Should a Long-Term Investor Worry About Short-Term Market Trends?

I was going though my personal collection of finance and investing books the other day and picked up William J. O’Neil’s book, The Successful Investor. In this book O’Neil devotes an entire chapter to teaching the skills required to read the market as a basis for entry and exits. In the end what he is talking about is market timing which as long-term investors we know is not generally something we worry about. For each stock purchase I make I am not focused on what is going to happen over the next few months; I am concerned about what is going to happen in the next 15 – 20 years. However, I have also learned that money in the stock market is made when you buy as opposed to when you sell, so I opened my mind to try to learn what O’Neil was trying to teach. So at the risk of offending the true anti-market timers out there, I present what I learned from O’Neil and how I think a long-term investor can use this information.

Which Way is the General Market Going

Most critics of O’Neil suggest that what he proposed people try to do is to figure out what the market is going to do. Instead, I think what he is try to help people do is to help people figure out what the market is doing and invest accordingly. In no way am I defending O’Neil here, but it is clear he is not suggesting people get out their crystal ball and try to predict what the market will do. He is attempting to help people read the market. In the short-term investing world this is crucial.

To summarize in as few words as possible, The Successful Investor’s method to determining market direction is to watch for distribution. Distribution is the opposite of accumulation and both are defined as follows:

Accumulation: When the stock market indexes are experiencing both an increase in price and trading volume. In other words there are more and more investors buying shares in stock driving prices up.

Distribution: When the stock market indexed are experiencing a decrease in prices and an increase in trading volume. In other words, there are more and more investors selling their shares sending indexes down.

The “trick” according to O’Neil is to figure out when the market is finished with its distribution and starts the accumulation phase again by watching the volume and price action very closely. Of course it sounds very easy to do, but in theory it is much harder to figure out when these shifts in the market occur. In the book he goes into great detail on how to do this – if you are interested I would recommend you get yourself a copy.

The next question is how does this apply to us long-term focused dividend investors?

How Does this Apply to the Long-Term Investor

I am interested in this topic because in the past I have been burned many times by buying a stock only to watch it go down shortly after I have purchased it. I am sure many of you are aware of this scenario:

You have been tolling on the analysis of a particular stock for a few weeks, or even months. You have read every news item and press release the company has put out. You examined the earnings and sales closely and have examined all sorts of ratios including debt-to-equity, price-to-sales, payout ratio, and return on equity. You are convinced this is a strong and viable company and decide to buy.

You purchase the stock and then 5 days later the price and the market tanks and you are now in the hole. What if you had just waited a few extra days – you would have bought at a much lower price.

In my opinion, most of the time this decline in price is not because you made the wrong decision to buy the stock. If your analysis process is sound, then the stock is probably just fine. What is more likely is that the market is having some trouble and all stocks are taking a beating. You had purchased the stock when the market was in accumulation mode and the switch to distribution is taking your stock along for the ride down. When this happens even the most seasoned investor is at risk of making a poor emotional decision.

By being a well-rounded long-term investor who understands how the market works, I believe we can reduce the risk of bad emotional decisions. I am not saying we need to predict what the market is going to do. All I am suggesting is that we realize that the market goes through these two types of phases and try to determine which one we are in so that we can mitigate these emotional risks. I suspect that I will be wrong at times, but at least I had tried and knew I was doing everything I could to help my money grow. Doing anything other than that I might be selling myself short.