Actionable insights straight to your inbox

Equities logo

Is the Risk Trade ON… or… OFF?

In the stock market... risk is NEVER off...Below are some interesting and, in some cases, somewhat disturbing 'factoids': Every time the GDP has dropped more than 2% in one year, our country has

In the stock market… risk is NEVER off…

Below are some interesting and, in some cases, somewhat disturbing ‘factoids’:

  •  Every time the GDP has dropped more than 2% in one year, our country has gone into recession. As of Friday’s report, Q2 GDP was down 1.5% over the previous year.
  • Garden-variety recessions see an average drop in the market of about 40%. Estimates are now that the likely upcoming recession (assumption of many) could push the market down by 30% or more from current levels.
  • Unemployment is being woefully under-reported. When you include those who are working in temporary jobs to get by along with those who have given up looking for a job, the estimates are closer to 17%+.
  • The European banking and sovereign debt crisis has all the appearances of spiraling out of control. Could a default of one or more European country start a cascade of events that could throw the world into a depression or worse?
  • The US economy is, at best, stuck in neutral with our own sovereign debt crisis. No one knows, for sure, how stable our economy would be if the European financial crises moves beyond the current tipping point and a contagion of default ensues.
  • No trade… no stock… no equity investment… has zero risk forever.

In last week’s letter, I said the following:

“Please do not sit back and let another 2008 wipe out half or more of your holdings. If your money manager moves you to cash in this environment, great. If your money manager knows how to sell, great. If your money m anager is doing neither of these strategies, my advice is to look for another manager.”

This comment triggered an amazing number of emails and phone calls from readers with horror story after horror story. Not every story was the same, but they all had a common theme:

“I have had my money with the same money manager for years. In fact, he is a good friend of mine. He has me in dozens of what he calls good companies (and they are), but he never sells. My portfolio has lost more than 30% in the past year and he still won’t sell or go to cash. I have tried to convince him to take me to cash but he always says that the market will come back… that selling now is just selling at the bottom. But, he always says that. What do I do? I am afraid that if the market drops more, I will have lost over half of my life’s savings.”

My response to these inquiries is this… First of all, your money manager could be right. We could be at the bottom and now would be the worst time to sell. The question is not so much, “Should I hold on or sell?”. The real question is, “How much risk am I taking on if I do not sell?” And, keep in mind… risk is not always one-sided. Yes, there is risk that the market could drop lower and maybe much lower. In this case, selling would avoid this risk of loss. On the other hand, the market could move a lot higher. Selling now would result in a loss of the potential gain.

The thing to keep in mind is there will ALWAYS be risk in putting on a position and risk of not putting on a position. Most people worry much more about the risk of loss in an existing position than the risk of a missed opportunity for higher profits. But, both should be considered in every trade.

Certainly, you should consider the risk of putting on a trade versus sitting on cash. Cash earns nothing but that is a far cry better than putting on a trade that results in a substantial loss.

When considering a stock market investment strategy, you should always… and I mean ALWAYS… first consider the risk of the trade. You should always ask yourself this question, “What happens if this trade moves against me and at what point should I cut my losses and exit the trade?”

We manage many millions of dollars for our clients’ stock market investments. Our clients expect us to make smart, intelligent, informed decisions about when to buy, what to buy, when to sell and what to sell. They expect us to weigh the pros and cons of each trade and decide if the risk is less to be in the trade versus the risk of earning nothing by staying in cash. They expect us to outperform the market, but they do not expect us to buy and hold. We never buy-and-hold. In fact, we have an exit strategy for every trade we make.

Here is a test for your current money manager… (and if you do not have a money manager or financial advisor, then apply this test to your own investment strategies.) Call him or her on Monday and ask the following question: “Would you please go through the holdings in my portfolio, one by one, and tell me what your exit strategy is for each position?” You might be surprised to learn that your manager does not have an exit strategy. Further, you may learn that your money manager doesn’t believe in exit strategies. You may ask, somewhat incredulously, “Why not??”

First of all, most money managers do not actually manage your money by making equity trades. Most financial planners and advisors, use a mutual fund approach to money management and will spend more time telling you how great the fund manager is than telling you how great your portfolio is doing. Remember… It’s your money and your return that you are interested in… not how many times a fund manager has beat the “Lipper Average”.

I should hasten to add that most money managers and/or financial planners, sincerely want your portfolio to grow and prosper. The bigger your portfolio the happier you will be and the larger the income will be for your manager.

Indeed, some money managers actually buy and sell equities for their clients. But, unfortunately, a large number of these managers have not read my book, “10: The Essential Rules for Beating the Market” (unabashed self-promotion). In Chapter Three of my book, I explain that you should use Fundamentals to help you identify ‘what’ stocks to ‘consider’ owning, but you should use Technicals to tell you when to buy and when to exit the trade. I expand on this concept in Chapter Four, where I introduce how to calculate a volatility-based stop-loss strategy where you can set your stop-loss just below a stock’s ‘normal’ volatility on a week-over-week basis.

If a money manager only uses Fundamentals to get into a stock position, they don’t know how to get out of the stock if the Fundamentals don’t change… even if the stock’s price drops 20% or more. Most money managers tend to be ‘value’ investors. They (wrongly, I submit) believe that the lower the price of a stock, the higher its value and therefore the more reason to own it. They are taught this in school and they are trained to think this way in their companies. Money management (for most big investment houses) is really defined as how much money can we manage without having to make a single trading decision. That is not how you would invest your own money in the stock market and that’s not how we invest our client’s money in the stock market.

But… back to my comment on risk assessment… Below is real-life example of what I’m talking about…

I happen to believe that the price of gold will move significantly higher for years to come. I believe it is the one true inflation hedge and should be a serious component of every investor’s portfolio. But, this week, I sold all of my gold positions…! That’s right, at this writing, I hold no gold in my portfolios. How can this be, you may ask? If I believe that gold should be a component of every investor’s portfolio and I believe gold will skyrocket higher in price in the future, why would I sell my gold holdings and now have no position in gold? The answer has to do with risk mitigation and disciplined exit strategies.

Let me explain…

I have reserved a portion of my client portfolios for gold. Depending upon the portfolio’s asset allocation structure, the percentage can range from 20% to 30% of the portfolio when fully invested. However, that does not mean that I am forced to hold gold in the portfolio 100% of the time. When the price of gold is trending higher, I look for buying opportunities But, once I have gold in the portfolio, I always have a downside exit strategy in play, If the exit price is triggered, I jettison my gold holdings accordingly. This is exactly what happened this past week.

As you know, gold had been moving higher for weeks… recently, it moved into almost a parabolic move higher. I was bullish on gold (and still am)… probably you are bullish on gold… just about everyone has been bullish, to one degree or another, on gold.

As such, we had about 20% of our portfolios in the SPDR Gold Shares (GLD). We also had a trailing stop on our GLD shares. I do not always use a “trailing” stop, but I always have a stop in play. This week, the gold trade began to get a little frothy. We were up nicely in our GLD shares, so I placed a stop-loss exit strategy based on the GLD ‘Expected Move’. Then, when gold began tumbling lower mid-week, our stop was triggered. We made a healthy profit and watched as gold continued to move lower. I am now looking for the next entry point for gold. Since I like to get into a position based on our SuperCycle technology, I will be waiting until the SuperCycle oscillator and the time-cycle trend are in alignment. When that happens, I will be back in gold. When that day occurs, I will also have a sell-strategy in place.

It is important to understand that we all may ‘believe’ that gold will go higher for year to come, but there is no guarantee that gold will always move higher. In fact, there are scenarios that can occur that would cause gold to plummet in price. Just like everything else in life… “Always hope for the best but plan for the worst!”

Our stops are in place to protect our clients from the risk of a market reversal. There is no guarantee that gold will go to $2000 an ounce before it goes to $1000 per ounce. There are no absolute guarantees in the stock market. Every trade… every single trade… has risk of loss.

Remember… regardless of how smart or intuitive or knowledgeable you are or your money manager is… No one can say with absolute certainty what the market is going to do in the future. The key is to ALWAYS have the ability to take risk off the table when risk of loss becomes too high. The way you take risk of market loss off the table is to merely move to cash and look to trade again in the future. When risk gets too high, cash is ALWAYS king. Keep the amount of risk you take in the market as much in line with your tolerance for risk as you can.

Speaking of getting back into gold… This week, our models are forecasting a SuperCycle long biased trade for GLD but the time-cycle model for the gold commodity is weak. We are watching these models with a long bias at the moment. But… and this is important to understand… we believe the risk is too high to jump back into gold at this moment, based on our models. That can (and likely will) change as the week progresses. If the risk of loss diminishes, the higher the likelihood that we will make our next trade for gold.

The Elves are Rampaging…

The Bull-to-Bear ratio is neutral, but the Turner CrossOver Oscillator Composite of Signals (black) line has dramatically accelerated lower while the Short Sell (red) line is now trending significantly higher indicating an oversold condition. This is why the Bull-Bear Ratio is still negative. According to these data, the market appears poised for a bounce and perhaps a significant bounce. The bottom has not been set, however. Caution is advised if buying long.

The dramatic jump in the Short-Sell (red line) trend indicates the market is extremely oversold. This does not mean a bounce is guaranteed, but it does indicate a bounce is likely.

 Behind the Numbers…

I fully realize that perception is reality when it comes to whether or not we are in or will soon be in a recession. If companies ‘think’ a recession is coming, they will prepare for the worst, which means cutting back on Cap-Ex, hiring and potential expansion plans. Individuals will put off buying the big-ticket items, which in-turn, curtails demand for those goods, which negatively impacts store sales and ultimately slows down manufacturing.

As such, I do not want to be piling on but I do have some very serious concerns about the US and global economies and the dearth of intelligent political and economic leadership that seems to exist right now.

Before I get into some of my thinking on this subject, take a look at the time-cycle forecast of the S&P 500, below:

It doesn’t take a PhD in chart reading to see that the forecast is more than a bit choppy for the next 3 months.

With the above chart in mind, think about what is happening politically in our near future…

  •  We are soon to get an economic recovery plan from Obama. I guess it’s in poor taste to lament the fact that it has taken him nearly three years to come up with a plan. All of the left-wing crowd are screaming for more incentives and more stimulus and more debt. Maybe we will be surprised to see a real plan instead of a political buy-the-next-election wealth redistribution plan. I hope so.
  • Europe is grasping at straws. Germany’s Merkel is under a lot of political pressure from the German people who do not want to throw their good money after bad countries’ debt, brought on through out-of-control spending driven by socialist agendas. These programs have failed and it looks like the only way to stave off sovereign bankruptcies is taking on the too-big-to-fail policy of bailing out bad decisions. If Germany decides to not bail out the European debt crises, the EU could collapse. If Germany does bail out the European debt crises, the problem does not go away and will resurface in the near future, but in a much worse and far more cataclysmic condition.
  • The vast majority of Americans want a change in Washington. Those on the left think Americans want the Republicans to cave in (as they normally do) to the Democrats. Those on the right think Americans want the Republicans to finally stand on principle and refuse to compromise on core conservative positions. To the left, compromise is the key because it always means conservative values are diminished. To the right, compromise is what got us into this nanny-state, socialistic condition where the country is going broke.

In this background, the so-called congressional ‘Super-Committee’ is supposed to come up with a plan for serious debt reduction without killing our economy. This plan must be completed by the end of November or there will be massive budget cuts that almost no one wants. With so much political power on the line in 2012, I do not see how a realistic plan can be forged that does not leave one side or the other in trouble for the 2012 elections.

As such, I am afraid that the current lack of intelligent leadership in Washington will exacerbate our economic condition. This could be bad and perhaps very bad for the market.

If the market does roll-over (more) and continue its downward trend, I plan to be buying puts and/or owning inverse ETFs. If we are at a market bottom and if there is no recession in our immediate future and if the EU does not collapse and if Washington can actually find some real leadership and if our government can somehow come up with a multi-year plan that gives all of us some reasonable expectation of stability… (breath taken)… then, maybe we can get back on track and witness a lowering of volatility and growing economy along with an upward trending stock market.

Have a great week in the market!

A weekly five-point roundup of critical events in the energy transition and the implications of climate change for business and finance.