten. This kind of money comes in most readily when the cycle is nearer its end than its beginning. Relatively little money is thus in the aggressive pools of capital on the way up and a lot more on the way down.)


The Selling Climax.
· "The Market's Going Way Down''


The torrent crashes down the falls. In the frightful plunge some stocks give up in a day their gains of a year, and drop 30% in a week.

Pete Pusher urges his customers to sell before the lose everything It
is so sudden and so awful that for a while many investors can’t quite
believe it. When the smallest investors finally throw in the sponge and sell out, it turns up in the newspaper figures as odd-lot short sales. The
man who can't afford to deal in hundred-share lots goes to his broker
so sure that the end is at hand that he sells short seventeen shares, say,
of GE, hoping to buy them back for a lot less after the cataclysm. This
paroxysm of odd-lot despair often takes place right at the bottom of the
market, during what is called the selling climax. Such a climax does
not always occur, but when it does, an experienced investor can feel it
clearly. Fairly often it comes in October. For years I've wondered why.
One possibility is that October is when the crops move from the field
into the barn, and a risky crop loss becomes a solid one on inventory.
So here we are again, four years or so after we started out, half
drowned, bones broken, washed out, all passion spent.
But if you've kept some reserves intact, and have the knowledge to
recognize real value when it's being dumped by panicky, uninformed
sellers, and have the guts to act, then at these moments you can make
the buys of a lifetime. We've had eight economic storms since World
War II. During almost all of them investors became convinced that the
skies would never clear and the sun shine again. But it always does.



Crises

I have mentioned that one should try to determine the main trend of
the market, and then look for buying opportunities during reactions
against that trend.
An infallible formula for this exercise is buying during crises, par-
ticularly war scares. Wars are inflationary, thus they are bearish for
money compared to things, including things represented by stocks in
companies. The immediate shock of a war scare, death of a president,
or other crisis creates an imbalance in the market that forces prices too
far down.
One solution is to buy six-month or one-year calls, if they are rea-
sonably priced. Your broker will have to help you determine that.

**********************************************************************


The Rally Builds Steam
David Dreman 11.27.06, 12:00 AM ET



More From David Dreman



Dangerous Devices
Desperate Acts
Dethroned
Sharp Sabres
America's Largest Private Companies
Complete Contents

Related Quotes
HD 37.72 - 0.38

LOW 30.00 - 0.34








Through late October the 30 big stocks of the Dow Jones industrial average have advanced through resistance point after resistance point to an alltime high over 12,000. The S&P 500 has risen 77% from its 2002 low of 777, to within striking distance of its March 2000 record high. And the widely followed Russell 2000 small-cap index is 29% above its March 2000 level.

The trillion-dollar question today is whether this is the last gasp of a four-year-old bull market that has carried the Dow up 65%, or an upside breakout with a 1,000 points or more to come? My bet is that we are in a solid rally that could gain steam as 2007 progresses. But there will be speed bumps along the way.

First, it's impossible to get a good grip on how far the housing slump will go. The optimists state the decline in new home sales is almost over and home construction will bounce back vigorously both next year and in 2008. That's a hard story to buy because of the strong headwinds that await this important industry. Even if new construction is cut back fairly sharply, there is still a large inventory of new units to work off. With diving house sales, stocks of home builders look cheap today. However, proceed with caution. My fellow columnist Laszlo Birinyi finds several a buy, despite weakening earnings. I'd wait a bit.

Many builders have bought call options on new land. They would argue that they are thus protected if land prices drop because they do not own the land. That's true only up to a point. Call options on land are not free. A 12- to 18-month option to buy land can cost as much as 15% of the property's value. Let that option lapse and you eventually have a hit to earnings for the premium paid.

Investors are also concerned by the collateral damage to the sales of home improvement retailers such as Home Depot (nyse: HD - news - people ) and Lowe's (nyse: LOW - news - people ) if home building continues to slip. In addition, the drop in the price of lumber, copper and scores of other building materials have hurt these cyclical industries, resulting in rising unemployment.

To date, jobless numbers haven't worsened as construction workers have moved over to commercial and other types of building where demand continues to be healthy. While the downturn in home building can still dampen increases in the gross domestic product, it should not send the economy into a tailspin.

Will the slump in housing and commodity prices pressure the Federal Reserve to cut rates anytime soon? Probably not. The Fed is likely to stay on the sidelines for some time before cutting rates, which means that the yields on Treasurys are too low for current conditions. The risk here is what happens if oil, now trending downward, reverses and socks us with a huge price spike--whether through a terrorist action or a geopolitical crisis. The resulting surge in inflation would put the Fed in a box.

On the bullish side, corporate earnings continue to expand briskly and should be up better than 15% this year, and another 10% in 2007. Rapidly rising earnings since 2002 have cut the price/earnings multiple of the S&P to a little over 15 times, slightly below the average P/E over the last 100 years. The important stock indexes have not been so cheap on strong underlying earnings growth and other solid fundamentals since the mid-1990s. That is why, despite qualms about the fallout from housing, we should see a good market ahead. I would continue to buy large-company stocks available at low multiples and high yields.

Here are several ideas to look at now:

Housing will come back eventually. Home-builder stocks may be bear traps for a while. But a safer strategy is to buy home improvement stocks. They are near their 12-month lows, are still growing at low double-digit rates, and are not entirely dependent on new home construction for their sales. Home Depot (36, HD ) and Lowe's (31, LOW )both present good value. Home Depot trades at a P/E of 12, with a 10% growth rate and 1.7% yield, while Lowe's trades at a P/E of 15 with a 12% to 15% growth rate and a yield of 0.7%.

Another cyclical, CSX (38, CSX), the nation's fourth-largest railroad, also looks good, amid the ongoing economic expansion, because of the growth of its coal-hauling business. Coal traffic on this railroad, 23% of its freight volume, is up 7% this year. The still-strong economy has boosted freight volumes for chemicals and other industrial products, too. In the competition between railcars and long-haul trucks, high fuel prices favor the railcars. And, despite the recent pullback, fuel prices now are much higher then they were a few years ago. CSX trades at a P/E of 17 and yields 1.1%.

David Dreman is chairman of Dreman Value Management of Jersey City, N.J. His latest book is Contrarian Investment Strategies: The Next Generation. Visit his homepage at www.forbes.com/dreman.



******************



The long and short of financials
By John Keefe

Published: October 5 2008 20:49 | Last updated: October 5 2008 20:49

All investing has a degree of opportunism to it, and London hedge fund manager Marshall Wace’s announcement of a new financial equities fund, at a time of great weakness in that sector, is no coincidence.

But Amit Rajpal, recently enlisted to head the strategy, believes the financials have timeless qualities as well. “The financial sector is the largest of all verticals in the market, and accounts for 21 per cent of the MSCI World index,” says Mr Rajpal. Moreover, he contends, the long-term potential for alpha creation has been much greater in the financials than in any other sector.

EDITOR’S CHOICE
Hedge fund reinvention is on the cards - Oct-05The Short View: Hedge funds - Oct-02Millions held in hedge funds lockdown - Oct-01Wyser-Pratte fund blocks client withdrawals - Oct-01Hedge industry faces big closures - Sep-28Poor performance fails to dent investor’s strong faith - Sep-21“If you had the benefit of hindsight, and went long the top decile of stocks and shorted the worst decile of the financial domain globally from 1990 to 2007, your annualised return would be 144 per cent per year,” says Mr Rajpal. “And that is market cap weighted. A simple average would be closer to 200 per cent.”

The greater opportunities inherent in financials, on both the long and short sides, come from their built-in leverage. “Financial institutions are inherently volatile,” says Mr Rajpal. “What other industry levers itself by 15 or 20 times, and the market calls it reasonable because we have regulations on capital adequacy? What it means, though, is that even small swings in asset values translate to great swings in equity. This creates the outsized difference in performance, both on the way up and way down.”

Mr Rajpal, 35, came to Marshall Wace from Morgan Stanley, where he was a top-ranked analyst of banks and later headed the firm’s global proprietary equity trading.

The hectic sell-side life has not afforded Mr Rajpal sufficient time to cultivate the indulgent pastimes of many hedge fund managers. “Like every Indian male, I love to watch and play cricket, and I must watch Indian movies, no matter how inane and insane they seem to most people,” he says.

The fund will take a conservative stance: market neutral; distributed across the geographies of the Americas, Europe and Asia; and diversified in 60 to 80 stocks. “There are many opportunities, both long and short, to extract alpha within the financials without taking lots of market risk,” Mr Rajpal says. “We believe that’s the highest quality alpha an investor can achieve.” He expects the portfolio to have an eventual capacity of $5bn (£2.8bn, €3.6bn).

Prospects for achieving the market neutral strategy of the new fund could be dimmed by recent temporary prohibitions against the short selling of financial stocks, imposed on the US markets until October 17, and in the UK until January 16 2009. (Several other European markets are similarly constrained.)

If any bans are made permanent, a regulatory posture Mr Rajpal deems very unlikely, the group would work around them by emphasising markets where short-selling is allowed, and synthesising needed exposures by shorting market indices and buying exchange traded funds on the non-financial sectors.

A hands-on team of four will run the portfolio. Mr Rajpal and three analysts will work from Hong Kong, while a planned senior hire will cover the European markets from London.

While the team will select securities through classic fundamental techniques, they will rely on Marshall Wace’s quantitative infrastructure, known as Tops, for monitoring earnings estimates and market context.

In addition to waging the day-to-day long-short market battle, Mr Rajpal will position the portfolio to benefit from two long-term financial themes: “The fund will have a bias toward the emerging markets,” he says.

“Asia is by far the largest population base, and the leverage embedded in the economies is low. Riding the growth and the pickup in leverage we expect creates a long-term opportunity.”

Conversely, he expects long-term trouble in markets with overbuilt real estate markets. Growth in credit is driven by property prices, and institutions in the US, UK, Spain, Ireland and Australia are vulnerable: they have the highest ratios of loans to deposits and the weakest capital bases.

Mr Rajpal poses another long-term question, on the future of the capital markets-based financial structure of the US. While the framework can be more efficient and draw capital from more sources, it has fewer embedded pools of capital, such as bank deposits.

“Can a capital market-led system survive an asset downturn without becoming effectively nationalised, or converted back to a system based on banks?” he wonders.

Asked for an assessment of the current tumult, Mr Rajpal says it is too early to call the trough on the fundamentals: “We’re watching the rate of change in delinquency formation, but it’s still rising. Only when it stabilises can you predict with some certainty where credit losses will peak, and price that into the stocks.”

Uncertainty notwithstanding, he would prefer to have started the fund sooner, “because the opportunity set is so substantive right now. We all know the big negatives – Lehman, Fannie Mae and Freddie Mac. But there has been a great opportunity for the winners, which have stable deposits and benefit from the flow of cheap money – Wells Fargo and JP Morgan, and a number of regional banks that are doing well.

“In terms of stock prices, we are about 12 months into this crisis, and so far there has been a drop in the ratio of price to book value of 30 per cent,” he adds.

“Even in the most mild of the recent crises in Asia, Scandinavia and Japan, there was a 50 per cent drop in price to book value, and prices took at least 18 months to bottom out. I’m looking for any one of these metrics to tell us that things are starting to stabilise, but we haven’t seen it yet.”