Sunday, February 14, 2010

 

Opting out of the "meltdowns"


Up and down cycles are a fact of life in the stock market, and the reason is very simple - human emotion. Investors become caught up in a buying frenzy during the boom times, and panic-sell when the market starts to drop.

Take a look at this chart of the last quarter century or so of the overall performance of the market (the All Ordinaries Index) :

All Ordinaries index history
We see a history of ups and downs including

Some people are still gun-shy about investing in the market following the "meltdown" of the "Global Financial Crisis" - but a chart like this tends to put things in perspective.

To be sure, the bear market of 2008 was indeed precipitous - but crikey! - look at the bull market that preceded it! Surely it's common sense that the steeper and more bullish the uptrend, the more severe will be the "correction" that follows it. Notice how steeply the market rose before the "crash" of '87. And notice also how that rise is dwarfed by the extraordinary bull market throughout 2003 - 07.

In fact, if we were to put a long term trendline on that chart...

All Ordinaries index history with trendline
... we can see that there is an underlying uptrend to the market that is still unbroken throughout its history (or at least as much history as you can get from finance.yahoo.com).

In other words, despite the eternal up and down cycles there is an underlying upwards movement of prices that continues beneath the "noise" of sudden volatile movements. Volatility is to be expected in the stock market - years of very strong returns are almost inevitably followed by dramatic downturns. But history shows that after the downturn has run its course, the market always recovers those losses in the long term. We can't know how long that will take, but we can be very sure that the market will not only eventually recover - but go on to make new highs.

You can't avoid bear markets altogether - but you most certainly can insulate yourself from them (or even profit from them).

I've written elsewhere about how easy it is, using free online tools, to determine in a matter of minutes whether the market is currently rising of falling. Applying just the one very simple technical analysis technique discussed in that article to a chart of the All Ordinaries over the past five years...

All Ordinaries index with simple moving average
... makes it fairly obvious when it was a good time to be invested in the market (blue line above red), and when your money would be better off in cash or some other investment (red line above blue).

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