Yes, I just started this article with lyrics from Guns N’ Roses. Don’t count out a future post entitled, “Welcome to the Jungle.” Both titles are very appropriate springboards for a conversation about financial markets.
One of the overarching themes of my investment philosophy is patience. In the investing game, patience means acting only when opportunities present themselves, and not one moment earlier. Practicing patience, all by itself, can give you a huge edge over other investors because the hardest thing for most people to do is nothing. It’s incredibly difficult for investors to grasp the idea that making a decision to do nothing is just as proactive as making a decision to change something. But as you’ll see, doing nothing must become a regular part of your process if you want to be a successful investor. (For more, see: 6 Rules from 6 of the World's Top Investors.)
If I Can’t Have You Right Now, I Will Wait
As a starting point, I define an “opportunity” as a trade, long or short, where the quantitative and behavioral gravities for a given market align with that market’s fundamental gravity.
The market’s fundamental gravity helps me quantify its economic conditions and how the central bank of that economy is responding to those conditions. Over the intermediate to long term, nothing impacts asset prices more than the fundamental gravity. That said, the other two gravities are critical to identifying trading opportunities. While the fundamental gravity tells me how a market should be trading, the quantitative gravity tells me how it is trading and the behavioral gravity tells me how investors perceive that market.
To earn excellent risk-adjusted returns, year in and year out, you must understand the fundamental gravity for a given market and trade in the direction of those fundamentals, when and only when the quantitative and behavioral gravities align.
I monitor over two hundred markets globally across all four asset classes, and even in a universe that diverse, opportunities don’t present themselves every day just because financial exchanges are open for business. However, experience tells me that if I exercise a little patience, opportunities will present themselves. Let me show you the importance of patience by evaluating the aspect of financial markets that garners the most attention from investors: price action. (For more, see: 7 Stock Buying Mistakes and How to Avoid Them.)
I’m a big fan of Pareto’s Principle, which states that for many events approximately 80% of the effects come from 20% of the causes. This same principle can be used to better understand the price movement of financial markets, because most of the directional price movement occurs during just a fraction of trading days.
The rest of the time, a market’s price movement is simply noise within a trading range. As examples of this principle, consider the price movement of the U.S. dollar and the S&P 500 Index in the first 130 trading days of 2017.
The U.S. Dollar Index has declined 6.2% this year, but as we all know, markets don’t go straight up or straight down. In fact, so far this year, the greenback’s price has moved through four different price regimes on its way to that 6% loss:
Regime 1 - December 30, 2016 - February 2, 2017: -2.5% (22 trading days)
Regime 2 - February 3, 2017 - May 11, 2017: -18 basis points (69 trading days)
Regime 3 - May 12, 2017 - June 14, 2017: -3.1% (23 trading days)
Regime 4 - June 15, 2017 - July 7, 2017: -63 basis points (16 trading days)
The USD has experienced one of its worst starts to a calendar year ever, yet 90% of its losses occurred in just 35% of the trading days. The remaining 65% of trading days were simply noise within the dollar’s trading range.
Everyone’s Favorite Benchmark
Those investors screaming about the U.S. equity market’s “overvaluation” feel as though the S&P 500 Index has rallied unabated all year. However, most of the S&P’s gains occurred during a limited number of trading days. Similarly to the U.S. dollar, the S&P experienced four distinct price regimes on its way to its 8.3% year-to-date gain:
Regime 1 - December 30, 2016 - March 1, 2017: +7.0% (41 trading days)
Regime 2 - March 2, 2017 - May 23, 2017: -8 basis points (58 trading days)
Regime 3 - May 24, 2017 - June 1, 2017: +1.5% (6 trading days)
Regime 4 - June 2, 2017 - July 7, 2017: -20 basis points (25 trading days)
For this market, 84% of the year-to-date gain occurred in the first 41 trading days of the year. The entire 8.3% gain occurred in just 47 of the 130 trading days, or just 36% of the days during which financial exchanges were open for business. Pareto’s Principle, anyone?
As you can see, market prices spend very little time in a directional posture. If you think I’m cherry picking, feel free to randomly pick any market and any six-month stretch of time. While there will be some variability around Pareto’s Principle, what won’t vary is the fact that most of a market’s cumulative return will be earned during just a fraction of the trading days within that timeframe.
The Bottom Line
If just one factor of financial markets, price, wanders rudderless most days, then you can start to see why a multi-factor process doesn’t flash the “opportunity” signal every single day. For superior returns, patience is not a virtue but a necessity. The bottom line is that profits can only be earned when opportunity becomes available, not just when they are desired or needed.
You must have a willingness to do nothing, sit in cash and wait for real opportunities to materialize. If you remain data dependent, process driven and risk conscious, then opportunities skewed in your favor will present themselves. It’s just like Axl Rose says, “… take it slow, it’ll work itself out fine. All we need is just a little patience.” (For more from this author, see: Why Investors Should Be Data Dependent.)