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What I Learned from Trading: Respect the Trend Part 1
The ongoing debate between orthodox fundamental analysis and technical analysis is a contentious one. Critics of technical analysis liken it to forecasting the future by reading tea leaves. Pure technicians scoff at fundamental investors who buy stocks in an established price downtrend or continue to hold losing positions.

The reality is both fundamental and technical analysis can offer value to a retail investor. Rather than drawing a rigid demarcation line and standing on the side of fundamental or technical analysis, retail investors have the luxury of incorporating concepts from both disciplines. We’re not limited to choosing a particular style box, we can synthesise our own. There are compatible features in both paradigms. Your job as a retail investor is to develop a toolbox of concepts and techniques that leads you to make your best investment decisions for your personality type. The need to be profitable should override any desire to belong to any partisan group.

While the most important tools I use come from fundamental analysis, I incorporate several tools from technical analysis that improve my odds of making a successful investment. The most important tool is is price trend - the overall direction of an asset’s price.

In my last post on this series, I mentioned Van Tharp’s 6 market classifications used to identify the type of market you're currently facing. The first step is knowing whether you're in an uptrend or downtrend. Fairly easy using the eye test, but let's formalise it.

John Murphy in his seminal book "Technical Analysis of the Financial Markets" uses Dow theory to define uptrends and downtrends:

"Charles Dow defined an uptrend as one where each successive rally creates a higher high while each minor pullback creates a higher low. In other words, an uptrend has a pattern of rising peaks and troughs. The opposite situation, with successively lower peaks and troughs, defines a downtrend. Dow’s definition has withstood the test of time and still forms the cornerstone of trend analysis"

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Before I disclose how we use price trend in our long-term investing, let us provide context first. Those who have read our posts already know we run a core-satellite portfolio, with market index funds representing 70% to 80% of our portfolio. The remaining 20% to 30% is allocated to individual growth stocks that we think will outperform the market index. This is a portfolio tilting strategy. If we get some of our picks badly wrong, it's not going to ruin us.

We use our price trend rule only for opening a new individual stock position or buying more units in an existing individual stock in our high growth portfolio. It does not apply to buying more units in our market index or smart-Beta funds (factor or sector funds). It also does not apply if we want to buy income stocks. Although I have to admit that this "buy on an uptrend rule" sometimes will bleed into those purchases from time to time, especially if the broad market is in decline.

Our first step is to identify a quality business that we believe has a lucrative growth runway ahead of it, or a quality business that has suffered a one-time issue and the stock price has sunken to new lows (i.e a fallen angel that still has its wings). we'll only buy an opening position if the company's stock is an an established uptrend. We'll never buy it when the price is trending down because it's likely to get cheaper tomorrow. This is because a trend in motion is more likely to continue than to reverse.

If the price is falling, we won’t attempt to pick the bottom. We’d rather wait for a turnaround in the stock price and buy when a new uptrend has been firmly established. This means we'll always buy at a higher price than the most recent low. We're happy with this rule because an investing process is all about trade offs. You don't get something for nothing. Everything has to be earned. If you think you’re getting a free lunch, it’s because the Pied Piper hasn’t shown up yet. Eventually there's a price to pay. We'd rather pay a few dollars per share more for a quality stock in an uptrend. Trying to pick the bottom of a price decline is a very low probability strategy. Why not wait patiently until there’s evidence the business has improved (or at least sentiment). This will be reflected in the stock price which will have begun its recovery.

For example, here is a stock in a well-estubliehd downtrend. The investor has calculated the stock trades below intrinsic value and is preparing to buy the stock. However, what is the chance that the stock is going to reverse at this point and trend up? Why not wait to see if it gets even cheaper?

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If you wait until the stock bottoms and re-establishes a clear uptrend, you'll be less likely to fall victim to a value trap. Although there's no guarantee, you improve your odds of success if you wait until you buy on an uptrend. You’ll also save yourself the dreaded "buyer’s remorse" if the stock gets even cheaper in the days and weeks following.

In the following example, the declining stock price has already bottomed and the new price uptrend looks promising. You’ll end up buying the stock above its intrinsic value, but if it’s a quality company with an excellent runway for growth, chances are the stock will continue to trade well above intrinsic value. In all honesty, my calculation of a company’s intrinsic value using discounted cash flows is sketchy at best. It’s an art rather than a science. I've often wondered how many retail investors honestly calculate the intrinsic value of a company using discounted cash flows? My suspicion is that most retail investors look at the share price, see that it's trading well below its most recent highs and conclude that it's cheap. An inconvenient truth? I have to admit to doing this when I first started investing 35+ years ago. It was a cheat code for value investing which didn't work very well.

Our preference is to buy at this point, even if the stock is trading above intrinsic value:

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As a behavioural investor, I prefer to buy on an uptrend at the more expensive price rather than buying on a downtrend and likely watch the stock get cheaper. A key characteristic I’ve embraced from the trader’s mindset is I never average down, I only ever average up. If I buy a stock and its price declines, I’ll never throw more money at it. My rules only allow me to buy additional shares if the stock price recovers and rises above my original buy price. This investment policy has saved me from losing a lot of money on some very bad stock picks over the years.

Using price momentum has a sound basis in academic research. The price momentum effect is an investment factor that has demonstrated better-then-market returns. It was first identified by academic researchers Narasimhan Jegadeesh and Sheridan Titman back in 2001.

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Momentum is the tendency for past winners to keep on winning and past losers to keep on losing. This is intuitive: companies that are successfully executing on their business mission get on a roll, whereas companies that are distressed always take time to recover … if ever. In simple terms, momentum works because investors like winners. When a stock outperforms, more investors will gravitate to the winning company in herding behaviour.

Data from the Kenneth French library confirms that price momentum works for both small and large company stocks.

"Of all the potential embarrassments to market efficiency, momentum is the primary one"
Eugene Fama

Long-term value investors can leverage the momentum factor by waiting until a stock price shows clear evidence it has recovered from the downtrend and a new uptrend has commenced. Price momentum applies to both the upside and the downside, so trying to time the very bottom when the price is still in decline can be a fruitless exercise.

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Value investors are always tempted to buy a stock that’ has fallen from recent highs. As the price continues to fall, a value investor might add to an existing position because the stock has only gotten cheaper. However, buyer remorse can set in and even worse, the wisdom of crowds can sometimes be right and your value stock becomes a value trap. This is why I will wait to buy only after I see evidence of a bottoming pattern and a price recovery. With my trader’s mindset, I prefer to average up and buy at the green points rather than average down.

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This doesn’t work all the time. Sometimes I can get caught out with a dead cat bounce, but I’d rather jump in on a rising price than over jumping on a falling price. If I buy a stock and it declines in price, my rules prohibit me from buying below my cost price, even after the price is in a recovery uptrend. I can only buy above my cost price and average up:

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These rules only apply to individual stocks. I’ll happily average down in a market index fund because the market has never failed to recover and reach higher highs. This can’t be said for individual stocks, businesses fail quite regularly. Many survive to only end up being a shell of their former selves. You can tie unproductive capital for many years waiting for the stock to recover back to your break even point. Once again, I'm talking about high growth stocks here and most don't pay dividends. You're not renumerated for waiting.

Here is a real life example of an institution (who shall remain nameless) who issued multiple buy recommendations for a stock in a well-established downtrend. I tracked their recommendations because I knew the stock was in a well established down trend:

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The stock was considered a "value stock" and the consecutive buy recommendations were issued as the stock continued to trade below "intrinsic value". The only problem was the fundamentals of the business continued to deteriorate to the point where solvency began to be questioned (hence the price collapse). The business survived, barely, and 5 years later it still trades below 20 cents per share.

It’s perfectly fine to think the market is wrong about a business and hold a contrarian position. But why try to catch a falling knife? You have the luxury of being patient, waiting it out until the bleeding has stopped. Being humble means you have to sometimes respect the collective opinion of the market. Sometimes the market is right. Value traps are more common than you might think.

If you're a fundamental value investor and managed to get this far without frothing at the mouth in anger, congratulations. You have the open mind and disposition to at least consider a contrarian opinion. Investing is all about trade offs and preferences. You don't have to agree with this concept, but being aware of an alternative idea and opinion will have already made you a better investor.

True story: I once did a talk to a private retail investor group presenting this very concept. The group was primarily a fundamental value investing club and I was presenting what I believed to be a well-considered, alternative opinion about opening a new position in a value stock. I was skewered by the alpha personalities of the group and I had to cut my presentation short. They were obviously not looking for someone to present new ideas and alternative opinions, they just wanted confirmation bias of their priors. Suffice to say that was the end of my desire to speak to other investor groups. Thank you for reading.
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