The Avalanche Theory

 

Warren Buffett is famous for stepping in and buying when markets are in “meltdown” mode, and for avoiding the purchase when others are in a frenzy to get in the market. What seems simple in theory is difficult in practice.


Patience is a highly regarded virtue in the investment world. While many times investors get impatient to “get their money to work,” patiently waiting for the right time is very important, and may be the most difficult part for many investors.

 

We have extensively researched the indicators that have been promoted as the “silver bullets” of successful investing. Most of them have limited or no value when tested over the many different types of markets we have experienced in recent years. We have, however, discovered a few that have been very helpful in measuring the exuberance in a market and the signs that a trend may be running out of steam.


One of our favorites is the “Avalanche” theory. A question that is frequently asked is “What causes the market to correct?” We answer that question with another question … a simple but surprisingly similar example:  “What causes an avalanche?”


As you may know, there are many things that can trigger an avalanche -- a skier, a snowmobile, a wild animal, an earth tremor, a jet airplane’s sonic boom. Many different, unrelated causes may begin a slide. What is obvious, though, is that an avalanche cannot happen unless there is a lot of snow on the slopes! Early in the winter, when there is only a dusting on the slopes, you are not likely to have an avalanche. But as the winter passes and the snow grows deeper and deeper, the likelihood of an avalanche grows with the depth of the snow.


Much like the depth of the snow, we have found that the likelihood of a market correction is lower if there has not been a recent run-up in the market, particularly if one has not occurred within the last 12 months or more. Why 12 months? A sharp run-up in the market over the past 12 months means that many investors are sitting on highly profitable positions that now qualify for long-term capital gains tax treatment. With long-term capital gains treatment locked in, investors are more likely to sell and protect their profits if a sudden event shakes their confidence and weakens their belief in the market, potentially creating a market correction.


It has been our experience that paying attention to year-over-year market gains and heeding the warnings from these indicators are important practices. We believe these and other indicators that actually have a rational basis help us better understand and manage the risk in our portfolios.


“Be greedy when others are fearful and be fearful only when others are greedy.” -- Warren Buffett

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Dave Crouch and not necessarily of Raymond James. Raymond James is not affiliated with and does not endorse the opinions or services of Warren Buffett or Charlie Munger. This is not a solicitation to buy or sell Berkshire Hathaway stock or any other security. Investing involves risk, and you may incur a profit or loss regardless of strategy selected. Past performance may not be indicative of future results.