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The Wisdom Of The Chinese Gambler

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Aug 25 2010

This story was first published two days ago in the form of an email sent to paying members.

By Rudi Filapek-Vandyck, Editor FNArena

I never guess. It is a crucial mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.” – Sir Arthur Conan Doyle

I read somewhere that Westerners and Chinese have a fundamentally different response when confronted with a trend. In a betting environment, like for instance the roulette table in a casino, punters from Europe or North America are more likely to bet on the opposing colour winning rather than a continuation of an existing trend. Apparently, Chinese tend to do the opposite.

So let's say red has come up as the winning colour three times in a row. Would you bet on a fourth time red? Or would you now bet on black?

The irony is that from a pure mathematical point of view, it doesn't matter -not one single bit- how many times a given colour has won. Every time the roulette table turns and the ball is injected, there is a 50% chance for either red or black to come out on top; regardless of what happened in the past.

If my memory serves me correctly, the longest uninterrupted winning streak for the same colour in a US casino is 23 times. We can all imagine how much money that particular casino must have made during that streak as gamblers would continue placing bets on the opposing colour, and again, and again, and again. Until they either ran out of money, or simply gave up.

The same situation in a Chinese casino, however, might have forced the casino to shut its doors, or at least stop taking bets for the day.

I can hear some of you thinking: yes, but what are the odds of such a long streak happening? I am certain this is but your Western culture knee-jerk thinking kicking in. Surely, Chinese gamblers are making equally as much money by betting on the same colour coming up again next time.

Remember: the odds are 50%, no matter which colour you choose.

When it comes to the share market, I never advocate investors should treat it as a pure odds driven casino environment, though I know many retail investors do. (Good luck to all those who do. You will never find me on your side). I do believe, however, it is simply good practice to keep an eye on the risk-reward balance.

For now, let's stick with how we approach existing trends. When confronted with a negative trend, most stockbrokers respond like gamblers in a US casino. They advise their clients to double up their money and go with the opposing colour. Lost again? No dramas. Simply double up again and stick with the opposing colour.

Given the same choice in the same context, I am more like the Chinese. As I have written many times over in the past years, the trend is an investor's best friend. When the trend is down, as was the case between late 2007 and early March 2009, it does pay off to wait until the trend has been broken.

Sure, those investors who bet against the trend, and managed to pick the correct point of reversal, have been rewarded handsomely. The others, who waited until more certainty was available, have been rewarded less.

However, this conclusion is only drawn in hindsight. It makes heros of those who bought into share markets (and other risk assets) prior to early March last year, and of those who said they should do so, but it omits the fact that many of those same people also tried to pick the point of reversal at several previous stages during the downturn. Nobody ever talks about those many experts predicting in early 2008 it was safe to ride out the “market volatility”, or to stick with Australian banks, of those who were confident that a bottom had been seen (at various pauses in the share market sell-downs) or of those who have called a new bull market since.

I have been very reluctant to put any sort of label on this market since March 2009. What I do know is that share markets go through different phases, and it ain't always up. The period 1982-2007 was characterised by a firm trend upwards, even though it can be argued that US shares have been in a sideways pattern since 1998. (We had two short bull market and bear phases since).

What is casually forgotten by most stockbrokers and other experts is that share markets remained in a broad sideways pattern in between 1963 and 1981. Insofar that in the early eighties most indices were simply back at the same levels where they were some 18 years earlier!

(Incidentally, those readers who attended my presentations in 2008 and 2009 or viewed FNArena's DVD “Which Way Forward?” from 2009 will probably remember this was already embedded in my views back then).

How investors approach such an environment is dependent upon their risk appetite, their horizon and their personal expertise. I suspect the majority abandons buy-and-hold strategies and turns into a shorter term trader or otherwise trend-follower. Those with a longer term horizon, though, better pay attention to sustainable dividends.

As I pointed out in previous analyses, the Australian share market has effectively gone nowhere for twelve months now. In late August last year, the ASX200 reached for 4500, twice, which is some 40 points higher than where the index is right now.

Such long periods of sideways movement are rather unusual, and they can be explained both ways. One thing I know with a 100% certainty is that twelve months of no net gains is not characteristic of a bull market.

In July, many stockbrokers and investment experts advised their clientele to re-enter share markets. No doubt, this was done on the premise that the negative trend in US and Chinese economic data would soon revert.

None of this has happened thus far. (Instead, all the buzz around Wall Street is now “when”, not “whether”, the Federal Reserve is likely to jump into stimulus-action again). Inside the context of my opening sentences, these experts would now be advising you should double up your money and bet on the opposing colour. But what if this proves the mid-point of one exceptionally long streak of same colour wins?

I don't usually quote Robert Prechter, but there's one piece of sage advice he recently provided to investors I thought was very apt for the present market situation. Prechter is among experts who believe the outlook is not for a repeat of the sixties and seventies period I referred to above, but something similar to the TMT meltdown between 2000-2003, or of Japan post 1989, or of US equities in the decade after 1929. Prechter believes the Dow Jones Industrial Average, currently at around 10,200, is ultimately on its way back to 1000 (not a typo).

The sage advice Prechter recently gave to everyone who is skeptical about his forecast, was (not an exact quote): if I am correct and you remain in the market, you're gonna lose big time. If I am wrong and you're not in the market, you will still have all your money.

Consumers are not spending in the US. Companies are not hiring in a meaningful manner. Leading indicators continue pointing to a very weak US economy ahead. Forecasts among economists continue falling. According to some of them, US GDP might have printed a negative result in real terms in July. A growing number of economists is now contemplating a negative GDP number in either of the next three quarters.

It is possible that shares bought today will be worth more in twelve months' time. It is also possible this will not be the case. It is true that those who stick their necks out just before the trend is about to change reap bigger rewards. But investors should be aware the risks are considerable in case of moving in too early.

(Personally, I never gamble – see Sir Arthur Conan Doyle's quote on top of this story).

This story was originally written on Monday, 23 August, 2010.

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