Trading Trading the Turn

Tate on Trading - Trading the Turn

Here is a quick quiz for you.
When should you pay attention to the safety demonstration and the laminated instruction sheet offered on airline flights? At the beginning of the flight, or as your bum hurtles earthward at 600kph and everyone around is having a major attack of the sooky sooky la las because you are all about to be turned into people pate?

The correct answer is, of course, at take-off, but most people don't pay attention to disaster planning until they're about to become a giant skid mark on the landscape. Most disaster planning is done after the event when it is somewhat pointless.

Consider the current shake out in the market. If you're one of those people desperately ringing brokers, astrologers or lifeline asking whether it is too late to sell, then you are, to use a Roman term...stuffed.

Not because any action you take may prove to be incorrect, but because you have left your disaster planning until it is far too late to implement. The same goes for people who are desperately searching for a hedging system without understanding that all a hedging system does is lock in the status quo.
Contrary to the marketing of these things, it does not make you money. If you are in either of these positions then you are caught in no man’s land – no matter what decision you make it will be painful and most likely costly.

Granted, the market is fairly sick at present if you are one of these people who were convinced that the law of gravity had been repealed and that things never ever go down.
However, assume that you are one of the sensible ones who have a long-term exit signal or the ability to trade short. Your thinking should now be focussed on what you will do when the market turns - and markets do eventually turn.

To predict how long a market decline might last is folly. However, we do know that markets recover. So our thinking should not only be focussed on how to manage our current trades, but also looking forward to the time when we will have to adjust our current approach.
I've spoken in the past about how you might set up a macro-timing tool that orientates itself in the direction of the dominant trend so I won’t repeat myself here. You can read about this in the past newsletters on our website, under the ‘newsletters’ section.
What I want to do is to give you a sense of how markets look with hindsight after a severe fall.
The data below pertains to the S&P500 and tracks every major market fall since 1965. As I said, the aim of this is not to try and predict when the current fall might end, but rather to get a sense of what happens when it stops falling.

1966-66 - 35 weeks
1968-70 - 77 weeks
1973 -74 - 90 weeks
1976-78 - 75 weeks
1980-82 - 89 weeks
1987-87 - 13 weeks
2000-02 - 121 weeks
2007-2008 - 57 weeks (still in progress)

The interesting thing about this data is that the crash that is seared into the brains of most traders is 1987.
Yet in our sample size it is the shortest of the crashes at only 13 weeks duration. Certainly with a loss of some 53% it was a short savage downturn, but the crash following the tech wreck wiped 43% of the index and the current move down has lopped some 48% off the index.

It could be argued that because of the duration of the downturns, the damage done by the tech wreck and the current credit crisis has been more damaging to investors. The current move down has certainly affected investors' overall psyche because of the double whammy of a fall in equity markets plus a fall in real estate values.

If we examine 1974 and 2000 a little more closely we see an interesting pattern of reversals.
In 1974 the market put on 43% within 11 months of making a bottom. The reversal post the tech wreck was a little more subdued, the market put on 44% over the next two years.

Now all the usual caveats of indices apply – just because the index goes up doesn’t mean your stocks will.
In fact your stocks may continue to fall until they experience the same financial oblivion as ABC Learning. However, you will need to set up a checklist of what you will do when the market becomes more buoyant.
I would suggest that your checklist should include some of the following.

1. How will you decide that the market has changed tone?

Will it be by simple trend analysis, the number of stocks making new highs, long sided signals being generated by your system or a combination of factors?
Irrespective of which one you use you will only be able to make the judgement that the bear market has ended in hindsight. However, this is not a concern since if you have a trend trigger it will automatically orient you in the direction of the predominant trend.

2. How will you begin to re-enter the market?

This question touches on the notion of how we structure our portfolios if they have been out of the market for sometime with the bulk of our holdings in cash.
If you have been trading short through this period then your system will simply swing about and you will not need to answer this question. For those who have been in cash, the question is a complex one.
I don’t believe in simply lumping all your money in the market on the first few signals you receive. I am a fan of staged entry that is dictated by the market – you set a maximum level of exposure or risk at any one time and you enter the market according to changes in this risk profile.

3. When you will you opt for gearing?

The policy of banks lending vast amounts of money to people who could never possibly afford to pay it back is what got us in the poo in the first place.
However, that doesn’t mean we should ignore the earnings multiplier effect that gearing can have. This is particularly true if you trade an index vehicle or fund. Gearing can increase the rate of return over and above the market return you could achieve simply by holding these instruments.
Add to these the creative use of options and you have an interesting trading model. It may be that because the market is exiting a period of being smacked around the head that your first forays into the market are un-geared.
This is a personal choice and reflects your personal risk profile. A change in market sentiment represents an opportunity for the astute trader. Unfortunately many do not recognise this opportunity until it is too late or they have been so shocked by the ferocity of the decline that they are paralysed into inactivity.
The most important thing for a trader to realise is that the market is in a state of flux and no condition is permanent. Bear markets are followed by bull markets and vice versa. This is simply the natural order of markets. Make sure you’re ready to capitalise on the next market phase.

If you’re not quite sure about what to do, you have a limited period of time in order to sharpen your axe and commit to your own education.
Your future fortune relies on it.
- Chris Tate

 

This is just my opinion, but I wouldn't be worried about preparing a strategy for re-entering the market any time soon, I think capital preservation is still where everyone's focus should lie. I think the tide is turning, and not in a good way.

 

Capital preservation is very important but it does not mean that you should sit back right now and do nothing.
Every serious investor/trader should have a strategy in place no matter what market conditions are.
Investing/trading is a very serious business, so without strategy in place you’ll never make it.

 

Ironically my strategy is exactly that "do nothing". Though it will involve moving what cash reserves I have into GOLD before I proceed with my doing nothing strategy. Then I plan on playing the waiting game. I will specifically be waiting for the global house of cards to fall.