The stock market: Is it safe to go back into the waters?Article added by Christopher P. Hill on August 13, 2010
Christopher P. Hill, RFC

Christopher P. Hill

Vienna, VA

Joined: January 08, 2010

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Back in 1990, when I worked with one of the nation's leading money managers, he showed me some IRS statistics that confirmed this fact: Less than one out of every 100,000 investors will pay taxes on more than $1 million of stock market gains throughout their entire lifetime.

The two biggest reasons I believe most investors fail to achieve this level of significant long-term investment success are:
    1. They are unable to avoid large losses during Bear Markets

    2. They fail to take advantage of the mathematical advantages the stock market will occasionally provide.
When I refer to mathematical advantages in the stock market, what I am referring to is the fact that:
  • The stock market bears mathematical downside risk
  • The stock market affords geometric upside potential
To help explain this, here is an easy-to-understand example. Let's assume a stock declines from $200 a share down to $100 a share. This creates a -50 percent loss in the value of this stock. However, if this same stock rises from $100 a share up to $200 a share, this creates a +100 percent increase in the value of this stock.

With such an important topic to fully comprehend, take a look at this concept in greater detail.

Mathematical facts and examples
  • If you lose 50 percent, you must gain 100 percent just to get back to even
  • If you lose 40 percent, you must gain 66 percent just to get back to even
  • If you lose 30 percent, you must gain 45 percent just to get back to even
So as you can see, the single biggest threat to your ability to create substantial long-term growth is suffering large losses during major Bear Market declines.

Two real-life examples

Below are two real-life examples from the past decade, where I will illustrate this math using a hypothetical portfolio of $100,000:

Nasdaq example

Nasdaq Bull Market from 1998 to 2000 (approximate figures):
  • Nasdaq increased from approximately 1000 to 5000, or +500 percent
  • $100,000 portfolio grew well in excess of $500,000
Nasdaq Bear Market from 2000-2002:
  • Nasdaq plummeted from 5000 back to 1000, or down -80 percent
  • $500,000 portfolio declined in value back to $100,000
DJIA example

DJIA Bull Market from 2002-2007 (approximate figures):
  • DJIA rose from 7000 to 14000, or +100 percent
  • $100,000 portfolio grew to approximately $200,000
DJIA Bear Market from 2007-2009:
  • DJIA plunged from 14000 to 6500, or -55 percent
  • $200,000 portfolio declined to $90,000
Two key mathematical disadvantages to avoid

So as you can clearly see, in addition to the obvious loss of capital, large losses create two equally important "mathematical disadvantages":

Disadvantage No. 1: Suffering a severe mathematical decline requires geometric growth. As I illustrated above, if your investment portfolio experiences a 50 percent decline in a major Bear Market, you will need to double your money, or gain 100 percent, just to break even.

Disadvantage No. 2: By suffering large losses, you are unable to take full advantage of the geometric growth potential in the Bull Market periods that always follows Bear Markets. The geometric upside growth potentials in the examples above ranged from 100 percent to 500 percent.

How does this relate to today's market?

If we go back to November of 2009, when the DJIA first reached the 10,000 level, it took nearly six months to rise above the 11,000 level. So, it took about six months for the market to increase +10 percent.

However, if you look at the intra-day 1,000 point plunge that took place in early June of 2010, in just three weeks, the DJIA dropped back below 9,700, which amounts to a loss of more than -15 percent.

Don't go back in the water yet

With a market rise that has been accompanied by the weakest internals in history -- particularly the market's volume -- and with the significantly increased volatility as of late, I firmly believe the market is speaking a message that is very loud and clear. Right now is one of the most dangerous times to be an investor who is aggressively positioned in equities.

Yes, up until about a month ago, the market has been slowly climbing higher, largely in one direction. During this slow and steady rise, the volume and volatility have been historically low, and most investors have been lulled into thinking the waters are safe.

However, in the past month, the market has finally reminded us that it will always move in both directions. Furthermore, this past month should serve as an additional reminder that every time the market experiences an extreme movement, largely in one direction (either based on the market's length of time or the market's extreme percentage change), every one of these extreme movements in the market were followed by an extreme movement in the opposite direction.

So, there is absolutely no doubt in my mind that the market is proving, yet again, that just when you think the waters appear to be safe, the most dangerous times inevitably lie directly in front of you. That is, if you are actually looking ahead versus casually floating along the top.

"Come on in, the water's fine"

Given the dangers that I firmly believe still remain ahead, hopefully this helps you understand why I am fully focused on taking advantage of the mathematical advantages that the stock market affords us.

In other words, as the internal condition of the market continues to tell us that swimming in the water contains a high degree of danger, I believe the right thing to do is to remain safely on the shoreline until we feel as if we have the "all clear."

Why do I believe there is a high degree of danger?

Investors have been pulling money out of mutual funds and ETFs (which are similar to mutual funds) at levels that have not been seen since the 2009 Bear Market bottom. In fact, the most recent monthly data available from the Investment Company Institute for May shows an outflow from equity mutual funds of approximately $25 billion, which is the largest outflow on record since the market bottom in March of 2009, when the market experienced an outflow of approximately $27 billion. Similarly, there was an outflow of approximately $50 billion in equity ETFs, which was the largest outflow since October 2008.

So, if you read deeply into the data mentioned above, here is what you can logically conclude:

This recent period of decline was not only accompanied by a historic outflow of money from the stock market, but was also accompanied by the heaviest volume we've experienced since the 2009 Bear Market bottom.

The main reason why this should be interpreted as so negative is because the market's long-term trend has been, and will always be, driven by its long-term trend of heavy volume.

The good news is that we've recently experienced, by far, the heaviest volume trading since the 2009 Bear Market bottom.

The bad news is that almost all of this record volume was created as a result of the intense selling of stocks, rather than a broad-based buying of stocks. The harsh reality is, this is the exact opposite of the kind of volume and market action you should expect to see along the path of a Bull Market pullback or correction.

Is my plan to just kick back, relax, and do nothing? Absolutely the contrary. In fact, rather than sit back and relax on the shoreline, my job can be compared to that of being your lifeguard. In other words, my job right now is to be constantly watching over the waters, with my eyes wide open, and most importantly, keeping a lookout for that wonderful window of opportunity where I can find a high degree of confidence that there is the potential for geometric growth potentials. Like you, I long for the day when I can sound the alarm that I believe the waters are as safe as they be.

How can we succeed in the period ahead?

Looking ahead, I believe that the only investors who truly deserve to be rewarded are the ones who are willing to wait patiently, with the goal of looking to capitalize on the rare opportunity where you can fearlessly plunge into the water. And more importantly, plunge into the water head-first with a high level of courage and conviction, while the others are likely swimming back to the shore in panic and disbelief, screaming something like, "What in the world happened?"

The answer to "What happened?" is simple: The market always fools the majority, and it always will. This is exactly why those IRS statistics prove that only a tiny minority of people actually multiply their money over time through investing in the stock market.

Each of us should be striving to be in this elite group, and things appear to be shaping up very nicely for great geometric upside potentials in the years 2011 and 2012. But for now, stay dry.

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