The time is now to develop a game plan.
Last year’s performance in many asset classes was an anomaly. The bubbles in stocks, bonds and real estate are real. And they can burst.
Central-bank stimulus is no longer propping up assets. Volatility has increased. Markets are acting more normal. And if normal risk tolerances resurface, people are going to care that the S&P 500 Index SPX, +0.51% is near a staggering 25 times earnings.
That means those markets’ shelter can get swept away, potentially erasing gains made since 2012. Even after that, the markets would be fairly valued based on historical multiple comparisons.
Three steps
What do you do about this?
The first step is not unexpected. To take advantage of this, you first need to realize conditions have changed. If you don’t think they’ve changed, look at what happened in February. For everybody else, the second step is the hardest one.
The second step is to neutralize your portfolio. It doesn’t matter where the market is, it doesn’t matter if the market moves down or up after you make the changes; all that matters is that you neutralize your accounts against market risk. In IRAs and 401(k)s, that means sell everything.
For taxable accounts that are holding large unrealized capital gains, use a hedging technique in the stock market with ProShares UltraShort S&P500 SDS, -0.99% ProShares UltraShort QQQ QID, -1.53% ProShares UltraShort Dow 30 DXD, +0.70% or ProShares UltraShort Russell 2000 TWM, -3.36% as used in our CORE Portfolio Strategy.
The CORE Portfolio Strategy has been neutralized since the SPDR S&P 500 ETF Trust SPY, +0.52% was at $276.1. It is designed to be conservative, and it sometimes virtually eliminates risk. That’s the key for this second step.
When we neutralize ourselves against risk, we finally have the opportunity to be objective. Imagine having your entire portfolio exposed to the market. You did great during the stimulus period, but times have changed. You want them to be like they were, you are hoping, holding, and you have a bias.
However, having a bias is the biggest hurdle to transitioning to strategies that can take advantage of expensive markets. When we remove the bias, when we become objective, we can be open to taking advantage of market moves more readily. That’s the third step.
The third step is to find a strategy that can work in markets like these. Buy-and-hold is not likely to work for a long while — at least that’s what tends to happen when markets are expensive. And ours is not only expensive, but there’s less liquidity. So moves can be amplified.
Find a new strategy
Proactive strategies can work. Below is an example:
At Stock Traders Daily, we have been watching a trend in the stock market that began in February. The chart below is of SPY.
Although the declines were severe in early February, and although the markets failed to make new highs recently, the slope of the trend is actually up. There were a series of higher highs and higher lows, according to the chart, and the channels are wide.
When the market tested resistance, we neutralized our CORE Strategy with SDS, but we also bought short positions to profit from the downside in more aggressive strategies. Also, our Sentiment Table Strategy, for example, told us that the market was overbought on Feb. 27. That strategy is holding QID, and that quantitative-algorithm observation supported the test of resistance that had happened.
Our current downside target is near $260 in SPY, based on the charts. The SDS position in the aggressive strategies is already up about 5.9% from our entries, our conservative strategy is neutralized, and we have a game plan.
That’s the point. When we are objective, we can develop a rational game plan. Investors have not needed to have a game plan for years, but that’s changed. Everyone needs a game plan now.
Thomas H. Kee Jr. is a former Morgan Stanley broker and founder of Stock Traders Daily.