A Plan And A Trade

Like most late mornings I was watching Barney Miller reruns when Joellyn saw a headline on her Yahoo page about the stock market being down a lot and thought that I might want to check it out. Just kidding--humor attempts are ok.

The other day I said I had mapped out a trade if the market dropped to a certain level and this happened between somewhere around 2:15 EDT; given what was happening I did not take notice of the exact minute but I know I was done trading by 2:30 EDT.

My plan was to increase our tech exposure on a pull back. We're underweight that sector, financials and discretionary. The way I have tech constructed, about 85% of the sector is in a broad tech ETF and the rest is in a stock. The trade was to increase the tech ETF by 25% subject to rounding.

The trade, done in large accounts, does a couple of things but I should note some background here. In 2008 by virtue of some lucky sales and a position in the ProShares Ultra Short S&P 500 (SDS) we were down much less than the market. In 2009 I did not reequitize enough and we lagged the S&P 500 some, but not badly. In 2010 near the high based on what parts of the market were leading we were trailing by a noticeable bit and now the gap has almost gone away during the pullback.

From here if the market goes back up I would hope that the increase in tech will let us stay closer to the market. If the market drifts lower then the position in SDS, which is now a little less microscopic, will grow to hedge more of the portfolio.

If we breach the 200 DMA then I will increase the SDS position. During that crazy 20 minutes Matt Nesto made a point of mentioning that the S&P 500 was below the 200 DMA. The way I have used this is to wait for the second day before taking some sort of defensive action. If near the end of the next day the S&P 500 is below the 200 DMA I will place a trade.

It should be noted that my focus is the result over the entire stock market cycle--however many years that might be. Additionally I am trying to avoid the full brunt of down a lot. While I would love to beat the market every year it is far less important to me than the result for the cycle. The trade placed yesterday will either look like a good one or not a month from now but we are two and half years into this event (longer if you think about financials peaking in June of 2007 or New Century filing for Chapter 11 on April 2, 2007) which means there is a good chance that we are a long way in. A long way in even if it means growth on the other side is not so hot for a while.

One market truthism that mostly held up during the last decade, despite the 24% drop, that I think will hold up this decade is that the stock market has an up year 72% of the time. In the last decade US stocks were up six out of ten years and anyone who heeded the warnings of the 200 DMA and the inverted yield curve probably came out of the decade up on the period versus that 24% decline.

While it is possible that this decade will as bad or worse it is not probable. This means it will make sense to be close to fully invested more often than not (but for god sake have some sort of defensive strategy to protect your portfolio). To be clear I still believe that US will be relatively unattractive and while I plan to have clients close to fully invested more often than not it will be in more foreign countries which is something I have been writing about since I started this site.

I also wanted to respond to a couple of reader comments from yesterday. One reader was kind enough to share his experience of getting whipsawed with stop orders. I have used stop orders occasionally but they have drawbacks and the reader unfortunately experienced probably the biggest one. The market panicked, stop orders were elected and then the market snapped back. I don't have a great answer but I am not a fan of across the board use.

Another reader asked about using the 200 DMA for individual positions. This is not necessarily a bad thing to do but I view things from the top down. If I have reduced net long exposure sufficiently, either by buying SDS or selling stock, then the bottom line of the portfolio should go down less if the SPX ends up going down a lot. To illustrate with an extreme example; if at the peak a few weeks ago you went 95% cash and kept 5% in one stock. Let's say that two weeks from now the S&P 500 is at 1000, down about 20%, but the stock you held onto is down 60%. That 60% hit in the stock would only be 3% of the portfolio, would the drop in the stock in that circumstance matter at all? The more important event in that case was the raising of cash not the drop in the stock, the drop in the stock is practically irrelevant.