Why people fail to make money in bull markets

The average stock market investor conspires with his/her inner self to avoid making much money in a bull market. Here are some of the ways people manage to trip themselves up.

1. Trying to get rich quick

Very few people who set out to get rich quick in the stock market actually become rich and the small minority that do succeed do so purely as a result of chance (and will therefore probably not keep their riches for long). This is because trying to get rich quickly causes people to take on too much risk, either via excessive leverage or by investing too much money in one particular trade/investment. In other words, people who are in a hurry to make a lot of money tend not to do a good job of managing risk.

Managing risk involves focusing more on the potential downside of a trade/investment than the potential upside and having an objective method to limit draw-downs in the value of your portfolio. If you do not do a good job of managing risk you will almost certainly lose money over the long-term even if probability is on your side, that is, even if you are buying during a bull market. For example, if you continually bet everything you have on a trade in which the probability of success is 90% you will eventually lose everything. Sure, you will most likely look like a genius for a while, but the one out of every ten trades that happens to be a 'loser' will wipe you out.

2. Watching stock prices too closely

The people who make the most money in a major bull market are the ones who don't pay much attention to the daily, weekly, or even monthly price fluctuations. The best course of action for most people is to keep the big picture in mind at all times, observe the short-term volatility with detached amusement, and take advantage of the periodic buying opportunities that occur when those who are influenced by the short-term swings in the market 'puke up' their shares.

We get the impression that a lot of people these days - people who are not professional stock traders - follow the hour-by-hour or even the minute-by-minute price fluctuations of the stocks they own. But by doing so these people are only increasing the probability that they will make a buy/sell decision based on an emotional reaction to a price change, that is, they are increasing the probability of failure.

3. Trend-following

The 'investing public' is, by nature, a trend follower. By this we mean that it typically does most of its buying after prices have already gone up a lot and ends up doing the bulk of its selling after prices have already fallen by a long way. This is, of course, the opposite of what it should do.

Peter Lynch, one of the most successful mutual fund managers of all time, has said that the majority of people who invested in his fund didn't make money even though the fund's average annual return over many years was excellent. This is because people would often buy into the fund after a period during which large returns had been achieved and then sell after the fund had experienced a brief period of poor performance. 

Further to the above, all the talk during the 1990s equity bull market about the public 'buying the dips' was rubbish. Most of the public's money went into the market during those periods when prices were at their least attractive levels, for example, during the first quarter of 2000.

In a bull market, buying the dips is the right approach. It is, however, difficult to do because it involves going against the trend-following urges that are inherent in most of us. Correspondingly, waiting for prices to move substantially higher (when everything appears to be rosy) before buying is an ill-conceived approach that will result in losses, or mediocre gains at best, even in a bull market. During a secular bull market prices will continue to make higher-highs so those who prefer to buy when everything looks rosy might still be fortunate enough to get bailed out by the longer-term trend. But, the greatest gains will be achieved by those investors who have enough understanding of the big picture and enough courage to fade the periodic sharp sell-offs that happen during bull markets.

The US Stock Market

Current Market Situation

From a short-term perspective stock market sentiment is very fearful right now. For example, the equity put/call ratio was greater than 1 on both Monday and Wednesday of this week, despite the fact that the market did not suffer a large loss on either day (the market actually rose on Monday). This is unusual (an equity put/call ratio of greater than 1 will typically only occur after the market has plunged for several days in a row). However, a major rally can't occur because everyone is still 'long' and mutual fund cash levels are very low (they are now down to 4.4%). That is, there is no buying power waiting to be released. It appears that the only fear in the market greater than the fear of losing money in the next major decline is the fear of missing the next bull market.

Regardless of the 'oversold' extremes being seen in some of the sentiment indicators, we think the next sharp move in the market will be to the downside. This is based on our interpretation of price action. For example, after breaking below support at 870 the S&P500 has traded sideways (see chart below). Whenever a market declines sharply over a few weeks and then enters a sideways consolidation, the next big move is usually to the downside.

Also, on Tuesday the NASDAQ Composite finally closed below support defined by its November pullback low. It tried to move back above this support (now resistance) on Wednesday but was unable to do so. 

Both the S&P500 Index and the NASDAQ Composite Index appear to be on their way to last October's lows. 

By the way, the Australian stock market broke below important support on Tuesday (see chart below) and followed up that breakdown with another 30-point fall today (not shown on the chart). After today's fall the Aussie market is now precariously positioned within a few points of its October low. In fact, most of the major stock markets of the world are currently poised at, or just above, their respective lows from last October. New bear market lows are likely to occur this month.

Gold and the Dollar

Gold versus Gold Stocks

Most gold stock investors (including us) have been surprised by the lack of response of gold stock prices to the recent surge in the gold price. Actually, what has really surprised us wasn't the general lack of response by the gold stocks, but the lack of response by the stocks of those companies that had good leverage to the spot gold price and were reasonably valued prior to the run-up in the gold price. Prior to the recent gold rally the stocks of some of the popular large and mid-size North American gold producers (e.g., Goldcorp, Agnico Eagle, Glamis Gold and Meridian Gold) were priced as though gold were already trading at $450. It is therefore not difficult to explain why these stocks wouldn't rocket higher in response to the gold price moving from $330 to $380. However, in many cases the major gold producers with the greatest leverage to the spot gold price have under-performed over the past 2 months. Also, there has been minimal speculation in the shares of the junior gold companies, the area of the market where the greatest leverage and the best value can be found. Many of the juniors we follow have done very well over the past 2 months, but nowhere near as well as we would have expected given the performance of the gold price.

To gain some perspective on what is happening let's now take a look at some charts showing the performance of gold stocks relative to the gold price over different time frames. 

The first chart shows the performance of the AMEX Gold BUGS Index (HUI) relative to the gold price (London PM Fix) since the beginning of 2002. Over this period the percentage gain in the prices of unhedged gold stocks (as represented by the HUI) was more than three times larger than the percentage gain in the gold price, so gold stocks behaved exactly as they should have behaved. That is, they behaved like leveraged plays on the gold price.

The next chart compares the performances of the HUI and the gold price since the beginning of December last year. Over this period the HUI out-performed the metal, but the out-performance was clearly nowhere near as pronounced as it was over the past 13 months. Furthermore, the last 10% gain in the gold price did not result in any increase in the HUI.

The above charts show that the leverage being offered by gold stocks has reduced over the past few months. This, of course, is something most gold stock investors would already be aware of. This reduction in leverage over the recent past is at least partly explained by the huge gains achieved by some gold stocks during the first half of last year.

The final chart shows the ratio of the Barrons Gold Mining Index (BGMI) and the gold price since January-1966 (the Barrons data is compliments of www.sharelynx.net and Mark L). This chart illustrates that a) the long-term peak in the prices of gold stocks relative to the gold price was achieved way back in 1968, b) the BGMI/gold ratio trended lower throughout the gold bull market of the 1970s and bottomed at the same time that the gold price was peaking in January of 1980, and c) the BGMI/gold ratio has moved sideways since 1980.

The downtrend in the prices of gold stocks relative to the gold price during the 1970s seems counter-intuitive at first blush, but is simply a function of the massive rally in gold stocks that occurred during the 1960s while the gold price was fixed at US$35/ounce. Clearly, during the 1960s the financial markets began to discount the breaking of the official gold-US$ link and the ensuing monetary chaos. Gold stocks did extremely well during the 1970s, but they under-performed the gold price because at least part of the eventual gains in the gold price had already been factored into gold stock prices before the gold bull was unleashed. On a much smaller scale a similar thing happened during the first half of last year.

The green arrows on the above chart point to the times that intermediate-term rallies in the gold price reached a peak. It can be seen that all intermediate-term gold rallies, with the exception of the 1977-1980 rally, ended following a surge in the prices of gold stocks relative to the price of gold. Even during 1971-1975, when gold stock prices were in a long-term downtrend relative to the gold price, there was a sharp move higher in the BGMI/gold ratio before an intermediate-term peak was reached. 

The fact that the latest gold rally hasn't yet resulted in a surge in the HUI relative to the gold price indicates to us that we have not yet reached an intermediate-term peak. If the HUI continues to be held back by the extremely high valuations of some of its components then we would still expect to see rampant speculation in the junior gold stocks before an important peak is reached, but speculation in the juniors has been restrained up until now.

So, why have those stocks that are reasonably valued and offer good leverage to the spot gold price not moved much higher during the recent gold rally? The only explanation that really makes sense to us is that many owners of gold stocks are fearful of a sharp correction in the gold price and are constantly trying to sidestep such a correction. The way the gold price has moved higher ? in almost a straight line with no significant 'backing and filling' along the way ? would tend to feed such fears because straight-line moves are rarely sustainable. 

Excessive short-selling of gold shares does not, by the way, appear to be a factor in the sluggish performance of the gold sector. For example, below we list 10 of the largest (by market cap) gold stocks and the change in the short interest for each stock during the month of January. The total combined change in short interest across these 10 stocks during January was -1.4M, that is, short-sellers were net buyers of gold stocks during January.
 

Current Market Situation

In the latest Weekly Update we mentioned that the premium to its net asset value at which the Central Fund of Canada (CEF) was trading was high, but at 21% it was still below where it was when the gold price was peaking last May. However, on 4th February the premium rose to 30.4%, well above the peak reached last May. 

Below is a chart of the gold price in terms of the euro. Yesterday's closing price for gold was still about 10-15 euros below the trend-line at which every significant gold rally of the past 3 years has peaked, but during Asian trading on Wednesday the price did move up to near the trend-line (gold briefly traded as high as US$390, corresponding to about 360 euros, on Wednesday).

In the latest Weekly Update we cautioned against doing any significant new buying in gold stocks because the risk/reward ratio was no longer particularly attractive. This advice is even more applicable now because, further to the above, the level of risk in the gold market has just moved up a couple of notches. However, unless you have attempted to leverage your gold stock gains by buying on margin or you have all of your money invested in gold stocks (that is, you have no significant cash position), this is not the time to be doing much selling. We might get a sharp pullback in both the metal and the gold stocks, but as discussed above the absence of a surge in gold stock prices over the past month suggests that gold has not yet reached an intermediate-term peak. Furthermore, the junior gold stocks we are interested in are still priced as though gold were trading in the $325-$340 range, so there is no significant valuation risk in these stocks.

If you have been trying to leverage your gains in gold stocks by, for example, buying on margin, then you are asking for trouble and should de-leverage immediately. Note that this would be our advice even if we thought the gold price was going to rise by $100 over the coming week. 

For the newcomers who don't yet have much exposure to the gold sector or, for that matter, anyone who doesn't have much exposure to junior gold stocks, look for opportunities to buy several of the high-potential juniors on weakness. For example, here are a few suggestions with indicative buy levels:
Desert Sun Mining (TSXV: DSM) below C$1.00 
American Bonanza (TSXV: BZA) below C$0.30
Red Back Mining (ASX: RBK) below A$0.38
Cumberland Resources (TSX: CBD) at around C$2.60
Richmont Mines (AMEX: RIC) below US$3.60
Golden Star Resources (AMEX: GSS) at around US$1.75

Gold is trending higher in terms of all the major fiat currencies (with the possible exception of the Swiss Franc). For example, below is a chart of the A$ gold price showing the nice uptrend that began more than 3 years ago. The only problem with this chart is that the current price is well above the long-term uptrend-line. A better time to buy would be after the price has pulled back to near the trend-line.

In last week's Interim Update we canceled the short-term bearish view on the US$ that we'd maintained since 24th January last year. There is a reasonable chance that the Dollar Index will drop to the mid or even the low 90s at some point over the coming 2 months, but the Dollar's short-term upside and downside risks are now close enough to being in balance that holding a neutral view seems appropriate.

Below is a daily chart of March silver futures. Once again silver has dropped to test critical support at around 4.75. It traded as low as 4.70 earlier today (the chart shows the drop to 4.70), but at the time of writing it had recovered to around 4.76. 

Update on Stock Selections

On 5th February Western Copper began trading on the AMEX under the symbol WTZ. Also, if approved by shareholders at a meeting on 20th March the company will change its name to Western Silver. We expect Western to ultimately move much higher and from a technical perspective the stock looks quite good, but it appears to be fully valued at around C$4.20 based on the current silver price. 

We've previously mentioned Wheaton River (AMEX: WHT, TSX: WRM) as a potential future addition to the TSI Stocks List, but in the 27th January Weekly Update said we'd wait until after the recent large acquisition and private placement were complete before re-assessing the stock.

It looks like the recently announced purchase by WRM of a 25% stake in the Alumbrera copper/gold mine in Argentina and 100% of the Peak gold mine in Australia is going to proceed because BHP is not going to exercise its pre-emptive right to buy the Alumbrera stake being sold by Rio Tinto. Also, details have now been released regarding the private placement of new shares being done by WRM to finance the acquisition. After completion of the deal we calculate that Wheaton will have annual revenue of around US$227M, based on current metals prices, with the following split: 55% gold, 31% copper, 14% silver. It will have about 450M shares outstanding, so assuming a stock price of US$1.00 it will be trading at around 2-times annual sales. This is low for a gold producer (in the current market) and high for a producer of industrial metals.

The huge private placement (230M new shares will be issued) is probably going to keep pressure on WRM for a while, but since we will be looking to increase our exposure to industrial metals over the next few months it is a stock we'll keep on our radar screen. 

There are three tech/internet stocks (AVNX, CPTH and SPLN) that have been in the TSI Stocks List for around 2 years but that we no longer follow closely. We will therefore realise the large losses on these stocks (they will be transferred from the Stocks List to the Historical Performance table).

MIM Holdings (ASX: MIM) was stopped out earlier this week for a profit of 32%. We will re-enter MIM if presented with a good opportunity (for example, during a period of severe stock market weakness) over the next several weeks.

Canyon Resources (AMEX: CAU) is suitable for a small speculation below US$1.30. As discussed previously, CAU is a gold company but buying CAU is not a play on the gold price it is a play on the outcome of a court case. If CAU eventually wins its legal battle with the State of Montana and is permitted to proceed with development of the 10M ounce McDonald deposit the CAU stock price would move to at least US$10 and perhaps as high as $20.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://bigcharts.marketwatch.com/
http://www.futuresource.com/