Too many investors approach the market with only one thought in mind: "I want to make money." Frankly, that’s never the proper approach to something as risky as the stock market. But in a downtrend, it’s even worse, as the probability of making money is greatly diminished. One of the more common mistakes investors make is to buy or hold onto stocks during a downtrend. Whether out of pride, hope or paralysis of fear, most investors seem to dismiss the signs of a changing market trend.

 

The key to surviving a downtrend is to minimize your portfolio drawdowns by staying out of the market until the environment improves. You never know how far down the market will go before it bottoms, and you can’t assume your stocks will escape unharmed. Remember, a falling tide lowers all boats. It doesn’t matter how good the fundamentals are, or how compelling the story is. We would rather risk getting out a little too soon versus taking a severe hit to our portfolio. Remember, when a portfolio is down 33%, it takes a 50% gain just to get even.

 

Defense should always be the number one priority over making money, which means that your capital preservation strategy must be in place PRIOR to investing in ANY stocks. Following this “defense first” strategy has helped our shop immensely, especially in the bear markets of 3/2000-3/2003 and 2008. People often ask me, "How did your shop know that 2008 was going to be so bad?” We didn't! But what we did know in November 2007 was that the market was starting a new downtrend.

 

We will never argue with a market that is clearly signaling the beginning of a new downtrend. This straight-forward analysis can only be done on a stock chart. A stock chart of the major indexes gives the investor the proper perspective on what the stock market is actually doing at the time as opposed to opinions of what the market “should” be doing. In addition to monitoring the indices, any investor that does not consult a stock chart prior to buying a stock is severely disadvantaged.

 

The good news is that every downtrend comes to an end at some point. Entrepreneurialism is woven into the fabric of our country and is alive and well. As innovative companies give investors new reasons to be bullish, the market will inevitably signal the beginning of a new uptrend. To make sure we are prepared to re-enter the market, we spend this time running our screens, watching Industry Group rotation, and maintaining our watch lists. We sit on the sidelines but stay engaged.

 

We all know how fast the stock market can change its character. The biggest sin is to tune out and then try to re-engage after the market has started a new uptrend. The largest gains are made at the beginning of every new cycle, and the best stocks always break out and move up quickly. The stock market offers phenomenal opportunities to those that are true MarketSmiths—true students. So now is the time to prepare.

 

Best Returns,

Scott O'Neil

President, MarketSmith Incorporated

Follow Scott O'Neil at Twitter.com/WScottOneil