Who's afraid of a bear market?

Almost everyone, but don't expect a crash to scare off day traders. In fact, it might turn you into one.

Published May 30, 2000 7:05PM (EDT)

Recently people have been asking me if the recent NASDAQ hiccup has reduced the number of day traders. My answer? Probably not. Terror is the day trader's best friend.

Day traders say you become an investor when your trade goes very wrong. You buy 1,000 shares, the price plummets and suddenly you start telling yourself that UBID is a "great value" that is sure to rise significantly "over time." But the opposite is also true. An investor can become a day trader when his or her trade goes unexpectedly right.

You buy some obscure stock that your cousin told you about, it quadruples and you can't stand to hang on to it any more, so you take your profits. Now what are you going to do with all that cash? It's already sitting in your trading account. Scores of "bargains" are flashing before your eyes every day. Come on. Just make one trade. One little purchase, just for the heck of it. There you go. Now how do you feel? Not so good, right? A little nervous? In fact, kind of panicky? Look, your stock is already up a quarter point. Little beads of sweat are breaking out on your upper lip. You are mouthing words, but no sound is coming out. That's OK, because now it's time to sell. Go ahead, sell it. Sell! SELL!

Very long-term investors, those who plan to hold their stocks for 20 years or more, can afford to ignore the movement of the market. But for people who might need their money in the next decade, the threat of a sudden collapse is terrifying. Given how much you are going to resent it if half your money suddenly disappears, perhaps you would actually be safer not holding any of those stocks you own overnight. When things head south, you don't want to be the last one out the door. On the other hand, you don't want to get left out when the market bounces. So you buy a few promising candidates and keep one nervous eye on the exits.

Congratulations, you're halfway there.

The following excerpt was adapted from "Dumb Money: Adventures of a Day Trader," by Joey Anuff and Gary Wolf

I started trading during the glory days of the Internet bull market. I quickly doubled my account size due to an extremely fortunate speculation on EBAY, and I entertained myself with visions of growing my low six-figure trading account into a mid-six-figure trading account. Since I was trading the sum total of all the money I'd ever earned, borrowed, swindled or inherited, this felt like quite an accomplishment. I gave myself extra points for having made a small fortune while the business page of the newspaper (which for the first time in my life I read religiously) was warning every day about the dangerous and unsupportable run-up in the prices of Internet stocks.

Sometimes I wondered if it was easier for me than for most people. I had a lot of tolerance for risk and seemed to have an uncanny knack for being at the right place at the right time. There's no denying that I had benefited from luck; but, on the other hand, perhaps luck is a talent like any other. You have to make the best of what you are given, I mused, and I seemed to have been given a gift for brilliant speculation.

During this time, a friend was regaling me with stories about the great money manager John Templeton, whom he had met while researching a magazine story. Templeton, now in his nineties, had almost single-handedly invented the foreign-stock mutual fund. One of his earliest investors, Leroy Paslay, gave $65,500 to Templeton to invest in 1954 and by 1996, Paslay's shares were worth $37 million. The Templeton Growth Fund had an average annual return of 14.3 percent. "Templeton thinks stocks are overpriced," my friend told me, as if he were imparting the secret code that unlocked the treasure chest of unlimited wealth.

I laughed out loud. Fourteen percent? You've got to be kidding. In my first half-year of trading I'd made more than 100 percent. The only times I went wrong were times I stayed away from the trading screen.

That conversation about Templeton, however, bore poisoned fruit, in the form of a 1932 reprint of a 1841 classic about bull markets and their victims: "Extraordinary Popular Delusions and the Madness of Crowds," by Charles MacKay. MacKay's book was one of Templeton's favorites. Since I was just beginning a reading binge about great stock market speculators (in an effort to better understand my heretofore undiscovered talent), I instantly found a copy and started reading.

That day marked the end of my innocent triumphs. I don't know what I expected: No, I do know. I expected a friendly romp through the history of stock market dopes whose bankruptcy would provide a suitably dark background against which the brighter stars of speculative adventure could be seen and appreciated. Today's deluded losers, I was sure, were the dummies who kept saying the Internet was a fad and the Internet stocks were a joke. My bank account told me who was having the last laugh about that.

I looked forward to a double handful of anecdotes of others who'd played the wrong runs, been plagued by the wrong timing, or been doomed by the wrong attitude, the better to torture my friends with. Although Templeton's returns were pretty weak by today's standards, he had been a player in his time, and I took it for granted that he would feel a kinship with me and my little victories over popular misunderstanding. If he was a fan of Charles MacKay, then I was prepared to be a fan, too.

The unexpected horror MacKay's tales inspired in me is hard to describe. Everybody knows about "Tulipomania." The Dutch went mad about tulips a few hundred years ago, and bid the price up outrageously, after which they came to their senses and the price fell. Big deal. Several hundred years later, their folly still lingers as the most trite of metaphors to be hauled out anytime someone thinks someone else is paying too much for something. Tulips were regularly mentioned on the stock discussion boards by desperate characters who were shorting a technology stock that continued, despite their evilest prayers, to go up and up. When I hear "tulip" I translate it this way: "I don't understand why this stock keeps rising but if it goes up another three points I'm going to be ruined." My response? "Tulip, you say? Time to buy more!"

So it wasn't MacKay's story of tulipomania that knocked me off my game, but his tale of the numerous London bankruptcies in the wake of the South-Sea bubble of 1720. Nearly everybody who touched the crappy shares of the South Sea company, with the exception of a few insiders, was damaged by the experience. Since MacKay tells it so well, there's no point in telling it again here. But the similarities to the run up in the Internet stocks were terrifying:

The advent of profitable trade with the Americas, sometime in the future, which would transform the economy of England; why, that was e-commerce. The South Sea directors and their cronies, who sold their shares into successive waves of buying; these were the Internet stock-option millionaires. The manipulation of the price to ludicrous heights using publicity; this was the laughable "we're now an Internet company" press release. The proliferation of meaningless business ventures by London sharpies in the wake of the first great success, including "a company for carrying on an undertaking of great advantage, but nobody to know what it is;" why, this was UBID, and KTEL, and Perfumania, and scores of others.

Explained MacKay: "It did not follow that all these people believed in the feasibility of the schemes to which they subscribed; it was enough for their purpose that their shares would ... be soon raised to a premium, when they got rid of them with all expedition to the really credulous." Hey, wait a second: that was me. In the end, everybody went broke.

One dose of pessimism led to another. Soon, I was devouring books about economic catastrophe. I read Charles Kindleberger's "Manias, Panics, and Crashes," from which I learned that one sign of impending doom is the emergence of financial swindles that capitalize on the general belief that it is easy to become rich. Each day, my e-mail queue was peppered with announcements of new stock picking services guaranteed to drown me with cash. In the past, I'd ignored them. Now, I saw them as omens of the rout to come.

Kindleberger even predicted the proximate cause of the latest phase of the bull run, which was the lowering of interest rates in late summer, 1998, in response to the Asian crisis. The head of the Federal Reserve Bank, Alan Greenspan, had long been critical of the uncorrected boom in share prices, but when the Asian economies faltered he cut interest rates anyway, though this was likely to set off another manic stock market run to record highs -- as it promptly did.

Kindleberger, in his dry prose, writing long before the fact, reveals why even conservative bankers can't head off a dangerous bubble under these circumstances: "When commodity and asset markets move together, up or down, the direction of monetary policy is clear. But when a threatening boom in share prices or real estate or both rears up when commodity prices are stable or falling, the authorities face a dilemma." Indeed, they do. Greenspan chose a nice, easy rate cut, and I had a hundred thousand dollars to show for it. For the first time, however, I began to reflect on the possibility that I would have all of this money stuck in a promising Internet stock on the very day that the market went South in a panic.

My fate was sealed when I settled down for the weekend with the ultimate stock market snuff movie: John Kenneth Galbraith's "The Great Crash of 1929." "The only reward to ownership in which the boomtime owner has an interest is the increase in values," Galbraith wrote. "Could the right to the increased values be somehow divorced from the other and now unimportant fruits of possession and also from as many as possible of the other burdens of ownership, this would be much welcomed by the speculator. Such an arrangement would enable him to concentrate on speculation which, after all, is the business of the speculator."

This was an exact description of my heart's desire, but Galbraith's sympathy ended there. He seemed to take a dry delight in the fact that after the big drop in 1929 came the long, murderous compaction of the early '30s, by which point most of the amateur speculators had gotten all their funds pummeled out of them.

I had always assumed that even if the market dropped radically, all the traders in the world would simultaneously scream "Buying opportunity!" and up we'd race again. I believed that after a big dip there would be lots of cash available to go back into the market. This, I learned, is a common misconception based on a failure to recognize that after a long, relentless bull run, a run that forces all the lingering skeptics to give in, all the cash is already in the market. And then it is gone. Gone where? Gone, as a great speculator once said, "where the woodbine twineth." He meant, I'm pretty sure, up the spout. Gone, in the words of another grim accountant, to join "the silent majority of vanished savings." In the great crash of 1929, stocks fell by 50 percent. During the next three years, they fell by another 80 percent. How were you supposed to make your money back under those circumstances?

Then and there, I concluded that my trading method was insane. Yes, I'd made a bundle of cash. But a circus chimp could have doubled his money buying the stocks I was playing during the winter of 1998-1999. It was simple. Dow hits 7,500 in August. Buy anything. Dow hits 10,000 by year end. Sell everything. Luckily, I was too dumb to know better than to get in at the bottom. But after dosing myself with MacKay and Kindleberger and Galbraith, I wasn't dumb enough to stay in at the top. I was finished trusting the market to reward me for not trying. It was time to trade risk for security.

When I'd started out, cashing in all my mutual funds and wiring the proceeds, along with all my savings, into my E-Trade account, I had made a conscious decision to trade it as if I were going to blow it. After all, I had just turned 27. I had a life of savings ahead of me. Might as well pull off all the risky investment stunts now, while I could still chalk it all up to youthful folly.

On the other hand, I don't think I really believed I'd lose it all. Perhaps "I don't care" was just a mantra to soothe the nausea and to quiet the blind panic that came late at night. In any case, now that I had had my pay day -- nay, my pay season -- and was ready to double my stake again, I meditated on how I would feel if it were gone. Every few days, I tried on my old casual point of view to see if it still fit. "Easy come, easy go," I tried to say one night to my brother, but my voice trailed off into an anxious squeak. I'd done it. I no longer could convince myself I didn't care. If I lost it all now, I knew it would shape my identity for the rest of my life. I couldn't live with that.

Okay, the hard part was over. I'd admitted that I cared. Next, I needed a sensible trading strategy. I wanted rules. I wanted science.

In Edwin Lefevre's classic trader's travelogue, "Reminiscences of a Stock Operator," the author recounts a conversation with a friend so unnerved by his investments that it literally keeps him awake at night. "I am carrying so much cotton that I can't sleep thinking about it," he told Lefevre. "It is wearing me out. What can I do?" Lefevre's reply is simplicity itself: "Sell down to the sleeping point." After spending the uncorrection of late 1998 bumbling into absurd profits, I think I knew what my sleeping point was. It was zero percent stocks, 100 percent U.S. dollars.

After all, who gets hurt when the music stops? The people who are still standing. The market equivalent of looking around in the sudden silence and realizing that all the chairs are taken is opening your trading account and staring at a list of securities whose value has fallen by 50 percent and is still dropping. If I was going to stay in the market, I wanted no risk of an overnight decimation. I was going to expose myself to the vicissitudes of the market for the briefest periods of time possible. My old mantra, "I don't care," was going to be replaced by a new one: "End the day in cash." That meant serious day trading.

I knew that my plan to reduce my risk by trading more often flew in the face of every investment commonplace. Nonetheless, the way I figured it, day trading was the safest possible strategy. After all, my favored Internet stocks had already risen 400 percent, 500 percent even 1,000 percent. At this point, conventional wisdom was out the window. Buy and hold? The only person who held eBay all the way up was the guy who bought it at the IPO, went out for a bike ride, got hit by a car, and lay comatose in the hospital for the next three months.

No, now that the Dow had crossed 10,000, "buy and hold" seemed laughable. I could just picture the big stock market managers, the traders for the mutual funds and the pension plans and the municipalities, for whom these new profitless Internet stocks had always seemed excessively risky, finally shaking their heads and capitulating. Every day I saw it on CNBC; the buy and hold crowd was getting in. It was time for me to get out.

- - - - - - - - - - - -

That was the beginning of my day-trading career. By the end, I'd learned some rather surprising things about the mechanisms of the stock market. "Dumb Money," the story of my education as a day trader, was published on April 18, a week after last month's NASDAQ correction. Nearly every day since, I've heard somebody say that a bear market would make day trading go away. This is wrong. Things are just getting started.

By Gary Wolf

Gary Wolf is a contributing editor at Wired magazine.


By Joey Anuff

Joey Anuff is a founder of Suck.com.

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