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What We Can Learn from Trading Places

| February 28, 2020
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Market's Got You Worried? - Look to Louis and Billy Ray.

Many of you may remember the 1983 movie Trading Places.  What you may not know is that the movie was inspired by a true story.  In the 1970s, William Eckhardt and Richard Dennis reaped enormous profits taking advantage of the wild commodities markets of that time.  Eckhardt believed that he would be able to teach just about anyone with enough spunk and intelligence how to follow their systems and make money.  Dennis was not a believer so they decided to conduct an experiment to grow commodities traders much like the way they grow turtles in the turtle farms of Japan.

The good news is that Eckhart was successful in training many to become great commodities traders, although at least half did not have the right temperament for the endeavor.  Those who could follow the systems and not let their emotions get in the way did extremely well.  Those who got too greedy or overly fearful ended up finding other pursuits.

You may remember that in the movie, Randolph and Mortimer Duke entered into a bet in which they wanted to determine if their best people were a product of their environment or could be developed through coaching and training.  They decided to see if they could take a homeless man off the streets, turning him into a top performer and take one of their top performers and turn him into a homeless man.  They were successful, but there is more to the story.

The Dukes were planning to get rich by cornering the frozen orange juice market but Louis Winthorpe III (Dan Aykroyd’s character) and Billy Ray Valentine (Eddie Murphy’s character) discovered their scheme and decided to take advantage of the situation.

A fake crop report was delivered to the Dukes showing the crop was bad.  The Dukes and those with mis-information were buying as much as they could while Mr. Winthorpe and Mr. Valentine sold them shares at increasingly high prices.  As soon as the real report came out a selling panic ensued where Mr. Winthorpe and Mr. Valentine started to buy once they felt Orange Juice shares were close to bottoming.  In the process, they were able to dupe the Dukes and send them to the poor house.

The question that arises from this is, “Do we want to be the ones that get overly greedy and excessively fearful like the Dukes or do we want to learn to follow the systems like the successful Turtle Traders from the 1970s?


So how do we know when the selling panic has reached it’s climax?

The chart below shows something called the Market Volatility Index which many refer to as the “fear index”, and tends to top at market bottoms.  As of today, the “fear index” reached a reading of over 49, which it has only reached 2 other times since 2008.  If you look at how well the S&P 500 has done during 12-month periods following a reading of over 40, the average return is over 30%. 

From this chart, someone might determine that buying would be a better option than selling at these levels.

The US Investor Sentiment %Bull-Bear Spread is more of a lagging indicator.  It usually tells us when the market has reached a bottom about a week afterwards when the numbers are published.  As of February 26th this indicator had not reached Strong-Buy levels but it is very likely that it will be firmly in the green by March the 4th.

Looking at the major epidemics from the last 40 years, the average return from the onset of the epidemic through the end of the next 12 months is over 14%.  As you can see, the swine flu gave us the best market performance and the AIDs epidemic gave us the worst market performance.

If the recent market drawdown has left you anxious, you may want to consider this a shot across the bow.  We anticipate more frequent market downturns like this as the 2010s bull market draws to a close and we eventually encounter an economic slowdown.  As always, we want to look at our “Family Index Number” to determine the amount of risk and return we need to take to achieve our goals.  Toward the end of a bull market run, we would caution investors to take some risk off the table and dial things down a notch.

We would also caution investors to avoid “un-diversifying” their portfolios and moving too heavily into the areas of the market which are the most popular.  As can be seen from the chart below, those who stay diversified tend to hold up during all types of markets, while those who shifted to the largest most popular companies of the 1990s (the red S&P 500 block) lost money during the “lost decade” of the 2000s. 

If you adequately diversify a portfolio you will never do as well as the best performing index or investment, but you will also be more protected during the downturns and have a better likelihood of achieving your goals through risk management.

Lastly, we always want to keep in mind that the investment side is only one piece of being financially fit.  Those who focus too much on just the investments tend to run the risk of growing unhealthy in other areas of their finances.

Joe D. Franklin, CFP is Founder and President of Franklin Wealth Management, and CEO of Innovative Advisory Partners, a registered investment advisory firm in Hixson, Tennessee. A 20+year industry veteran, he contributes guest articles for Money Magazine and authors the Franklin Backstage Pass blog.  Joe has also been featured in the Wall Street Journal, Kiplinger's Magazine, USA Today and other publications.


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