In a typical bull market, half the gains are made during the last 10% of its duration. At least, that’s something I read recently. And, if true, it’s a remarkable fact. It means in a 10-year uptrend, you would make half your profits in the first nine years and the other half in the last year.
I was skeptical when I read that. My guess was that you’d make half your gains during the last 20%, not the last 10%, of a bull market. I asked Andy Gordon to run it down. This is what he said:
“Michael, your instincts are pretty good. I checked and found this 10% number was not based on a study but on some recent remarks by Dennis Gartman. Mr. Gartman, who authors the widely respected Gartman Letter, was talking strictly about commodities and not markets in general.
“After talking to you about this, I conducted my own research on a range of commodities to test Gartman’s assertion. None quite made his ‘last 10%’ standard.
“During its 2003-2007 run-up, half of uranium’s gains were made during the last 12% of that period. Gold during its 1976-1980 bull climb was second-closest. Half of its gains were made in the last 15% of the period. But for a slew of other commodities, it took 20%-28% of the total run-up period for the last half of the gains to be made.
“Gartman, it turns out, was exaggerating.”
Even if the gains are made during the last 20%-28% of a bull market, as Andy says, the point is the same. The typical bull market pattern is a curve that begins moving upward relatively slowly but gathers great speed at the end. Like this:
The beginning of a bull market is a slow-and-steady climb. That gives you plenty of time to get in without being too late. My rule is to get in after a price has gone up 20%. The challenge is knowing when to get out.This demonstrates what I’ve always suspected: With some limitations, it is possible to get better-than-average returns by timing the market.
Most investors stay too long and give back all the profits they have made, as well as much of their initial capital investment. But I believe that can be avoided by using common sense and emotional discipline. In other words, by establishing a selling strategy when you get into a market and then sticking to it.
Let me give you a specific example of what happens in a bull market.
In other words, the heaviest investing begins just when prices begin to be overvalued. And that heavy investing is caused, as we know, by “irrational exuberance” (a euphemism for ignorance and greed).Take a look at the chart. You can see that home prices during the last real estate bull market followed this pattern of starting off slowly and rising steeply toward the end. But look, too, at the value indicator: income growth. This shows what I believe is very common in bull markets. The steep rise begins just about the time that prices exceed their fundamental values.
So, to play it ultra-safe, you might make it your selling strategy to start to get out when you recognize that prices are higher than they should be. And you can determine that point beforehand, because you don’t need a crystal ball to measure prices against value.
But let me suggest another strategy. When you recognize that prices are higher than they should be, you start paying closer attention to the market… but you stay in. What you’re watching for is prices to hit a brick wall and start falling. Once they fall 20%, you take all your money out — and you make this a hard-and-fast rule. That way, when the time comes, you don’t have to make a decision. All you do is follow through on what you’ve already decided.
This strategy completely removes emotion from the question of when to get out of a stock or market. And it opens up what you can invest in, since you no longer have to invest only in markets you know a lot about.
A variation of this strategy is to take half your gains once you’ve doubled your money. This suggestion comes from my colleague Steve Sjuggerud, who has given me some of my best ideas about investing through the years.
At this point, you’re playing with “house” money. So you can ride your investment up the chart to multiples of 100% without worrying about a loss if the market disappears while you were sleeping.
Fundamentalists inveigh against market timing because they understand that you can’t predict how high prices will go. But their solution is to take a long-term approach. Buy good companies when prices are cheap, they say, and sell when they are expensive.
The problem with this approach is that it doesn’t prevent you from getting in too early. Individual companies and market sectors can sit idle and cheap for years and years before they “adjust” upward. And all that time, you are not making any profits on your investment.
Momentum investors advise getting in after the market starts to go up, but they don’t have a way to tell you when to get out.
But if you use a combination approach — getting in after prices start moving up and getting out (gradually or quickly) when they rise above their fundamentals — you can have the best of both worlds.
I have been able to apply much of what I’ve learned as a businessman to the stock market. For example, as an investor in private enterprises, I learned a long time ago that the big money comes from riding trends, not buying on fundamentals.
Of course, investing directly in a business is very different than buying a stock. When you buy into a business, you have the chance to learn about it from inside. You can get to know it very well — as well as, or sometimes better than, the people who are running it. You can’t do that with stocks.
Another major advantage of direct investment is control. I rarely buy into a business I can’t control at some level. Again, you can’t do that with stocks.
When you are buying a business, you might not mind paying more than it’s worth if you understand its value — especially if you know that it is positioned to become immensely more valuable because of what you bring to it and because of an anticipated upward trend in the industry.
If you can buy a start-up business for, say, $50,000 and sell it five to seven years later for a million or even 10 million dollars, you don’t worry about paying a 20% or even a 50% premium for it.
Private equity also offers a better chance to sell at the right time. When you know a company and its industry from the inside, you know when it is overvalued — and that’s when you try to sell it.
Buying into a market solely because it is cheap is foolish. But staying in a market solely because it is rising is smart, as long as you have an exit strategy that lets you escape before big losses are incurred.
This holds true in business as well as the stock market.
Let me give you another example of how playing an uptrend works — this time as it relates to uranium and the nuclear power sector.
As you can see from the chart, from 1988 to 2005 the price of uranium ranged between $10 and $20 a pound. Yet nobody was shocked when it climbed past $20 at the beginning of 2005. For one thing, oil and gas prices were rising. And the thriving global economy was gobbling up new electricity capacity so fast that the need for more nuclear power plants seemed inevitable.
That pushed uranium past $30 and then $40. At this point, uranium had doubled. Still, there was talk of prices nearing $50, mostly because China’s ambitious plans to build dozens of nuclear plants were getting a lot of ink in the newspapers.
And that was when prices got detached from reality. Remember, during uranium’s climb there were no actual shortages of the metal. Only talk of future shortages. But prices, instead of stopping or slowing down at $50, sped upward.
The buzz was that uranium had to replace oil. Unsaid was that this was more than a decade away from even beginning to take place. The fundamentals of what was happening on the ground was completely ignored.
Uranium was clearly overpriced but it still took a while for the market to top. When it did peak at $135, it then dropped all the way down to $40.
Fundamentally, it would have made sense to get in at $25 and get out between $50 and $55. But doing it my way would have made much more money.
As I said, my rule is to get in after a price has gone up 20%. And my exit strategy is to take half my gains once I’ve doubled my money… and to get out completely after an investment has topped and gone down 20%.
Using this approach, I would have gone in at $25 and cashed out half my gains at $50. Then I would have let the remaining half of my investment ride uranium all the way up to $135 before I cashed out completely when it hit $118 (20% below its peak).
And I would have doubled my profit AGAIN at the $100 mark. So letting your winners ride, even with a half a stake, can really pay off.
Let’s get back to real estate — a market I’m personally familiar with — and see how playing an upward trend works there.
Countrywide, rental real estate is at 20-year lows. On a fundamental basis, it is very cheap. I’ve been making this case in recent issues of the Liberty Street League newsletter. I’ve explained, for example, that my partners and I are buying properties for six to eight times rental income. In other words, we are buying single-family homes that can be rented for $1,200 a month for between $72,000 and $96,000.
The fact that they are cheap doesn’t indicate that their prices will rise rapidly in the near future. In fact, I don’t think they will. But in very specific micro markets they have been gradually trending up. You wouldn’t know about it by reading the papers because the media covers the major markets, not the little ones that we study. But some of those little markets are moving up because professional investors know what we know: The properties are well priced — so well priced that they are worth owning even if prices don’t go up for another five or 10 years.
And sooner or later, real estate prices in general will start trending up. They probably won’t do so quickly. They will probably follow this same pattern — a slow start and then rapid acceleration just as they become overvalued.
We intend to ride this trend strategically — getting in very slowly now and increasing our exposure as the trend moves up… but then reducing our exposure when the market gets irrational. (And it will get irrational again. I’m confident of that.)
Ninety-nine percent of the people reading this will not invest in rental real estate now or even when prices start moving up by five and 10 percentage points. They will keep their money in zero-percent bank accounts or take long shots on gold futures. They will get in when real estate becomes a big topic in the mainstream press. But that won’t happen until the market is fully priced or even overvalued. In other words, most people won’t get into real estate until I am selling it.
Real estate isn’t the only market sector that’s trending up now but is still fundamentally cheap. So I asked Andy Gordon for his recommendation.
His report was too comprehensive to include here. But you can get the full story on a sector that fulfills my qualifications — and one company in particular in that sector that’s poised for runaway growth.
All you have to do to get access to Andy’s report is sign up for Sound Profits.
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