- The bear market continues to take a toll on the stock market.
- Rules reduce emotion-driving decision-making, potentially improving returns.
- A systematic and objective view can help traders navigate in 2023.
It’s been a lousy year for the stock market. It happens. Stocks don’t go up or down in a straight line. So, the S&P 500 doubling post-COVID meant investors would eventually pay the piper.
And pay her, we did. With a little more than one week to go, the S&P 500 is flirting with a 20% year-to-date loss, mainly because widely owned, high-profile growth stocks are down big. For example, according to Bespoke, six companies (Apple, Microsoft, Amazon, Alphabet, Meta Platforms, and Tesla) have lost a combined $5 trillion in market value this year. Since Microsoft, Apple, and Amazon comprise over 30% of the NASDAQ 100, that market index is down 32% in 2022.
Of course, there have been encouraging bear market rallies, but each preceded another downturn. For the most part, this year’s selloff has been relentless.
Could 2023 usher in better times? Absolutely. If history is our guide, stock prices will eventually find their footing. Individual stocks will bottom before the market, and the market will bottom before the economy.
When? Well, that’s anybody’s guess. Some argue the next bull market’s individual stocks are already emerging. Others argue that we need a lower wave to flush more investors out of the market.
In the meantime, poor economic news will continue grabbing headlines, given unemployment is likely to climb, further stressing credit markets. GDP is likely to contract, taking earnings lower with it. Those narratives will make staying the course tough.
In 2023, a trader’s survival will still require rules and a commitment to stick to them.
Bear market rules for traders
In his daily Real Money Market Recon newsletter, Stephen Guilfoyle explains five rules he’s adopted to keep his head while others are losing there’s. Here they are, followed by my comments.
No. 1: “Understand... The environment is the environment. Neither you nor I can change the big picture. That said, we are far from helpless. Be pragmatic. Trend recognition is key. Be true to what you see. Remove personal bias from interpretation.”
It’s human nature to view the market through our biased lens, but that’s dangerous. We can find arguments supporting any view if we look hard enough. Similarly, we can bend data and draw trendlines until confirmation bias kicks in, leading us to proclaim, “see, I told you.”
Ultimately, profit is what pays the bills, so price matters most. Accept that you have no more control over stocks or economic news than the wind, and you’ll find it’s easier to objectively determine if your thesis is intact or broken and the steps necessary because of it.
No. 2: “Identify... See both threats and targets of opportunity for what they are. Do so in real-time as much as possible. Doing so after the fact still has value. See avenues of approach. Determine upon what ground and how you will defend yourself. The same goes for playing offense. Know your weaknesses. Know your strengths. Know your tolerance. Prepare accordingly.”
The ostrich approach to trading has limited appeal. Don’t ignore the fact that stocks are down, understand why, and you’ll make better profit-friendly decisions. The market always offers risk and reward. If you’re an active trader, it’s your job to objectively analyze risks (to control them) and opportunities (to maximize them). Knowing thyself is key. How you react to information because of your personality can help or hurt your portfolio, so do some soul-searching.
3. “Adapt... Most important. Be flexible. Be what you need to be when you need to be it. There can be no victory without the ability to evolve, without the ability to develop. It is far easier to learn how to accomplish goals if one changes, rather than to try to bend the environment to one's own setup or one's own strengths. The ability to adapt is the single most important character trait I know of that is present in those who do well in difficult places.”
Rigidity is dangerous. If you invest in individual stocks, an unwillingness to adjust to new information can wipe you out.
Case in point: Carvana (CVNA) . In 2020, sales soared because nobody wanted to spend hours in a dealership. Cheap money (thank you, low rates and stimulus) fueled demand and provided plenty of financing for Carvana’s growth despite being heavily indebted and unprofitable. Now, people are returning to pre-pandemic behaviors, inflation has crushed consumers' disposable income, and rapidly rising rates have put Carvana’s financials on shaky footing. The result? Investors unwilling to adapt to the changing environment and anticipate its impact on Carvana have watched in dismay as its shares have fallen from $376 to below $5.
4. “Overcome... Have an exit strategy upon victory and, just as importantly, even in defeat. This item is the personal expression of self-discipline. Having a plan of action that sets a clear path upon multiple outcomes is key. This best removes emotion from real-time decision-making. Never lie, cheat or steal. Create and live by code. Failure to overcome becomes habit, as does persistence, as does resiliency. Clear as a ringing bell.”
Most of the best money managers in history are right less than 60% of the time. Billionaire Jim Simons became one of the richest investors in history with a rin rate similar to a coin flip. You’ll be wrong a lot. If you don’t accept that fact, it will be impossible to overcome setbacks. Accepting your weaknesses is freeing. It allows you to recognize the importance of proactive planning of entry and exit points. It helps you execute because you’ll recognize that your success or failure depends on sticking to your trading plan rather than changing it to assuage your ego. Simons’s success wasn’t because he was a great stock picker. It was because he embraced systematic, quantitative, and rules-based investing.
5. “Maintain... Level head. Carry on with the mission. No celebration. No despair. Act as if this is not your first rodeo. Always act for a reason that you could easily explain to a novice. Stay vigilant.”
Peter Lynch, the famous former manager of Fidelity’s Magellan Fund, said the most important thing about investing was knowing what you own and why you own it. That’s the basis for any good thesis, and a good thesis is important to maintaining a level head when things go awry. It’s also key to another Lynch rule, “if you can’t explain to a 10-year-old in two minutes or less why you own a stock, you shouldn’t own it.”
No one’s immune to emotion, so removing it entirely from investment decisions is unrealistic. Instead, ask, “what’s the root reason I feel emotional about wins and losses?” Doing so allows you to more easily set emotions aside to focus on your rules and thesis.
The Smart Play
It’s easy to make money in a bull market when monetary and fiscal tailwinds forgive every mistake. It’s much more difficult when rising interest rates and a deteriorating economy are your enemies.
An active trader's survival in a bear market requires discipline, a clear understanding of your weaknesses, rules governing your buying and selling, and commitment to your trading strategy.
“I do not necessarily hit for a very high batting average. That said, because I know where I want to go, and know where I do not want to go, and because I believe that I am very good at managing risk, I have had a reasonably decent career…you must know what you are trying to accomplish, and what you are not willing to tolerate. This means very simply, to place a price target and a panic point on every single position in one's portfolio…One rule. No exceptions. Act at price targets and panic points. It's OK to change these levels due to changing information. It's not OK (at least not for me) to sit on my hands at these levels.”
An unwillingness to lose big money on any one trade is one reason for Guilfoyle’s success. He proactively sets a target price and maximum pain point and acts when those levels are reached.
For example, the maximum loss he’s willing to endure in a position is 8%. If he loses more money than that, he takes his loss, freeing up capital for his next idea. He’s in good company. The famous investor William O’Neil similarly cut losses when down 7% to 8%.
Of course, cutting losses can mean missing out on some winners that rebound, but you’ll also avoid big losers. Since the primary trend for most stocks in a bear market is down, using stop losses to limit losing trades is important to surviving it.