Market Update: Waterfall Declines & the "Prime Directive" of Investing
On occasion, I'll reference what I call the "Prime Directive" of investing and trading...
This seems like another good time to talk about it. With this week's CPI report and yesterday's Federal Reserve meeting out of the way, it appears the markets are taking the next leg down in the ongoing bear market.
It appears that sooner or later we're going to "fill" the "breakaway gap" that was created back in early November:
When that gap is filled - my guess is we'll work our way down to it by the start of New Years - that's when the danger grows of a much steeper "waterfall" decline in early 2023.
If you haven't experienced one before - it can be very traumatic if you're unprepared. While I'm painting an extreme scenario here, I don't want that unprepared investor or trader to be you.
As an example, here's what a "waterfall decline" looked like in the waning months of the 2008 bear market. The major indexes fell about 40% in 3 months' time, enroute to an ultimate bear market bottom in March 2009:
The thing about waterfall declines, they are chaotic - and they go on for days. Everyone hits the sell button at the same time. Then there's a big one-day rally...and then another wave of selling hits.
Companies you thought were safe get caught up in the same outgoing tide, and before you know it, your portfolio has lost a lot more value than you thought was possible.
The reason I say all this.... there's still time to prepare for the growing possibility of such a decline in coming weeks and months.
The best time to sell is early. Waiting until the storm hits is sort of like trying to nail hurricane shutters over your windows (if you live in Florida like I do) while the worst of winds are already blowing through your neighborhood.
The Prime Directive
In the original Star Trek TV series, the prime directive was the "law above all over laws" that guided the voyagers as they traveled the galaxy.
My version of a "prime directive" is similarly the first investing and trading rule above all others...
That prime directive is, quite simply, to keep your losses small.
Keep. Your. Losses. Small.
- If your portfolio is down 10%...it takes an 11% gain to get back to breakeven.
- If your portfolio is down 20%...it takes a 25% gain to get back to breakeven.
- If your portfolio is down 30%...it takes a 42% gain to get back to breakeven.
The deeper the loss, the harder it is and the longer it takes to rebuild your portfolio.
So don't let losses build up without a plan, in the vain hope that a favorite position - currently down, say, 20% - will turn around soon enough. It very well could turn around...but the risk is that it only rebounds after the shares are down 40% or more, at which point the worst damage is already done.
What do I mean when I say "the worst damage"?
The worst damage doesn't happen to your portfolio. It happens to your self confidence as an investor and trader.
That's what bear market bottoms - the true, historic ones - are built from...the combined heartbreak and complete loss of confidence of millions of investors who let their stock losses and portfolio declines get out of control.
If you thought we were already at that point of heartbreak a few months ago in October...just remember that bear markets are funny, terrible things. They plunge - and rebound...plunge, rebound...and plunge some more.
The indexes like the Nasdaq, Dow, and S&P 500 will do it over and over until the revulsion against stocks is total and complete.