One of the biggest issues we face as traders and investors is the issue of timing our entries into the market, or back into the market following a period of drawdown, as we have experienced of late. This is when the sustainability of our trading system will be fully put to the test, and when we as traders and investors need to have the strength of mind and conviction to trade within the rules of the system.

There is no doubt that the current bear market will eventually end and share markets will bottom out. Share markets may rise immediately or may then consolidate for an extended period of time before the next uptrend or bull market begins again at some as yet unknown point in the future. The question of how to time entries back into the share market will then be at the forefront of everyone’s mind as they try to decide whether or not to re-enter the market, and on what basis.

The problem is that just about everybody has experienced drawdown in their portfolios during the downturn. Not participating in the inevitable rise will guarantee that portfolios remain in drawdown.

In a recent article in the New York Times, Warren Buffet had the following to say about timing the market. It makes wonderful reading and all traders and investors need to give some thought to what Buffet is saying in this article, and to their personal interpretation of his words.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

The full article can be found by clicking on this link "Buy American, I am".

Whilst it is obvious that we can’t and don’t all invest as Buffet does, the important points in this article are the ability to have a set of guidelines to follow for trading and investing in shares, rules for timing your decisions to re-enter the market, and the fact that some exposure to the market in times of absolute fear is not a bad thing.

The SPA3 system covers all these aspects within its overall trading plan. We have a definite and precise set of rules for entering and exiting every trade, our overall timing decisions are based around market risk parameters – buying during periods of low market risk and reducing overall exposure during periods of high market risk. And, depending on the risk profile under which you are trading, perhaps maintaining a reduced exposure to the market even during a bear market in order to be in some stocks when the bear market ends and the market turns up again and thus effectively being ‘first cab off the rank’.

It is important to maintain cool, calm and collected, or put another way, consistent and objective, during these turbulent times in order to be prepared to participate in the ‘good times’ in the share market when they inevitably return. The key is to have a rigorous process that keeps you engaged, even if your exposure is very little or nothing, such that you get a call to action from your system when the market does turn.

Well, we certainly got off to a flying start with the new blog. In this first week we have had nearly 3000 ‘hits’ and there were a healthy number of juicy comments and questions – I thank you all for being so open and active in your postings to the blog. This is exactly how I envisaged this blog would begin to work – as an open and transparent way for you all to have an active role in sharing information, experiences, questions and your thoughts.

A recurring theme from last week was the fact that those of you that are actively trading are experiencing an equity drawdown of varying degrees, so I thought a few comments on understanding drawdowns may be appropriate.

Trading systems will always experience equity drawdowns. No system, regardless of the market in which it operates can continue to show ever increasing equity, without experiencing drawdown or profit give-back at some stage. A Portfolio can potentially spend up to 75% of it’s life in drawdown. It is the severity of the drawdown, and how it is managed that is the most important factor of any trading system. When a portfolio is not in drawdown it is making a new equity peak, which when you think about the All Ordinaries Index, or any index, stock or commodity for that matter, doesn’t happen that often.

Futures market traders are, by nature of the markets in which they trade, much more aligned to an acceptance of equity drawdowns than are the majority of equity traders. This arises for 3 main reasons. Firstly, futures positions are not normally considered to be long term ‘buy and hold’ type investments. Secondly, futures markets tend, on average, to experience trends that are much shorter in length than trends in equity markets. It could be argued for example, that the recent bull market for equities has lasted for anywhere from 3 to 5 years. It is rare to see these excessively long term trends in the majority of futures markets. Thirdly, far more futures traders trade with mechanical systems than equity traders. Mechanical traders expect drawdown as a natural part of their trading because they accept it is a part of their edge.

So, futures traders expect that systems will go into drawdown as a result of the system being out of sync with the direction of the market for periods of time. Overall though, if the system is solid, has well researched entry and exit rules and strict money management rules that provide an edge, it will be in sync with the direction of the market enough to be profitable over the long term.

An issue with equity market traders can be one of expectation and when expectations are not met people experience emotional hurt. Once an uptrend starts and the ‘herd’ get on board, then the expectation becomes that it will continue indefinitely and traders and investors alike will sit back and watch the successful trades roll in and their bank accounts continue to grow. Much as we have seen up until late 2007.

For those that get onto a successful system, such as SPA3, relatively early in the move, the profits are indeed substantial and the traders overall equity expands significantly. When the system gets out of sync with the direction of the market, as will occur with every system, and a drawdown occurs, these traders are more easily able to weather the storm, financially and mentally, as the equity dip is from profit as opposed to investment capital. The problem occurs though for those that began trading the system a few weeks or months prior to the beginning of the drawdown. In this case the losses are either from initial capital, or the profits that they were able to initially make, are quickly eroded. The loss leads to emotional hurt manifested through high levels of frustration, even anger or feelings of betrayal and revenge which, in turn, often ends with the trader deriding the system and even ceasing to trade it altogether. They then move to another method and maybe even different trading instruments until drawdown occurs again. And then they move again, ensuring a lifelong cycle of inconsistency.

The only way to handle the drawdowns that occur within any trading system is to stick 100% to your trading plan so that when the system synchronises with the direction of the market again the portfolio can rise out of drawdown. If it is a robust system that has existed for many years and traded across a wide variety of market conditions then it is highly likely that the drawdown will end and when it does the system will return to delivering profitable trades and consistent profits, eventually making a new equity peak.

SPA3 for example, has returned just under 18% compounded return per annum over the past 7¾ years, compared to just under 4% for the Australian All Ordinaries Index over the same period. This includes -29% drawdown during the -41% 2007/2008 bear market. I know that it is tough when you are experiencing drawdowns because I, like you, am also in SPA3 drawdown. But it is during periods of drawdown that we grow as traders and learn about ourselves and how to trust and surrender to our edge and processes. If you cease trusting your edge as a result of drawdown then what will you trust when the market turns again? I know and trust that the SPA3 drawdown will end with a new equity peak through profits made when the market rises again.

The key to success when trading is not so much what you make when your system is generating profits, but how you mange it and yourself when it is not! It doesn’t matter what happens, it is how you take it that counts.

Whilst the world equity markets continue to display high levels of volatility and irrational behaviour in line with the turmoil being experienced in financial markets, now is a great time to reflect on how these conditions have impacted your own trading and exposure to the markets and how to learn from any mistakes so that they are not repeated in the future.

It is an often quoted line (and one that I am constantly reminding people) that you cannot engage in any trading or investing activity without a predefined plan that will include an investing strategy (or strategies) that is proven to be profitable over the long term. Your strategy can also be referred to as your trading ‘edge’. More will be written about what an ‘edge’ in future postings.

Those of you with a detailed trading plan will, hopefully, have stuck to the rules detailed in that plan and taken the steps detailed in that plan to exit trades as and when the rules told you to do so thereby reducing exposure to a falling market. Your strategy may also include portfolio hedging rules under certain market conditions.

For those of you following the SPA methodology, this simply involves taking the exit signals, as and when they occur and reducing exposure to the bear market. The exit signals are executed without any subjectivity or rationalising of the decision – the positions are simply exited according to the rules within the SPA system.

Those traders who have not acted on exit signals, or became subjective in the decision making process, may now find both the share portfolio’s and the cash amount available to take future signals significantly more reduced than what they should have been! Portfolios can recover from 10% loss trades or even 30% loss trades but large loss trades in the regions of 70% to 95% wipe out portfolios, especially if traded on leverage. There have been plenty of large negative moves such as these in this market even in stocks that were considered fundamentally sound when this bear market started. Proven exit signals using technical analysis is the ONLY way to eliminate large loss trades.

There are many, many lessons that we can all learn from this latest phase in the ongoing saga of the equity markets. From a period of extreme euphoria only 12 months ago, the markets are now in a period of extreme pessimism and capitulation. This too will change, as it always does. With a detailed plan and methodology for engaging the markets we will be able to confidently go about our business and re-engage the market as the world moves on and trading and investing opportunities continue to present and re-present themselves.

I look forward to your comments and input into my blog and hope that it can become a forum for us all to share our ideas, knowledge and experiences.

Gary Stone is a mathematician and computer scientist that fell in love with the markets nearly 20 years ago.

His passion evolved into researching stock markets and developing 3 commercially available Mechanical Trading Systems for short, medium and long term trading for private investors.

Gary has become one of Australia’s most well respected Stock Market educators; based on his research and knowledge of the markets and the results of ShareFinder’s #1 Mechanical System, SPA3.

Gary has also been a regular contributor to Share’s Magazine, Personal Investor magazine, the ATAA, Sky Business News and the ASX Investor Update.

Gary enjoys training ShareFinder customers on the benefits of mechanical trading and personally uses all three ShareFinder products which include; SPA3, SPA3CFD and Long-Term IntellEdgence.

A single figure handicap golfer, a passionate cricketer and marathon runner, Gary is still active in his sporting pursuits.

Since 1995 ShareFinder has been providing mechanical trading solutions to private investors investing in the stock market.

The company’s philosophy is to provide DIY investors with researched and proven tools as well as coaching to out-perform the relevant market index. This has never been more relevant than in ShareFinder’s audited SPA3 public portfolio, which has outperformed the Australian ALL ORDS index by over 14 compounded percentage points per annum since 25th January 2001.

The company currently has solutions for
• Australia
• South Africa

And soon to be
• USA Markets
• London

ShareFinder has mechanical systems for medium and long term investors.

ShareFinder researches and builds the tools while you, the investor, focuses on trading.