David Merkel: Most of the Time, Rules Work ... What About When They Don't?

65% of the time, the rules work.  30% of the time, the rules don’t work. 5% of the time, the opposite of the rules works.

When I wrote that to Cramer in 2003, his comment was that he loved it. To me, this meta-rule about market rules in general expresses how markets work. Re-expressing the three periods:

1) There are rules, and they work most of the time. Value and Momentum strategies work on average. So do many other strategies that work off accounting quality, distress, neglect, company quality, low volatility, etc.

2) But they don’t work all of the time. Sometimes it seems that there is no discernible reward to a strategy, and performance is market-like.

3) But even valid strategies occasionally attract too many followers. Too many foxes versus rabbits, means that foxes will die. During those times, you think that the world is coming to an end, but these times are usually mercifully short.

In early 2000, a lot of great value investors got fired. They had just suffered the worst period of relative performance in a decade, and investors were fed up. Those firings were a sign that things were about to improve for value investing. Near market troughs, qualitative signals occur to show that people are giving up because the rules have been reversed.

What does this mean for us regarding portfolio management? The first and easiest solution is to stick to your discipline no matter what, and ride out the hard times. After all, the rules work most of the time; you will get rewarded following them.

It is like what Max Heine said to Michael Price during Price’s younger days (extreme paraphrase from memory): If you follow this method, you will earn 15% per year on average. One year out of ten, you will look like a genius. One year out of ten, you will look like a loser. Be mentally prepared for that.

And perhaps, that is the main message here. Be prepared, like a good Boy Scout. Be prepared for the days when your strategies, so strong in the past, go dead, or even become corrosive. That is not a reason to abandon strategies that have a strong argument behind them, like momentum, value, etc. It is a time to show courage, and buy the best stocks you can find. Crises test investors, and the best stick to their guns and concentrate on the best opportunities.

The irregularity of the markets exists to shake out market players that cannot handle losses. Those that cannot handle losses had unrealistic expectations. Markets are perverse, and they suck in amateurs near peaks, and the amateurs leave near troughs. They help provide the excess performance of the best.

The second message is to realize there are no strategies that work year-after-year, and that you have to accept years where your normally valid strategies don’t work, or worse, become toxic. Don’t lose heart.

The third message is after a strategy has had a long run of success, don’t be afraid to lighten up. Eventually the evil days come, when the results of investing at high prices relative to value are punished.

Follow the rules, then, and be ready to absorb losses during the fleeting bad times.