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Jeff Saut: Truth or Consequences?


Admitting mistakes part of succesful trading.

Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stockpicker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future (maybe the real trick is persuading clients of that inexorable truth). Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene."

The aforementioned quote, from the brilliant Peter Bernstein (author, historian, economist, and investor), hangs on the wall of my office, for in this business one is often wrong. But, as Bernstein notes, "Being wrong comes with the franchise of an activity whose outcome depends on an unknown future." Our redeeming feature is that when we're wrong, we're wrong quickly! Or, as stated by William O'Neil:

"The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and (that) costs them dearly."

Indeed, I'm always trying to manage the "risks" inherent with investing (or trading), for as Benjamin Graham stated, "The essence of investment management is the management of risks, not the management of returns. Well-managed portfolioours start with this precept."

And that, ladies and gentlemen, is why I often "wait" on an investment until its share price is at a point where, if I'm wrong, I'll be wrong quickly, and the incidence of "loss" will be small and manageable. To be sure, I'm always considering the consequences of being wrong. This is when risk management lives up to its real meaning. Again, as Peter Bernstein wrote in a recent New York Times article:

"The key word is 'consequences.' I learned this lesson many years ago from studying Blaise Pascal, a French mathematical genius in the 17th century who spelled out the laws of probability more clearly than anyone before him. This was a thunderclap of an insight that, for the first time, gave humanity a systematic way of thinking about the future. Pascal was both a gambler and a religious zealot. One day he asked himself how he would handle a bet on whether 'God is or God is not.' Reason could not answer. But, he said, we can choose between acting as though God is or acting as though God is not. Suppose we bet that God is, and we lead a life of virtue and abstinence, and then the day of reckoning comes and we discover that there is no God. Well, life was still tolerable, even if less fun than we might have liked. Here, the consequences of being wrong would be acceptable to most people. Suppose, however, we bet that God is not, and lead a life of lust and sin, and then it turns out that God is. Now being wrong has put us into big trouble.

...RISK management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal - encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall."

To these "truth or consequences points," I turned cautious on the equity markets in early May. Since then I've been waiting for an anticipated price decline that would produce another good risk-adjusted "buy point" like the ones I identified in late January and mid-March. My downside target zone for the S&P 500 (SPX) has been 1320 – 1330. Consequently, when the SPX entered that zone, I began recommending a "scale-in" buying approach of the indices of your choice. As always, I never buy an entire position all at once, preferring to tranche "in" with three or four purchases.

To me, the set-up looked about right given that the selling stampede, which began on May 20th, was late in the downside skein (they typically last 17 – 25 sessions before exhausting themselves on the downside), as well as the fact that my firm's proprietary oversold indicator was more oversold than it had been in a few years. And, that strategy looked pretty good until last Thursday's "tumble" stopped me out (read: sold) of all my long index recommendations with de minimis losses. Indeed, "If you're going to be wrong, be wrong quickly!"

Subsequently, I said in Friday morning's verbal strategy comments that quarter-end "window dressing" had turned into an "undressing" that caused the D-J Industrial Average (DJIA) to break below both its January and March "lows." I further opined that selling stampedes rarely bottom on a Friday as participants tend to brood about their losses over the weekend and return on Monday in "sell mode." And that is why the mantra of "Never on a Friday" also hangs on my wall; implying that markets seldom bottom on a Friday! Therefore, I "sit and wait," attempting to calculate the next move for trading accounts, for as General George S. Patton said, "Take calculated risks. That is quite different from being rash!"

As for the investing side of the portfolio, I continue to like my recent dividend-yielding recommendations of: Alaska Communications (ALSK), Embarq (EQ), Linn Energy (LINE), Magellan Midstream Holdings L.P. (MGG), Schering-Plough's (SGP) convertible preferred "B" shares (SGP+B) and Wyeth (WYE). For further information on Schering-Plough and Wyeth, please see the research from my firm's affiliate Credit Suisse.

The call for this week: In this business, when you're wrong you say you're wrong. At least, that's what the pros do. Clearly, I was wrong in trying to catch a "falling knife" over the past two weeks! And that wrongfooted strategy was punctuated by last Thursday's Dow Dive, which stopped me out of my "long" index recommendations. This said dive turned out to be another 90% Downside Day (the second since the May highs).

That is, Points Lost equaled 93.5% of the sum of Points Gained plus Points Lost: and Downside Volume equaled 91.2% of the sum of Upside Volume.

Usually following a 90% Downside Day there is an automatic rally lasting two to seven sessions. The fact that the market didn't rally last Friday is not a good omen, but I'll say it again, "Never on a Friday!"

Interestingly, while the DJIA fell to new yearly lows last week, the D-J Transports are nowhere close to doing the same. Likewise, the NYSE, S&P 400, S&P 600, Russell 2000, NASDAQ, Wilshire 5000, etc. are all above their respective March 2008 "lows," causing one old Wall Street wag to exclaim, "Can you spell downside non-confirmation?"

Meanwhile, today is day 29 in the "selling stampede;" and over the past 38 years, I can count on one hand the number of times when such skeins have lasted more than 30 sessions! Plainly, "concern" has morphed into "fear" as the word "crisis" has begun to echo down the canyons of Wall Street. But remember, the Japanese kanji symbol for "crisis" (kiki) is made up of two characters which roughly represent "danger" and "opportunity"! I continue to invest accordingly.
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