Oil: How low can she go?

Oil: How low can she go?

 

 Oil has been taking an absolute hammering over the last few months, falling from around $110usd a barrel in July to below $60usd currently. This correction has been caused by a combination of factors including an undermining of the traditional oil business dynamic by the explosion in US Shale Oil development, a general lack of demand for oil due to a slowing global economy, with demand according to the Organization for Economic Co-operation and Develoment (OECD) currently at 15 year lows. High levels of stockpiled oil around the globe, and lastly, liquidation of speculative long positions on oil by investors who thought the price would rally and have been caught long and wrong.

The bad news for the oil market is that the first three of the factors mentioned are likely to persist for some time yet, and certainly in the case of oil demand I would expect it to fall substantially from here as the next leg of the GFC starts to bite and undermines the global economy still further. In the case of the speculative liquidation we can see how this is developing by using the Committment of Traders Data (COT) that is published weekly by the US Commodity Futures Trading Commision (CFTC). This data covers a whole range of markets and breaks the ownership of futures and options in each particular market into three categories, commercials, large speculators and small speculators. We have used these charts previously as they can offer great insight into where a market might be heading because of the tendency for commercials to consistently get it right, and for the speculators to consistently get it wrong!

Here we can see the current COT data for crude oil.

We can see the extreme short position by the commercials in July of this year when oil peaked (signified by the red bars), and the fact that they have bought back those shorts and reduced their positions as the speculators have sold out. However, they still hold a sizable short position even after the price falls we have seen, and the general picture is not compelling that a sustainable bottom has been reached. I would expect to see the commercials close out all of their shorts and possibly even go long before the true bottom is found.

Because of oil's pivotal role in todays society, being used in everything from pharmaceuticals to fertilizer and plastics to clothing, as well as its obvious role as a transport fuel, this drop in price has been welcome news with the price falls acting as a tax cut and boosting the cash in our pocket in a very direct way. According to Bank of America this windfall may be the equivalent of $1 trillion worth of stimulus, no small sum! Unfortunately, the benefits aren't distributed equally, with the stresses found in many of the current oil exporting countries, many of which are either experiencing civil unrest like the countries of the middle east, or are becoming increasingly aggressive in their dealings with their neighbours, like Russia. Most of these countries are entirely reliant upon oil revenues to keep their economies operating, and with oil at $58 many of those countries are financially underwater. This rising tide of unrest, either internal or external, allied to a severe constriction in revenues moving forward does not bode well. During most of the oil price correction many equity markets have rallied, enjoying this oil-based tailwind, but as the fall has became a rout, these fears over the resulting macro issues have grown and overwhelmed the earlier exuberance. The fall in equities  over the last few days has directly stemmed from the unresolved question - how low can oil go?

So with a view to answering that question, lets have a look at the current chart of crude oil.

We can see that oil is close to a previous line of support around the mid 50's, we can also see how extremely oversold it is on both RSI and Stochastics, levels last seen at the  lows of the GFC. Should those levels give way, the next major support is the 2008 low of $37.57, and should that fail, hang onto your hat!

Whilst these charts give us some idea of levels where support might be found, and how oversold oil currently is, they are no use for giving us a potential target price. 

For that we have to turn to point and figure charts.

Here is a long term chart of Light Sweet Crude, a particular type of crude oil that is predominant in the US. When I first saw this chart I amost fell over as it is showing a downside count or target of $8.95, which seems incredible. I therefore ran multiple P&F charts over different scales and durations and a figure around $8 to $9 appeared a number of times. This is concerning on a number of levels, the fact that the targets appear on multiple charts  gives it more substance, but most importantly, if we actually reach $9 it means that all hell has broken loose in terms of the global economy.

Before we get too carried away, I have to say that P&F charts are not infallible, circumstances can change, targets can be cancelled out and prices can just fail to reach the target. But they can also be incredibly accurate and provide information that no other type of chart can provide. 

Whilst the $9 downside target certainly came as a shock I can certainly foresee the reasons why it might happen. Apart from the systemic problems outlined at the start, there is also the issue of a rapidly appreciating US dollar which will continue to exert downward pressure on all commodities, including oil. This, allied to the pending collapse in sovereign debt markets and a deflating global economy are more than enough ammunition to drive oil much lower. You should also not be surprised to hear that commodity prices are themselves cyclical and we are currently in the down phase of that particular cycle.

We at least now have an understanding of what might happen, the key will be the support levels. If the mid 50's can hold and a concerted rally occur there is a chance that the technical damage can be undone. My gut feeling is that oil will go much lower, though not necessarily in a straight line and not necessarily now. 

Have a wonderful Christmas and a Happy New Year, see you in 2015

Correction Time - Its Finally Arrived

Correction Time – It’s Finally Arrived

Back in May I wrote a post called 'Seasonality and the Stock Market'
http://kiwiblackers.blogspot.co.nz/2014/05/seasonality-and-stock-market.html
which explained that statistically, stock markets are weakest during the May to September timeframe. I also discussed that although the markets were still rising, they were losing momentum and that because the rally had gone on for so long without a major correction, there was a good chance of one developing over the next few months.

The US equity markets rallied for another couple of months until succumbing to a short, sharp correction in July. Whilst this made investors nervous, the 4% correction was nowhere near enough to bleed off excessive investor optimism, and they returned to the markets driving them to new all time highs in September. However throughout this period the internal dynamics of the markets had continued to deteriorate, with fewer and fewer stocks participating in the rally, and many technical indicators flashing warning signs. The markets may have been at all time highs, but they were on very thin ice.

Whilst the equity markets have powered ahead, a number of storm clouds have gathered. In Europe, the same old problems are rearing their head with many of the economies in recession and the entire eurozone in danger of falling into outright deflation due to the ineffectual financial management of the European Central Bank (ECB). This fear of deflation is leading to speculation that the ECB will have no choice but to launch a massive wave of quantitative easing (QE) to attempt to boost the eurozone out of a deflationary slump, a move that up to this point in the GFC the ECB has refused to make. This combination of a faltering eurozone economy and the risk of ECB money printing has exacerbated the flow out of euros and into US dollars, helping to drive the dollar to it's longest consecutive week rally in history.

Global unrest is continuing to grow, with separatist or democracy movements rising in the UK, Spain, South America, Syria, Hong Kong and other parts of Asia. As well as the ongoing conflicts in Ukraine, the Middle East and of course the battle against the Islamic State. More of these conflicts will flare up and intensify as the global economic situation worsens.

Lastly, the fear is rising as Ebola continues its deadly creep across the globe. This is playing out in a predictable manner with initial apathy replaced by concern, concern replaced by fear, and finally once the horse has bolted, fear replaced by panic. How bad Ebola proves to be only time will tell, but my insticts are telling me it is going to get a whole lot worse before it gets better.

According to the financial media, this toxic brew of bad news was the reason for the current stock market correction. But as we know from previous posts, it is never the news that causes the move, it's the condition of the market. When the market is strong, bad news is constantly shrugged aside and discounted and the market continues to rally, or 'climbs a wall of worry' as it is known. However when the market is exhausted and ready to correct, almost any news will be interpreted as bearish and the market will fall simply because it is time for a correction.

Having reached those new highs in September the US equity markets have fallen over the last few weeks, with volatility increasing and volume growing as sellers start to overwhelm buyers. 

Let's have a look at a chart of the S&P 500 Index to see where support might lie.

 It is clear to see the fall of the last three weeks, and the increasing volume reinforcing the significance of the move (denoted by the three expanding red bars at the bottom of the chart). If we take the arbitrary 10% correction figure from the high of 2019 we get very close to the 1814 level that acted as support back in April. This area should the first real level of support, should this give way, we could see a short, sharp drop down to the 1737 level which would signify a 14% correction from the high. There is of course the 1904 level which is as yet unbreached, however I think the chances of this holding for any length of time are not good.

I have spoken before about Point and Figure charts and their capability to give price forecasts, so let's see if it corroborates the chart above.

We can see that according to this chart when the 1930 support level was broken, a downside count of 1840 was activated, meaning that the index should fall to this level and possibly further. We can also see the blue line of support currently at 1820. At this point I must stress that counts are not always reached but they are a useful tool when it comes to trading or investing.

Whilst I believe we have further to fall, I do not believe this is the major top that we know will come, the pieces are simply not yet in place. This is just an overdue correction before we take off to new highs and as such, it provides a buying opportunity.

As Safe as Houses?

AS SAFE AS HOUSES?

The debt fuelled excesses of the early 2000’s drove house prices in many parts of the world to incredible heights. When the bubble burst in 2007/8 it sent prices into retreat, and after a few years with corrections of up to 40%, valuations were (in some parts of the world at least) once again at fair value. Since then prices have generally recovered, as valuations once again rise to normal levels. However this recovery has been quite patchy with some areas recovering normally, some parts of the world soaring to post 2007 highs, and other parts of the world stagnating or falling further.

This recovery from low valuation levels is quite normal and part of the repeating cycle from low to high and back again that we witness in all asset groups. However, this specific nature of the global house price recovery is being driven by the increasing stream of money looking for a safe haven. Due to a combination of political uncertainty, higher taxes and a deteriorating economic outlook, this money, which is flooding out of China, Europe, Russia, the Middle East and Latin America is looking for an asset that is in a safe location and relatively liquid. As a consequence we are seeing high-end property booms in places like New Zealand, Australia, Canada, London and a number of cities in the US.

This phenomenon is causing serious distortions in those property markets, and with the top-end continuing to power away, the market is getting extremely stretched and out of balance in some countries.

Back home here in New Zealand, the effect is particularly acute as Auckland has a disproportionate effect on the NZ property market as a whole. With it being the centre of commerce for the country, the place where most migrants come and settle, and with almost a quarter of the country’s population residing there, what happens in the Auckland property market has implications for the rest of the country. As when house prices take-off, whatever the reason, the Reserve Bank resorts to raising interest rates to try and control it, and often what is right for Auckland is wrong for everybody else.

Despite many arguments in favour of a broad range of measures to combat excessive house price rises, the blunt tool of raising interest rates has been the default setting of reserve banks around the globe for many years. In previous posts I have commented on the need for changes in both the tax treatment of property investors, and changes in the rules for high Loan to Value (LVR) mortgages, as well as treating mortgage risk on the lending banks balance sheet differently. And back in October last year, the Reserve Bank of New Zealand (RBNZ) did finally introduce new restrictions regarding banks ability to lend at levels greater than 80% of the property’s value. This has had the effect of reducing demand amongst first-time buyers in the lower house price bracket where the high LVR’s are more prevalent, however its had absolutely no impact on the top-end, and because of the lack of restrictions on property investors, the potential beneficial effects of this policy change have been mitigated.

Also in New Zealand’s case, these effects are being compounded by the relative lack of new houses built over the last few years, plus the increase in net migration. And so we see the gap between the top and bottom of the property market continue to grow.

However, even if Governments and Reserve banks around the world developed and introduced cohesive policies to prevent excessive house price rises (which is highly unlikely), it still would not eliminate the current problem. These types of rules work fine during ‘normal’ economic periods where relative investment return is the driving factor -  if the return of one investment is reduced by taxation etc, money simply moves to the next best alternative. But when the economic landscape changes, the imperative becomes the return of your money, not the return on your money. This radically changes the mindset of investors and renders many of the normal rules obsolete.

We will likely see this trend continue for some time, with the underperforming cities, regions and countries continuing to lag as money increasingly flows out of these places, whilst the outperformers race ahead as it is redeployed. It is important to understand that this process has got nothing to do with value, in the property hotspots of the world we left value behind long ago. It is purely about the weight of money, and whilst there is enough to levitate prices higher, it will continue.

My guess is that things will start to crack once we see the next global downturn, the second and much more damaging leg of the GFC sometime in 2016. Once it really starts to bite and finally affect the US, its safe haven status will be undermined. At that time, the money that has distilled out into these property hotspots will start to look for the exits. And is when we will see these incredible price gains unwind, brutally, if history is any guide.

If you are a property investor in these hotspots, I would recommend you pick your moment to leave the party very carefully.

If not, then just sit back and enjoy, it should make interesting viewing

Seasonality and the Stock market

Seasonality and the Stock Market

The adage ‘Sell in May and go away, don’t come back till St. Leger day’ is once again starting to resonate around equity markets. Originating in Britain in the early 1800’s the expression started because of the tendency for stock markets to under-perform during this 5 month period, and was a warning to be sitting in cash rather than be invested during this time frame.

 The phenomenon was caused by the mass exodus of investors and senior market participants on their summer vacations, which at that time of course included attendance at the five classic horse race events that occurred throughout the summer (commencing in early May with the 2000 Guineas Stakes, followed by the 1000 Guineas Stakes, the Epsom Oaks, the Epsom Derby and finally in late September the last of the five, the St. Leger Stakes). 

Whilst the expression had been known for centuries, very little statistical work had been done to establish its accuracy until 2002 when analysis from Bouman and Jacobsen showed that the effect had occurred in 36 out of 37 countries examined, and as far back as 1694 in the UK, it truly is a global phenomenon.

However, just because we know it is a factor in stock market performance does not mean it is the only factor. There are many reasons why the under-performing bias at this time of year can be overwhelmed by other, more powerful factors, not the least of which is whether we are operating in a secular bull or bear market. To highlight any differences, the two charts that follow show an averaged performance breakdown of the Dow Jones Index over the calender year, indicating how each month compares. The charts encompass different periods to show how the phenomenon compares during secular bull and bear periods.

The first chart shows the period from 1956 to 1982. The years from 1956 to 1966 were part of a secular bull market and witnessed a sharply rising stock market, whilst the the years from 1966 to 1982 were a secular bear period and caused stock prices to fall dramatically, resulting in the Dow Jones being virtually unchanged over this 26 year period.

Predictably we can see that during this period there is a noticeable fall through this May to September time frame.

 In the next chart we see how the Dow Jones performed during the period from 1983 to 2010, a period of time that saw the greatest secular bull market in history.

More surprisingly, even during this period of rampant stock market gains there is clearly an under performance during the May to September time frame, even continuing into October. Maybe Mark Twain was right after all when he observed that October is one of the most dangerous months to speculate in stocks, although he did add "the others are July, January, September, April, November, May, March, June, December, August and February." 

It appears therefore that regardless of whether the broader market is in bullish or bearish mode, the seasonal bias is still strong enough to register a noticeable underperformance during the May to September period.

So having established that we may well encounter a head wind for the next five months, are the US equity markets looking healthy enough to weather it? Well if we look at the chart below of the S&P 500  which is a broad based index and therefore a better indicator of the health of the entire stock market, the answer is possibly no.

We can see that whilst the index has been rallying since the turn of the year, the technical indicators on the chart have been falling (see the downward sloping red lines), this is known as a negative divergence and is a sign that the market's rally is losing momentum and that the potential for a correction is increasing. 

Another  worrying factor is the length of time it has been since a major correction occurred. Normally in strong market rallies we should expect the accompanying large corrections (around 10%) to bleed off the excessive speculative fervour and create the energy for the next move higher. However the last time we experienced a major correction was back in late 2011, and we are now well overdue for one (I have drawn a 10% correction target line on the chart above for reference). Buffering that argument is the fact that often as strong rallies reach their conclusion we often get less intense corrections, still, we should expect a correction of sorts even if it doesn't quite fall into the major category.

This potential for a market fall, allied to the time of year means we should be alert to the possibility of a reasonable sell down in equities over the next couple of months.

Should a healthy correction occur it will provide a great buying opportunity to get in for the final blow-off rally still to come as money flows into the safe haven US dollar and chases yield in the US stock market, propelling the indicies to new highs.

It may be time to go 'off to the races', but don't take too long a vacation.

 

Deja Vu for the Precious Metals

Deja Vu for the Precious Metals

The precious metals sector has been through quite a rollercoaster ride since we last talked about it back in May of last year. At the time of that post http://kiwiblackers.blogspot.co.nz/2013/05/a-dead-cat-bounce.html , gold had crashed through important support levels around $1530 and plunged as low as $1321 before staging a weak rally. The question at that time was whether or not gold had bottomed and would continue to rally or would the bounce soon peter out to be followed by more weakness. In that post I clearly outlined the reasons why I felt that the rally was a 'dead cat bounce' and that gold and silver still had a long way to fall before reaching a true bottom, I also mentioned a price projection in gold showing a downside target of $1070.

Subsequently both the metals resumed their descent, reaching new lows in July last year of $1179 in gold and $18.17 in silver, after which they again rallied before falling to test these levels of support once again in December. At this point the support levels held, forming a 'double bottom' chart pattern, reinforcing that level of support and allowing the metals to once again stage a rally. 

We can see this double bottom illustrated in the chart below.

 In this chart we can also see the rally that carried prices up to a high of $1392 in gold before topping out and suffering a sharp correction over the last couple of weeks.

So here we are again with the metals at a point of indecision-  Will they recover, resume their rally and finally end the correction that has been ongoing since mid 2011, or will they once again crash through these support levels and carry on to new lows?

To find the answers lets take another look at some of the factors that influenced our decision the last time around, our answers then and how it currently looks.

• At a genuine low we should expect the rebound to be strong with good volume as buyers return to the market and chase the price higher. Whilst this could still occur, thus far the recovery off the lows has been relatively weak with low volume. 

This time around the volume was once again unremarkable, and certainly not the surge in volume that would suggest a sustainable rally.

• As was discussed in 'Gold Revisited' the move through the long-term support level in gold has triggered a downside price objective of $1070 and whilst this might not eventuate, it is far from a positive development.  

This downside target still exists and has not been altered by the bounce from the double bottom, in fact it would need a rally up to around $1800 to invalidate the signal. Although we must remember that these targets are not always reached, it is still a bearish sign.

• On a price move as violent as we witnessed I would have expected the 'commercials' to have aggressively covered their short positions, but the latest COT data below shows that although they have bought back some of their 'shorts' it has hardly been dramatic, suggesting to me that they expect another bite at that cherry.  

 Lets look at the current Gold COT picture below.
 
 

You will recall that the red bars signify the net long/short position of the commercials, who for want of a better description we can think of as the professionals, the people that know what they are doing. We can see that the commercials did reduce their short positions substantially, reaching there lowest in July and December, the two periods during which the double bottom occurred, what a coincidence! However, since those December lows their short positions have expanded rapidly, and recently reached there biggest levels in almost a year. This does not paint a pretty picture for the bulls.

If we look at the Silver COT chart for confirmation, the situation is even more pronounced.

• Lastly, we are entering the weakest period of the year for precious metals. Traditionally gold prices enjoy three bullish periods within the calender year driven by demand for physical gold, the first of which is the buying induced by the Chinese New Year celebrations around January/February. The second period is around August/September when Asian farmers harvest their crops and invest the profits into physical gold, and lastly the Indian marriage season that lasts from September through to November which creates the biggest demand spike of all, as gold is a hugely important part of most Indian wedding ceremonies in its form as a dowry. This May to July timeframe is absent of any drivers of physical demand so we often witness weakness in the precious metals during this period.

This seasonal affect still holds true although it can be over-ridden to an extent by other more powerful factors in some years, but absent of something abnormal we should expect the precious metals to under-perform through this May to July timeframe.

All of these factors seem to point towards further weakness in the precious metals, however we should also expect this bearish outlook to be mirrored in the  outlook for the share prices of companies in the sector. A good proxy for the sector is the Market Vectors Gold Mining Index or GDX, so let's have a look at a point and figure chart to see if it gives us a target price.

 This seems to confirm the bearish outlook and gives us a downside target of $19.62, almost a 20% drop from current levels.

When we combine these factors it looks increasingly unlikely that we have seen a sustainable bottom in the precious metals, and as a consequence I still expect that $1170 price target in gold to be reached in due course. 

When and if it is, expect it to be accompanied by a chorus of calls declaring the end of gold and silver as an investment, experts suggesting the next stop is $600 in gold, and investors throwing in the towel swearing they will never touch the shares or metals again. This will be the anecdotal evidence we need to tell us the end of the correction is finally here, and the beginning of the rally that will take the precious metals back to their old highs and beyond has arrived.

The Sands of Time

The Sands of Time

Back in 1987, three physicists called Per Bak, Chao Tang and Kurt Weisenfeld wrote a computer program to simulate what happens when  grains of sand are repeatedly dropped onto a table top. They developed it to try to solve the problem as to why sometimes the dropping of one small grain of sand on a pile will cause no effect, sometimes it will create a small avalanche, and sometimes there will be a catastrophic collapse. After much dropping of sand they concluded that there was no pattern to the outcome, sometimes it was negligible, sometimes total collapse ensued, it appeared totally random.

 Next they decided to look at the sand pile from above and show the degree of steepness of the faces by colouring flatter, more stable areas green and steeper more unstable faces red. As the test continued and more grains of sand were dropped, more of the face became red. Starting with small independent areas of red, slowly but surely the area of red increased and linked together forming a matrix over the surface of the pile. Up to this point the dropping of one small grain of sand could only affect small areas of the pile, but once the matrix was complete it had the potential to cause a total collapse. Scientists refer to this situation as a critical state, the point at which there is an opportunity for significant change.

Once this discovery was made, its influence was recognised in a whole range of seemingly random events from ecological disasters to earthquakes, and epidemics to traffic jams.

We also see this slow development of a critical state develop in financial markets.  As markets rally over a long time period they often climb a ‘wall of worry’, meaning that despite an increasing stream of market negative news-flow, investors continue to disregard or put a ‘positive spin’ on things and drive the market higher. At times investor’s ability to ignore reality is a sight to behold, as one by one the positive arguments for the market fall away to be replaced by negatives, they increasingly cling to the remaining bullish arguments until we finally arrive back at that sand-pile, and its critical state. At this point the market has reached an incredibly unstable condition, and any piece of seemingly innocuous bad news can be the grain of sand that causes the market to crash.

Another area where we are currently witnessing this phenomenon is in the increasing civil unrest occurring around the world. Over the last few months we have seen problems occurring in South America, the Middle East, Spain, Turkey, Thailand, Malaysia and most recently Ukraine. In all of these countries the people are rising up to protest at declining living standards, low economic growth, increasing taxation and rampant corruption. These problems have been developing for many years, laying the foundations for the crises we are seeing now. Like the financial ‘wall of worry’, the problems gradually intensify but change can’t happen until the time is right and we reach the critical state, then one more event occurs that breaks the camels back and the civil uprising begins. That is what we are seeing play out around the globe, and as the months roll on we will see it spread like an epidemic.

As I have discussed in previous posts, the financial implications of this will be the increasing flow of money to the last safe haven, the US dollar. Far more concerning will be the human cost as this cycle plays out, and its predictability doesn’t make it any easier to witness.

It’s clear to see that the phenomenon of the critical state is all around us and seems to permeate all aspects of our lives. But whilst its effects can be immensely damaging, knowledge of its existence and prevalence gives us all at least a chance to occasionally see it coming and avoid its outcome.

Cycling around the South Island of New Zealand

I am a trustee of a New Zealand based charity called The Shortbread Trust. Based in Nelson, we work to help people in developing countries by fundraising to build water wells to provide clean drinking water in Nepal, funding micro finance projects to give a helping hand to farmers in Africa, and buying Shelter-boxes to send to disaster zones. We take no administration fee and guarantee that 100% of donations go to the cause. Please see http://www.theshortbreadtrust.com/ for more information.

Currently our Chairman is preparing to cycle around the South Island of New Zealand towing a Shelter-box to raise awareness and as a fundraiser, see https://www.facebook.com/theshortbreadtrust for the full story.

If you like what we do, please consider making a donation.

Getting In Touch With Our Inner Spock

Getting In Touch With Our Inner Spock

As investors we all like to believe that we are smarter, shrewder and much more in tune with what’s happening in the world than the next guy. Our investment decisions are based on facts, a good understanding of the big picture and a clear grasp as to the reasons why our investments will out perform both the market and our contemporaries.

At least that is what we tell ourselves – unfortunately the reality is quite different.
 
 As a general rule, the average investor has a very poor grasp of the current or future investment drivers, has no clear understanding of why they make the investment choices they do (other than it's what everyone else appears to be doing!), and as a result consistently under-performs the market.

The cause of this phenomenon is rooted in the way our brains handle decision making. From extensive research it appears that we have two systems in the brain, the first we can call the X-system and we can think of this as our emotional approach to decision making (the Dr McCoy system for those Star Trek fans). The second we can call the C-system and is a logical, methodical approach to problem solving (the Spock system). It seems that the X-system is our default setting with all decisions being made in this ‘quick and dirty’ manner for the sake of expediency, and in the majority of circumstances this system serves us well. But in situations where we need to be more thorough and thoughtful about our decision making we have to actually engage the C-system to override the default X-system, and this is where we can encounter problems, especially in the world of financial investment.

It should be clear to most of us that the key to successful investing is precisely the kind of 'Spock' type thinking that the C-system delivers -  rational, logical, methodical and untroubled by human emotion. After all a good investment is a good investment irrespective of the emotion surrounding it. However you do not have to observe markets for too long to see that the majority of investors are anything but rational. It soon becomes clear that rational thought is the last thing on many investors minds as they chase the 'hot stocks' higher and sell the under performers down to ludicrous levels, and you would be wrong to suppose that this trait is only amongst the uninformed private investor. In my many years working for an Investment banking I witnessed some of the biggest funds on the planet acting like headless chickens, caught up in the emotional turmoil of the moment. The only difference being it wasn't their own money they were wasting!

 Now let’s take a little detour and take a short test:

1.     A bat and a ball together cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?

2.     If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?

3.     In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

Easy yes?  Designed by Shane Frederick of Yale and known as the Cognitive Reflection Task (CRT), these three simple questions show how effective we are at engaging our 'Spock' system to override our default 'McKoy' system. They are amazingly effective because each question offers a simple, obvious answer which is unfortunately wrong, and it is only by engaging 'Spock mode' that we will get them correct.

Let's have a look at each question and see how you got on.

The obvious answers were:

 Q1.   10c      Q2.    100 minutes     Q3      24 days

However the correct answers are:

Q1.     5c        Q2.      5 minutes       Q3      47 days

Don't feel too bad if you got one or all of them wrong. This test has been carried out on numerous groups of people and even with the best performing group (students from MIT), only 48% got all three questions correct.

This is quite staggering when you think about it. The fact that some of the smartest people on the planet can fail to answer three simple questions correctly, simply because they cannot override their emotional thinking process when required tells us an awful lot about why good long term investing can be so hard to achieve.

Still, now that you are aware of the problem, surely you can just force yourself into Spock mode and think rationally when the need arises? Well unfortunately it is not that easy. According to more research conducted into our ability to use willpower to force ourselves to comply, it seems that it acts similarly to a muscle in that it can become exhausted from overuse and we effectively run-out of reserves, returning to type.

So if we can't change our behaviour in spite of knowing how damaging it can be what can we do?

Fortunately there is an answer, and it is called 'having a system'

When many of the world's best investors are asked  about their success, a common theme often appears. They have a predetermined set of parameters that the investment must meet, they decide on a buying price which if achieved gives them the investment at the right valuation, they conduct  all their research 'in the cold light of day' away from the emotional pull of the markets, and finally, when the investment comes down to their predetermined price, they always buy it.

Now on paper this seems quite obvious, and indeed it is hardly rocket science. But anyone that has invested in financial markets will know just how hard it is to buy something that is going down. The sense of fear can be overwhelming and we rationalise our inaction away by convincing ourselves that we will be able to pick the bottom and have time to invest when the time is just right, except that picking the bottom is a rare event indeed and that more often than not investors miss out on the fleeting opportunity and end up seeing the price recover and having to pay more.
No matter how many times this happens to us, and we curse the missed opportunities and swear that the next time we will act, when the next time appears we are once again gripped with fear and the opportunity is lost. 
This is why having a system and sticking to it is the key. You are able to mentally delegate your decision making to 'the system' and free yourself from the emotional turmoil involved in making it, and as long as your investment parameters are robust you will benefit in the long run.

As human beings we are poorly equipped to cope in the modern world of financial investment, but we are smart enough to understand the reasons why and do something about it, and bar becoming Vulcan, having a system and sticking to it is the best we've got.