The Van Tharp Institute

October 12, 2005 — Issue #241

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In this Issue:

Feature Article

A Perspective on the Secular Bear Market by Van K. Tharp

Peak Performance Peak Performance Traders Know How to Handle Stress
Trading Tip

On Randomness and Streaks by Van K. Tharp

Listening In Comments from last weekend's Exchange Traded Funds Workshop
Special Report Reports by Van Tharp: Self Sabotage Re-examined, Part One and Two

View this newsletter on-line, or read back issues

 

Feature

A Perspective on the Secular Bear Market

By

Van K. Tharp, Ph.D.

Many people believe I am predicting when I say that we are in a secular bear market.  That market started in 2005 and should continue for another 10 to 15 years.  Can I predict what the market will do next year?  No, the only prediction I’m really making is one of valuations.  By the time this secular bear market ends, we should have the S&P 500 stocks in a very undervalued condition, with single digit price earnings ratios and dividend yields of 5% or better.  However, this doesn’t even mean that the market will go down in price.  We could have prices going up in a highly inflationary environment in which prices double while earnings go up by many times.  This would still produce the highly undervalued situation that one normally gets in a secular bear market.

If you look at the U.S. stock market over the last five years, my statement about a secular (i.e., long- term) bear market relates to what has occurred.  Let’s look at the facts:

  • In 2000, we were in a clear bear market with all the major indices down.
  • In 2001, we were also in a clear bear market with all the major indices down.
  • In 2002, we were still in a clear bear market with all the major indices down.
  • In 2003, we generally had an up year, with the markets gaining about 25%.  But what happened was not as great as you might think.  

    Because even if you made 25% in the U.S. stock market, you still lost money on a world-wide basis because the dollar was down about 40% and the U.S. stock market was one of the poorest performing stock markets in the world.  In 2003, for example, you could have made 50% in Europe, 50% in Asia, 38% in Latin America, 37% in the emerging markets index (and that was for just the last 8 months for which I have data), and even 39% in Japan, which has been in a major recession/depression for ten years.

     

  • And in 2004-2005 the U.S. markets have been relatively flat, although you could have made lots of money by being in the right sectors.

The bottom line is that the U.S. stock market has not been a great place to be during the last five years.  And because we’re in a secular bear market, I’d expect that to continue for a while.

Incidentally, the stock market made a major turn down last week.  I wrote my update on Monday, thinking that we’ll probably have another flat week.  Boy, was I wrong and it was obvious even when the last issue of Tharp’s Thoughts came out.  Most of my long efficiency stocks lost money, while my short efficiency stocks made good money.  Last week, the overall profile of the market shifted from 60% positive efficiency stocks to 40% positive efficiency stocks in just one week.  And as of today, I’m now 46% long and 54% short in my portfolio.

However, not everyone sees it this way.  For example, Louis Navallier, in his $5,000 investment newsletter, comments as follows:

“Ouch! Last Tuesday, Wednesday and Thursday was pure profit-taking by unscrupulous traders. In fact, this three-day sell-off was almost identical to the three-day sell-off we saw last April. Just as April was the best buying opportunity that we had in the past several months, this week will be looked back on as another great buying opportunity.”

Now I understand.  It’s the fault of  “unscrupulous traders!”  (I’m being facetious here, of course.)  Once again, my goal in writing this is just to help you SEE what is going on.

 

Peak Performance Training

The Peak Performance Home Study Course

When people are over stressed, their capability of doing things well shrinks dramatically. It’s directly related to what happens to the brain.

During stress, the hormone adrenaline is released into the bloodstream. This has the effect of diverting blood from the brain to the major muscles of the body. It means that you can run faster, but it also means you are much less effective at processing information. In fact, the conscious mind, which normally has the capacity to process seven chunks of information, shrinks down to the point of being able to process only one or two chunks of information.

Think what that means to most investors and traders. They get stressed— either by the market or by something going on in their lives—and can no longer effectively function. They either freeze or keep repeating what they are already doing—only with more energy. Neither response is healthy in today’s fast markets.

One whole volume of Van Tharp's Peak Performance Home Study Course is devoted to stress management. You’ll learn how to measure your stressors and your stress protectors. More importantly, you’ll be able to add enough stress protection so that you can withstand the effects of today’s markets. But the course also helps you deal with stress in many more ways.

 

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Trading Tip: 

Trading Tip

On Randomness and Streaks

By

Van K. Tharp, Ph.D.

One of my favorite books is Fooled by Randomness by Nicholas Taub (Amazon.com).  I’d suggest that you purchase it and read it cover to cover several times.  The major theme of the book is that people totally fail to understand randomness – even logical, educated people.  In fact, sometimes logical, educated people can be fooled even more than the non-logical, and uneducated.

For example, last week in an article by Chuck Branscomb, you learned that good traders learn to tolerate long losing streaks, including making 12 losses in a row.  We got several comments on that one.

Here is one of them:

You say that a winner still knows that he's a winner even after an expected 12 losses in a row. Who in his/her right mind would "expect" 12 losses in a row?

 

If a system is designed to win 50% of the time, the chances are only 2 in 10,000 of getting such a result if the system is performing as expected.

 

Even if the system is designed to win only one out of ten (and presumably make more than enough on the one win to make up for the nine losses), the probability of 12 losses in a row is still less than 50/50 at only 28%. Getting a result like 12 losses in a row would more than likely mean that the system is not working as intended.

 

I understand the intent of your statement, but show me a person who "knows" that he/she is a winner with a system that loses 12 in a row, and I would like to see that system ... so that I can take the other side of the trades.  

My guess is that the author of this letter is very intelligent and understands quite a bit about probability.  For example, he was able to illustrate that the odds of 12 losses in a row with a 50% system are only 1 in 10,000.  He’s a little off — it’s actually 0.000244.

However, his calculations were based upon making 12 losses in a row in 12 trades with a 50% system.  What if you make 100 trades each year?  Or what if you are a short-term trader and make 1000 trades each year?  Then the chances of a long losing streak are quite large.

For example, I did 20,000 Monte Carlo simulations of 100 trades with systems that are 25% correct; one that is 50% correct, and one that is 75% correct just to see what the losing streaks might be.  What I found is shown in the table below. 

  • The first column is the win percentage of the system.
  • The second column shows the length of the losing streak that will occur 100% of the time in this system.  That is, you are guaranteed of having a losing streak that long.
  • The third column shows the average losing streak for that winning percentage.  You have a 50% probability of getting a losing streak this long.
  • The fourth column shows a 10% probability losing streak.  Losing streaks will happen this long 10% of the time if you make 100 trades each year.
  • The next to last column shows a 1% probability losing steak.  In other words losing streaks this long will happen 1% of the time if you make 100 trades each year.  And the last column shows the maximum losing streak in 20,000 simulations of 100 trades.

Losing Streaks As A Function of Winning Percentage of Your System

System % Win

100%

Average

10% Chance

1% Chance

Maximum

 

25%

10

13

18-19

25-26

51

50%

5

6

9

12

19

75%

3

4

5

6-7

9

 

Notice that with a 50% system, you are almost guaranteed to have five losses in a row in 100 trades and you’ll probably get six losses in a row.  If you simply calculated the probability of getting six losses in a row, you’d say it’s unlike because the probability is 0.0156.  You’d conclude that its nearly impossible. 

But it’s not impossible in 100 trades. In fact, it’s almost certain.

In our simulation, we also found that you have a 10% chance of nine losses in a row and a 1% chance of 12 losses in a row.  One percent is unlikely, but not impossible.  And just when you decide it’s impossible, it would probably happen for you.

I don’t have a simulator that will easily do 20,000 simulations of 1,000 trades, which is still quite likely for a short term trader to make in a year.  I will easily have over 1,000 trades this year and I’m not a day trader.  Many of my clients will easily have 1,000 trades each year.  I’m right on about 45% of my trades and I probably have a losing streak as big as 15-20 losses in a row this year.  Some of my students (who are superb traders) frequently report losing streaks as long as 20 in a row.

Most long-term trend following systems are not right 50% of the time.  They are more likely to be right 30-45% of the time.  Thus, the probability of having 12 losses is a row in 100 trades is no longer just a possibility – it’s a distinct probability.

So what does this all mean for you!!!

It simply illustrates the point that the average person does not understand randomness, even the average highly intelligent person.

Second, it says that long losing streaks are quite possible.  Most people who insist on being right will typically give up their system, thinking it is no good.  In reality, the system is doing what you probably should expect.

And, lastly it shows the critical importance of position sizing.  If you risk 1% on each trade, then after 12 straight losses you’d probably be down about 10% (i.e., you’d be down less than 12% because you’d only be risking 1% of what’s left after each loss).

Your next trade might be a 20R winner and you’d be up — even after 20 losses in a row.

 

Listening In... 

Comments from last weekend's Exchange Traded Funds Workshop with Ken Long:

"Great Course. Lots of new ideas for trading." John Kelly

"Acquired practical trading strategies that I can employ tomorrow with confidence." Riley Uglum

"Excellent. Good common sense for the person who can only look at the markets after work. Ken is up 100% during secular bear markets (2000-2005). How many people can match that!  Ken does all the work: gives you the systems, tells you how to trade them and then gives you the data through his website." Van Tharp

"Best course yet -- both in quality and quantity of material. Ken is a great teacher!" Jon Collard

"It was quite comprehensive with a good blend of basic background material and application, as well as Ken's philosophy." Joe Pleasants

"Excellent. Provided something for everybody." Robert Hartley

Participate on Van's Trading Forum, a place for traders and investors to share ideas and learn from each other

Special Report

Self  Sabotage - Two Reports of Self Sabotage

Click here to read page one of each report, or to order. 

Do Not Reply to this email using the reply button as the email address is not monitored. Please click this link contact us:  suggestions@iitm.com

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Quote of the Week

"As I grow older I pay less attention to what men say. I just watch what they do."

 ~Andrew Carnegie

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Did You Know...

Van Tharp is featured among Jack Schwager's original Market Wizards. 

The Market Wizards books are cited by top traders as essential reading. 

Here's a direct link to  Amazon if you want to learn more about it. Market Wizards

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Dr. Van Tharp's Trading Discussion Forum
 
www.mastermindforum.com

Ask questions, share ideas, information and feedback with Dr. Tharp and other like-minded traders and investors. 

 

 

 

 

 

 

 

 

 

 

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fx: +1 919-466-0408

Mail: 102-A Commonwealth Court, Cary, NC 27511

 

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