In his delightful book Get Smarter, Seymour Schulich notes that to invest well you need judgment and conviction - and neither is much good without the other.
With a correct view but weak conviction you could be rattled into selling your winners prematurely. But with strong conviction overlaid on bad judgment you could lose your shirt by obstinately holding on to losers.
How to develop good judgment? It's mostly innate, says Mr. Schulich, and I agree; but I also believe that doing physical research - sleuthing - can help you improve your judgment by seeing reality in the raw. Better still, doing your own work helps strengthen your confidence in your views - which is doubly important now, since a bear market would try its utmost to lure you in, well before it has ended. Why, just the other day I read an interview with half a dozen young brokers, all claiming they are contrarians and are therefore buying. Just like the Monty Python's movie Life of Brian, where a crowd chants in unison, "We are individuals!"
How would a bear market try to lure you? By staging sharp and sudden spike-rallies lasting just long enough to throw your caution into doubt. Such a rally may occur fairly soon, because the financial system is tottering and the authorities would do anything to buttress it.
Just last weekend the G7 met to see how to help the United States, and which country would share how much of the coming pain. But the pain would have been too great, and so they could not agree and told the U.S. it's on its own for now.
A few days later Warren Buffett said he'd insure municipal bonds, and U.S. Treasury Secretary Henry Paulson said no home foreclosures could happen for a month. Not major announcements, but they made the market rise for a day or two, despite the underlying awfulness.
But if/when a larger rescue package is cobbled together (think New York City and Mexico), the bear market may stage a longer up-thrust that could catch many shorts with their pants down. And then all contrarians who have kept the bullish faith (like the brokers noted above) would come out chortling, mocking the Chicken Littles, and this would also shake the weak bearish conviction of those who had rented it from a guru (a.k.a. strategist) - or had bought it cheaply from a newspaper columnist. But it would not shake the conviction of those who had done their own physical due diligence and arrived at their own conclusions. These latter would likely take the money of the former, because when the rally runs its course - as it must - the decline would continue like water torture: Drip, drip, drip, down, down, down, with occasional rallies, for a year or two - maybe more.
Why so long? Because New York City's bankruptcy and Mexico's insolvency were smaller fry compared with the current problems - continuing writedowns of trillions held by federal mortgage insurers, likely to be followed by credit card loans writeoffs, in turn likely followed by crumbling commercial real estate - and finally, as a coup de grâce, the unravelling of some large derivatives.
Why derivatives? Just think of it. There's $500-trillion-plus worth of these beasties floating in the financial Azkaban, while the total gross domestic product for the G7 is barely $40-trillion. Heck, the world's GDP is less than $70-trillion.
So fixing a major derivative mishap cannot even be contemplated. Will there be a mishap? I have no doubt there would be at least a small one. Will it be catastrophic? Nope.
As Warren Buffett said, the system is strong. Yet it may be buffeted mightily before it stabilizes, and this could take longer than the contrarians hope. (And if you think I am being extreme, you should read Eric Sprott's monthly letters on his website. My views are mild compared to his.)
Then, when derivatives finally flounder, the Chicken Littles would be squawking loud enough to cause some real panic - and this (I am painting a loose scenario here) would likely signal the end of the bear. How soon would this be? I don't know, but my guess is it's at least two years and 4,000 Dow points away. How could you tell it's the bottom? One sign would probably be a blind, floor-wetting panic everywhere - like in August, 1982, when a B.C. politician said a certain Canadian bank was going broke. This was one day before the biggest market bottom in a generation.
A second sign would likely be a total absence of contrarians, unlike today.
Or, a third sign may be a three-star Bay Street restaurant boarded with plywood, as was the case in 1982. But until such a dreary day, there's probably lots of grizzly left - although a few sectors (and stocks) may do well throughout.
How to find them, and what else to do? Three things.
First, stay more liquid than usual and own only what you have researched yourself.
Second, stocks you are not absolutely convinced about, sell into the up-spikes.
But third and most crucial - my view may be wrong (yup), or, even if it's right, the market might shake your conviction by a sharp and long rally - unless you have done the research yourself and came to similar conclusions on your own: If in normal times doing your own research is important, now it's crucial. And, doing it would help sharpen your judgment as well as strengthen your conviction - both of which you'd need to deal with the coming bear.