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Monday, October 13, 2008

The Dangers of Catching a Falling Knife

Much has been written about the dangers of trying to catch a falling knife. Suffice to say that keep doing this long enough, and you'll end up cutting your own hands eventually. It's rarely a question of if, but when.

In short, trying to catch a falling knife should not be a regular activity, but an occasional activity, when the odds favor the knife catcher.

And it should not be done with margins, but with small amounts set aside for speculation (say 5% capital), as opposed to serious trading or serious investing when one may then swing to another % to be close to fully invested.

Better still, avoid trying to catch a falling knife altogether if you can. There are far better times to do so.


Today, I was shocked to learn that at least one of the regular chatters in my chatbox appears to have had his hands cut quite severely. What surprised me is why he was so quick to go on a margin at this juncture.

Yes, the KLCI has dropped hugely this year. We've gone from a peak of 1524.69 in January 2008, to a low of 926.22 today (lunch time). That's nearly 40% fall from peak. But does this necessarily mean that prices have to stop falling after falling by 40% from peak? If not, why go on margins at this jucture?

Importance of Cash & Asset Allocation

In a falling stock market, it should be obvious that the most important thing is asset allocation. In a falling market our target should be 100% cash, 0% stocks. This allocation is far more important than market timing.

I also appreciate that human nature is such that when we see a lower price, we think it's cheap and we get greedy. But the problem is "Is it the right time to be greedy?". In stocks should one be greedy in a downtrend or in an uptrend? Do you know the difference between a bull market and a bear market from a quick glance at the charts?

If you can tell the difference from looking at weekly or daily charts, then, why go with over 100% allocation in stocks when the market is still bearish?

Do we simply not believe that what is cheap can get cheaper?

Allow me to show you 4 charts to illustrate this.

Chart 1 - 5 year period ending 29 August 1997

Up to August 1997, the KLCI appears to still be on an uptrend over the past 5 years. However, the uptrend line got broken in August 1997, as shown on the chart above. Furthermore, an earlier sell signal was generated twice before that, when the index first crossed below the 200 day MA, followed by the 50 day MA crossing below the 200 day MA. The fall below the uptrend line was the last call to sell.

Yet, the Index has gone from a high of 1332, down to a low of 777.46, or approximately 42% fall.

My question is at 777, is it time to go on a margin and be 100% in stocks?

Let's see what happens if you did this the following month.

Chart 2 - YTD to 29 September 1997

This chart zooms into 1997 YTD. You can see that in September, the market found a new low of 675, before doing a W shape and closed the month as a monthly "doji" suggesting indecision. The 2nd leg of the W shape is higher than the first leg, which is normally regarded as positive, although one would need confirmation from other indicators too.

There are a few issues here. The first is the greedy investor who went 100% last month at say 780. What's happened to him when the KLCI found a new low at 675? Did he have enough cash to buy more at lower prices? No. What was his frame of mind when KLCI went to 675? Probably nervous at the very least, if not a nervous wreck. What was his frame of mind when the KLCI went to 814? Relieved at the very least, but probably still feel a big greedy. Will he sell? My suspicion is that if he's already 100% invested in August 1997, then, he probably wouldn't sell in September 1997.

Chart 3 - YTD to 31 October 1997

KLCI opened 808, touched a high of 845, hit a low of 646, closed at 665.

Remember the investor who went 100% at 780? He's now 115 points down, or nearly 15% negative. What do you think is his daily frame of mind?

Ok. The right side of the chart shows possible "bottom" and possible "support" at around 646.

The question is with 15% negative return, should he "average down" again?

Chart 4 - YTD to 30 November 1997

In November 1997, KLCI opened 672, touched a high of 750, hit a low of 512, closed at 545.

At 545, the loss is a whopping 235 points, or 30% loss!!! What will be his frame of mind?

At the end of Nov 1997, it looks like there is a possible bottom. Is it time to "average down"?

Actually, the Asian Financial Crisis period is a terrible period for investors and greedy traders. The CI ultimately found a low in September 1998 (or 10 months after Chart 4), at 261.33.

It is obvious that what appears low can get lower from these 4 charts.

It is also obvious that if one trades without stop loss, not only will your fingers be cut, but also you could suffer serious, serious loss of wealth, and be in debt, if you play with margins.

There is a time for serious money, and there is a time for pocket money, and there is a time to stay cash.

Never ever forget what kind of time it is at every single day of trading.

In fact, trying to trade every day, or trying to "average down" every day is futile and self-defeating.

My goal in writing this article is to hopefully get you to think about the uncertainty of markets, and the difficulty in predicting bottoms. It's a waste of time and effort trying to predict bottoms. Much better to control your trade, and to cut if your stop loss is triggered.

As for the investors in you who never sells, my only advise is don't be so quick to average down.

Even those of you who are on a 50/50 stock/cash allocations.

It is better to give up bottom, and only go into stocks when it finally bottomed and then goes on an uptrend.

Update: Apologies for the typo errors earlier. This was typed in a very rush manner. Hopefully, the title of the dates are now corrected, and are now consistent with the dates shown on the charts.


Chan Kwang Yew said...

The aim of everybody dealing in stock is trying to get in at the final bottom, the problem is at every low, one is no sure whether that is the bottom. Even 1 month after the index has hit that bottom and has moved up by 10% to 20%, the up is still can be a technical rebound before setting another new low. In September 1997 when CI was at 261.33, there was no way to tell it was the bottom. If thing got worst and the CI dropped to 200, that would be another 30% gone. Even after it has moved up from 261.33 to 300, one was not sure whether CI was on a new wave. Normally it takes months to confirm the wave form. One can make an 'intellegent' judgement, but one can never tell whether the judgement is right or wrong until a later date. But this is basically the reason why the market can exist. At anytime there is always transaction and you can not tell whether the seller is right or the buyer is correct (excluding factor like forced sell, I am talking about genuine buyer and seller)untill many months after the event. This is the dilemma of small fish investing in stock. Big fish is easier, their fund is huge, they buy all the way down (Warren Buffett has started)and then hold and later sell all the way up. From my observation, one's luck do play a role in stock investment. But of course you cannot leave everything to luck.

Seng said...

Hi Chan,

I do agree - as I have mentioned many times in my chatbox - that the bottom is not obvious until one has actually seen it in the charts.

The main point of my article is to NOT go on a margin whilst trying to catch a falling knife. It sounds obvious when presented in that form, but somehow, it seems many still violate this fundamental principle.

In fact, I'm not a fan of margins.

On a minor point, you mentioned "The aim of everybody dealing in stock is trying to get in at the final bottom". Actually, this is not true in a strict sense, even though there might appear to be superficial benefits of doing so. There are actually many types of traders, and many of them don't even want to try to pick bottoms. For example, the wide class of trend following traders do not attempt to pick bottoms, but waits for trends to emerge and they then ride the uptrends. But this is in itself a different topic altogether.