Much of the recent commentary from experienced Wall Street professionals more or less promotes buying into stock market dips as the right investing approach for handling the current market. My problem with this approach is that, by definition, an investor is buying into a downtrend. Any purchase larger than a small add to a solidly profitable, existing position carries with it high risk. Best case, the investor buying on a dip will make a few extra percentage points on those stocks that snap back. But sometimes stocks don’t bounce back right away—or at all. Sometimes, a dip becomes a drop. And where a drop ultimately ends up is anyone’s guess.

The real issue is: what level of risk are investors taking by buying into a downtrend? Unfortunately, the allure of buying their favorite stock cheaper makes many investors gloss over risk assessment. The stock market is inherently a risky venture. We are risking capital to make money. That very fact should keep risk assessment front and center, but strangely enough when the market is at its riskiest, few assess their true risk.

There are countless rationalizations for downplaying risk. But this one should cut through them all. No one, including the investment legends of the last century, can consistently call market bottoms and tops. Nor can they consistently predict at which point a stock will stop going down. In the 1998-1999 stock market, analysts were continually upgrading their price targets on stocks and recommending investors buy them on the dips. We all know the bubble’s outcome. The old adage “try to catch a falling knife” comes to mind: Nortel Networks topped at 86 in July 2000, a year later it was around $8.00 per share; it went bankrupt in 2009. Nokia topped at 62.50 in June 2000, a year later it was hovering in the mid 20s and is currently around $5 per share. These were both great companies that had outstanding fundamentals.  An interesting but little-known fact: When a great, winning stock finally tops, the number of stockholders typically increases as it drops all the way back down.

Yes, this market will eventually go back into an uptrend, next week, next month, or next year. Who knows? But ask yourself: what is my risk-reward ratio in buying and owning stocks right now—so late in the cycle, not to mention all the volatility—versus owning stocks in a clear uptrend?

There are correct times to enter a position and many more incorrect times to enter one. This is why investors should consult a stock chart before making an investment decision. A chart is factual and removes all outside chatter. It also gives investors context and a perspective from which to better gauge the risk of entry at that particular time. We want to buy right, not cheap. We also want to sell right. Charts help investors do both, more consistently.

But you’re still thinking, “I don’t want to miss the upturn, so I’ll hold my best stocks now and endure the pain.” This was the prevailing thought among most investors in 2000-2002 and in the first part of 2008. I don’t think this correction, should it continue, will be nearly as devastating as those two downtrends, but we are in a downtrend now. And no one is smart enough to know how long it will last or how low the market will go. What we do know by consulting stock charts of the major indexes is that the market is not acting right. And fighting a downtrend can be costly.

As of this writing, I am watching the dozen best, strongest leaders resist this downtrend. They all have phenomenal earnings and sales. Their stories are compelling. However, when the tide is dropping all boats sink. Even that beautiful yacht for sale that everyone wants to own.

In a topping process, the very best stocks do hold up to the last. Unfortunately, that shred of hope—coupled with the market’s cunning ability to appear just good enough to invest in—keeps us interested and owning stocks. Many investors get so focused on the profit side they forget that defense always comes first when dealing with a market that, in the end, always tops all stocks.

As in life, patience (with a good dose of perspective) helps keep difficult situations from turning into despairing ones. Right now, patience is an investor’s best friend.

 

Best Returns,

W. Scott O'Neil

President, MarketSmith Incorporated

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