Warren Buffett And Weather Forecasts

Barry Ritholtz [8] had an interesting quote from Warren Buffett this morning:

"Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

This quote is crucially important but almost always misunderstood by the "bullishly biased" media/analyst community who use it as as the rallying cry for "buy and hold" advice. However, that is not what Warren is suggesting at all.

Read the last two sentences again very closely. "Sellers" in the near future should be happy with rising prices while "Buyers" should hope for falling prices. This is the very essence of "Sell High" and "Buy Low" which is the basic function of investing for the long term.

However, it is Warren that is right on this one. Most investors, including the vast majority of financial media and analysts promoting products or services to sell, get this one wrong. Rising prices are not necessarily the reason to "buy" and/or "hold." Sometimes, rising prices are a reason to "sell."

The next rule is critical.

"If you don't sell high, there is NO ability to buy low."

In other words, if an individual was invested in the markets when it was rising, if they fail to "sell" on the way up, they have no free capital to "buy" with on the way down. (This assumes that investors have been investing their savings on the way up as well.)

Why Am I Telling You This?

The following is an excerpt from the most recent weekly newsletter. You can subscribe for free e-delivery here. [9]

Over the last several months, the market has been in a broader consolidation trend that has defied the underlying deterioration in overall price action. It is important to remember that the "price" of the market on a daily, weekly, monthly or even a yearly basis is a picture into the "psychology" of the "herd" of market participants that make up the market.

That psychology, as I have shown this many times [10] in the past with the following chart, explains why price often become dislodged from fundamental realities for longer than rational logic would dictate.

[11]

The "buy and hold" psychology is particularly present near market peaks when it becomes assumed that "markets can never go down again." This belief is fortified by strongly trending prices with only relatively minor declines that are quickly reversed as shown in the chart below. The most recent decline in stock prices is barely noticeable when put into context of the market advance.

[12]

However, what is noticeable is the overall deterioration in the price action of the market which is suggesting that the risk of a more substantial decline is rising.

Of course, such a decline should not be surprising given the length of time that the market has advanced without a 10% or greater correction. As shown by the chart below, we are in the 3rd longest advance in history without such a decline.

[13]

The problem for investors is that while many indications, as discussed last week [14], suggest that "profits should be taken from winners and losers sold," most will do nothing as "greed" overtakes logical portfolio risk management practices. Furthermore, with respect to Mr. Buffett's commentary, even if you currently believe that the market will inevitably go higher, if "crops are not harvested during the summer, they can not be replanted following the winter."

Bullish Trend At Risk

For most, knowing when to "sell" is the problem.

While the bullish trend of the market does indeed remain intact, for now, it is extremely noteworthy that the deterioration in the underlying technical structures has gained momentum as of late.

This past Friday, I had a discussion with one of my favorite financial media reporters stating:

"The deterioration that we have discussed over the last few weeks is now becoming more reflected in the overall market action. As shown below, the recent oversold bounce that we saw this week, mostly a short-covering squeeze, exhausted itself at resistance. The downtrend that is being formed, along with a breakdown of the recent consolidation channel, suggests that portfolio risk has risen.

 

It will be very important that the market does NOT violate the 150-dma that has been the primary support of this bull rally since Dec 2012. A failure at that level will very likely dictate a larger correction in in the works of 10% or more.

 

I am recommending my subscribers this week begin to take measures to reduce portfolio risk and increase cash holdings modestly until there is better clarity to the market trend."

The chart below is WEEKLY data. Therefore, it is only the end-of-week closing price that matters. Therefore, it is critical that the market maintains the long-term moving average (red dashed line) by the end of the week otherwise the bullish trend that begin in 2013 will have ended. This would suggest that a larger correction is in process.

[15]

I stated last week that:

"...the markets need to rally and close positive on Friday. Otherwise, the downward pressure will likely continue into next week putting the recent breakout at risk.

 

The collision of the short-term moving average and the bullish trend makes Friday's closing action very important. A closing break below that level could trigger more selling next week."

This additional downside price pressure is what we are seeing today. A break below the long-term moving average, and a close below that level by the end of the week, will likely solicit more selling as computerized trading programs are triggered. The chart below shows the bullish trend that has persisted since the onset of QE3 in December of 2012.

[16]

I have identified potential correction levels given a break of the running bullish trend support lines. The most obvious correction would be down to the lows of January and a failure there would be the October lows following the end of QE3.

As a reminder, it has been a LONG time since the markets have experienced a significant correction, and for investors it will feel MUCH worse. The emotional need to "panic" sell at that point will be high which is where "opportunity" may be realized.

Why We Watch Weather Forecasts

In a recent study of forecasting, it was determined that "weathermen" were the most accurate forecasters three days into the future. The reason to watch weather forecasts is to gauge the possibility of needing an umbrella. However, it is interesting that financial media/analysts never forecasts rain even though "showers" happen on a fairly consistent basis.

Investors, like weather forecasters, should pay close attention to the weather. The technical deterioration, like a storm front approaching, suggests that it is currently "cloudy with a strong chance of rain." As an investor, action should be taken to be prepared to REACT if it does rain. In other words, if we think it MIGHT rain we take an umbrella with us, it doesn't mean that we walk around with it open.

Our job as investors is to navigate the financial markets in a manner that significantly reduces the destruction of capital over time. Learning to identify when market risk is elevated, reducing exposure, and raising capital, gives investors the opportunity to "buy" when prices become cheaper rather than "panic" selling to reduce further losses.

Currently, the markets are sending a very clear warning that a storm may be approaching; maybe you should grab an umbrella just in case.