Money in the Middle

A market spends the vast majority of time rising, falling or trending nowhere. So I start with the notion that, out of the hundreds of days in which I'll hold a trade, there's only going to be one or two of them that actually constitute a top or bottom. From a purely statistical perspective, an investment strategy that banks on being able to pick those few days has the odds stacked against it from the start.

In truth, you don't need to sell the top or buy the bottom in order to make money on a trade. The real scratch isn't made on the top or bottom 20% of a move, but within the vast middle 60%. To that end, the disciplined investor should always opt to play for the big moves — essentially, an overall valuation shift — much more than a simple three-point pop in Google (GOOG) or Amazon.com (AMZN).

The patient approach simply puts the odds on your side: When a big move takes place, such as we saw in technology during the late 1990s, bonds in the early 2000s or commodities in recent years, there's almost always enough gravy so that, one need not buy the bottom in order to make money on the trade.

Moreover, not worrying about catching the bottom allows one to become much more selective. Instead of chasing after every dead-cat bounce, traders should forgo the first few percent and wait for a market to show legitimate signs of strength before putting money to work. In my experience, this philosophy tends to keep one out of the impulsive, whim-driven trades with less-than-ideal probabilities of success. For example, although they have recently come back to life, hundreds of millions were lost calling bottoms in Merck (MRK) and Pfizer (PFE) over their protracted bear rout. The disciplined player lets a security get bullish before he does, waiting for positive price action ahead of committing capital. Truth be told, if you're right in your analysis, the first 10% or 20% won't matter anyway.

Conversely, if I believe a market is overextended or ripe to decline, no matter how bearish I might feel, I'll wait for some price action to indicate that a decline is under way before moving forward and taking a short position. The best example is Nasdaq, which — despite many pundits' revisionist history, didn't exactly plummet from 5000 to 1200 in a day's time. You didn't have to sell the peak on March 10, 2000, in order to preserve capital or even make money on the short side — only to wait until the persistently weak price action confirmed your bearish outlook.

And although trying to buy bottoms (or sell tops) is foolish, millions of pompous SOBs do it, not because they want to actually make money on XYZ, but because they're looking to bolster their own self-image. It's an exercise that's more focused on feeding their ego than their pocketbook — those who do it are looking primarily for a story to boast about at a dinner party or with drinking buddies. If it's accolades and attention you crave, you're better off just buying a Porsche or fancy watch. Over time, trying to pick tops and bottoms will be a much more expensive proposition — with nothing to show for your effort.

Because we only know through the benefit of hindsight if a top or bottom has been made, it's also helpful to make sure the behavioral indicators support a position before you go ahead and pull the trigger on a trade. At the bottom of a market, the security isn't necessarily hated...but virtually ignored. Volume is light, and the major prevailing attitude toward the security is doubt. Even when presented with evidence of strong price action, most investors are uninterested in getting involved. When an idea is working, and the herd isn't involved, it's usually a good bet the trend hasn't yet run its course.

On the other hand, by the time a market has reached the top 20% of its move, the herd has usually picked up the torch, glorifying the trade's unbridled potential on message boards or in the pages of glossy financial magazines. Volume, once sleepy and intermittent at best, is now significantly higher, and a security that once traded a few thousand shares a day might now do a million or more. By this late date, mutual fund companies and other financial intermediaries are probably just starting to roll out a bevy of new products specifically designed to target that particular sector or asset class, and the general tone amongst investors is that taking a position is safe, with perfectly plausible fundamentals supporting the bull case. When this sort of enthusiasm reigns — while the market's price action isn't confirming the crowd's outlook — is when I run for the exits. The top might not be in. But, chances are, it's close.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held no positions in any of the securities mentioned.