by Andrew Adams CFA, CMT, Saut Strategy LLC
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Charts of the Week
Dealing with hurricanes and bad weather is a normal aspect of Florida life. If you live here long enough, you get used to the drill anytime a storm threatens to make landfall: you fill up your gas tank; quickly buy whatever water and non- perishable food items are left in stores (and maybe some alcohol in case a spontaneous hurricane party breaks out); all while telling yourself that “it’ll probably be nothing” and soon you’ll have to figure out what to do with the 96 bottles of Publix-brand “spring” water you just bought.
Hurricanes are scary and can be disastrous. Here on the west coast of the state, we weren’t expected to get a direct hit from Dorian, but it still didn’t stop people from preparing for one. My wife casually mentioned late last week that if I was going to the store I might as well pick up some bottled water just in case. By the time I got there, though, (in the middle of the day) there was barely a parking space left in the lot, they were rationing the remaining water, and the bread aisle had been picked clean (which was fortunate for my keto diet). All this for a storm that was almost a week away from the state and not expected to hit our area based on the latest projection. Yet, preparing like this was the smart call regardless of the unlikelihood that the supplies would be needed.
It was a risk management strategy to protect against a potential very bad outcome, and, since this is a financial market newsletter, I’m sure you don’t need multiple prediction models with a cone of uncertainty to forecast the analogy heading your way.
The ability to manage risk is the most important skill to have if wanting to last as a trader or investor. It doesn’t matter how good you are at stock picking or entering a trade; if you don’t know how to protect against the downside when wrong it becomes extremely difficult to make money. Of course, most people don’t like to hear this and continue to put all their effort into finding that one trading pattern, indicator, or valuation method that is going to unlock the mysteries of the market and prevent losses altogether.
There’s a reason you can find hundreds of books out there dedicated to how to choose stocks and enter positions, but few, if any, focused exclusively on knowing when to exit a position. It’s not sexy; it’s not fun; and yet ask any professional who has been in the game long enough and I can almost guarantee that they’ll mention risk management as a key to long term success.
Let’s look at an example:
- A trader places 10 trades with a win rate of 80% (8 out 10 trades are winners)
- Each winner produces a 5% gain
- But each loser produces a 20% loss because the trader doesn’t manage the risk
- At the end of the 10 trades, the trader who started with $100,000 will now only have $94,557 — a loss of over 5% — despite being right 80% of the time
The above example is overly-simplified, of course, but it’s probably not too far away from how many traders and investors operate. They may have a lot of winners, but it only takes one or two big losers to destroy weeks, months, or even years of progress.
Long-term readers may recall that I am a huge fan of Jack Schwager’s Market Wizards series of books (particularly the first two released ~30 years ago). These works are collections of interviews with top traders and investors who have very different styles of making money in the markets. The qualities they all share, though, are that 1) they’ve found a method that works for them and 2) they manage their risk.
That is the “Holy Grail” of the markets, but, to many at least, it seems too mundane to actually be important so is instead ignored.
And yes, sometimes doing the right thing and cutting a position comes back to bite you. There are few things as frustrating as closing a losing trade only to see it reverse and go back in your favor, but the only way to prevent it is to stop trading altogether. If it happens regularly enough, then it starts to become very easy to tell yourself, “Oh, it’ll come back” or, even worse, “I should just double- down so it doesn’t have to come back as far.”
Strategies likes these work until they don’t, and when they don’t it can decimate an account. Likewise, it just takes one hurricane to destroy everything you have so each one has to be taken seriously as if it was “the big one.” You may feel dumb buying emergency supplies or even evacuating your home only to see the storm pass on by, just like you may feel dumb admitting that a position in your portfolio is a loser. Yet, in both cases, the worst case scenario is bad enough to justify the more cautious stance and will help keep you going in the long run.
Risk management is also why long-term investors diversify — both within and across asset classes. It was not that long ago that I was getting asked “why should someone own bonds when interest rates are expected to keep going higher and the stock market is in a secular bull market?”
Well, the developments over the last year are a better answer than I could ever provide. It doesn’t matter how confident you feel about an investment or trade; you have to decide at what point you are wrong and how much you are willing to wager for the potential to see your ideas play out. And remember, you can always get back in, but you can’t always get back out.
There are no set rules for “how” exactly to manage risk, but there are a few popular guidelines to help. William O’Neil’s famous “CANSLIM” method advocates selling whenever a stock goes 7-8% beneath where you bought it. If you truly are a long-term investor who plans to hold for years, maybe that can be bumped to 15-20% assuming your average winner is much larger than that.
As a trader, I try to size my positions so that if I’m wrong I won’t lose more than 1% of my account on any given trade. That way, I can be wrong quite a bit and still not suffer a debilitating loss. If I want to give a trade more room to work, I just decrease my initial position size, while if I use an extremely tight stop, it allows me to put on some pretty large positions for my account size. The most important thing is to have a system and stick by it though.
If you do have a risk management system in place, then the market’s fluctuations become a little less stressful. Its direction still obviously matters and it’s never fun to lose money, but if you have a good idea of your max loss in a position then it effectively removes one of the main unknowns that causes anxiety. That is one of the main drawbacks to going to a fully passive investment style.
While I do believe there are positives about passive indexing and asset allocation models, they do leave you completely at the mercy of the market and can actually heighten the emotional rollercoaster instead of lessening it since investors feel like everything is out of their control. At least when you take a direct active approach, you can more easily define risk and profit targets that provide a little more structure to the uncertain markets.
And if you’re wondering why I’ve spent almost 1,300 words on hurricanes and risk management, it’s because the major indices still remain in their respective trading ranges and there’s not much new to say. It initially appeared Friday that we’d get an attempt to break out over the recent reaction high in the S&P 500 and NASDAQ, but that was too much to ask for on a low-volume Friday before a holiday.
We did survive the long weekend without getting a major market-moving event, but yesterday was a microcosm of the last month with whiplash moves in the first hour followed by a low-conviction drift the rest of the session. The moves lower did, however, fill the gaps from last Thursday in the major averages and many stocks, which, while not a requirement for us to move higher, does make me feel a little better about any subsequent rally attempt. Gaps, particularly in the major indices, don’t have to be filled, but they very frequently are, and I don’t generally like to have an obvious gap sitting below the S&P 500 in case it becomes one of the majority that are eventually filled.
So, just like in past weeks, the best approach for most is probably to avoid overtrading and trying to do too much while the market is range-bound. It’s been a case where if you don’t take profits quickly you’ll probably give them back at some point, which hasn’t really been conducive to multi-day trades. It’s a tighter version of what we got last year from late October to early December; that range, of course, ended with stocks breaking down for another leg lower, but that doesn’t necessarily mean this one will. Therefore, we continue to watch and wait for the trading range to resolve itself while much of the east coast of the U.S. does the same with Hurricane Dorian.
This morning, it looks like the indices are back near the upper end of the trading range, which, by my count, marks the fifth time the S&P 500 has tried to eclipse the 2940-2950 area since breaking down several weeks ago. It’s rare that the index challenges a resistance level so many times without at least making an attempt to break out above it, so this is one to watch closely. Clearly, a move above the resistance zone would be a positive as long as it stays above it; we just need to be careful about false breakouts, which have been common in recent weeks. A false breakout that traps breakout buyers would not be good with so many watching the top of this range and would put us back in the same situation we’ve been in the last few weeks.
Yet, as I have written previously, there is not much additional resistance standing in the S&P 500’s way above 2940-2950 to get back up to all-time highs, so any true breakout can’t be ignored.
S&P 500 Sector Snapshot
S&P 500 Battlelines Redux
Just like in weeks’ past, the trading range is clear and we’re just waiting for a move away from it to provide some clearer signals of direction. With higher lows and a current position near the top of the range, it looks as if an upside breakout is the likelier outcome, but we can’t assume a breakout before it happens. So, instead, we watch and adjust as needed. Again, above the 2940-2950 zone, there’s not much obvious resistance to point to until up above 3000 and the recent all-time high.
S&P 500 Equal Weighted Index Not Doing Quite As Well
The equal weighted version of the S&P 500 is also largely trapped within a trading range, but it’s not quite as clear as in the normal, cap-weighted version of the index. It remains a decent bit off of its all-time high.
Russell 2000 Lacking Momentum After False Breakdown
I warned last week that the Russell 2000 could produce a false breakdown since it’s had a history of false moves over the last few months. That does appear to have occurred, though it hasn’t really accelerated higher yet like I had hoped it would. Still, it’s something to keep an eye on since false moves often produce more significant moves in the opposite direction and the Russell 2000 remains just above key support. Any breakout in the S&P 500 and NASDAQ will hopefully be accompanied by strength in the small caps.
S&P 500 Trying to Bottom vs Long-Term Bonds
There has been quite a bit of focus on the bond market lately and for obvious reasons given the flattened U.S. yield curve. The 30-Year U.S. Treasury Bond has largely outperformed the S&P 500 going back to late last year, but it does look like the S&P 500 is trying to turn a corner at support in the relative strength chart below. Generally, it’s just a better and easier time to be a stock holder when this line is moving higher.
Sentiment Supportive
Market sentiment still feels quite negative, an assumption supported by the difference between the AAII Bulls and AAII Bears. The Bears still outnumbered the Bulls by 16 percentage points in last week’s survey; anything above 15% over the last few years has signaled negative extremes in sentiment, which often coincides with market lows.
NYSE A-D Line Briefly Touches New High
Another positive is that the NYSE Advance-Decline Line is already back near its all-time high. This is good, though the A-D lines are just secondary indicators and don’t represent “the market” the same way the indices do since the magnitude of gains/losses aren’t factored in. They are best used to confirm action in the indices, so this will take on more importance if the indices join the A-D line by hitting new highs.
S&P 500 A-D There Too
The S&P 500 Advance-Decline line is looking good as well.
NASDAQ A-D Line Still Has a Ways to Go
Meanwhile, the NASDAQ version of the advance-decline line remains well below both the all-time high of last year and the highs of earlier this year.
Breadth Needs to Pick Up to Have More Confidence in Any Breakout
The percentage of stocks on the NYSE above the 50-day moving average remains fairly muted around 35%. We’re still not really seeing exceptional strength under the surface of the market.
$NASI Needs to Sustain a Positive Move
The NASDAQ McClellan Summation Index ($NASI) is a good marker for breadth and it just seems to be easier trading stocks on the long side when this indicator is also moving higher. Currently, though, it’s not doing anything too exciting, but a move higher would help create a better trading environment.
U.S. Dollar Breaking Out but Looks A Little Overcooked
Keep an eye on the U.S. Dollar Index. It appears to be breaking out of the rising trading range it’s been in for more than a year, though it hasn’t really accelerated higher after breaking above resistance. A lack of a pickup in momentum after a breakout is always a concerning sign to me, and a false breakout would likely imply a weaker dollar is on the way. The strength of the U.S. Dollar obviously has a big impact on commodities priced in dollars, as well as on U.S. companies that do business abroad.
Commodities Weak but At Support
Not surprisingly with the strong U.S. dollar, the Reuters/Jefferies CRB Index has been under pressure and not really showing signs of turning around. However, commodities, as a group, do appear to be at major support right now and any weakness in the dollar could help them out.
Crude Oil Remains in Range
I haven’t written much about oil in recent months because there hasn’t been much to say. WTI has largely been range-bound between $50-60 recently and until that range breaks it’s hard to feel much conviction on its direction. However, over the last few years higher oil prices have coincided with higher stock prices, so it would likely be a positive to see some strength in the commodity.
China Still Very Interesting
The Shanghai Composite Index continues to quietly act well after breaking the downtrend it had been in since earlier this year. Many investors have given up on China during the trade war, which is usually when bottoms are made. The Shanghai Index remains above major support and may imply that Chinese stocks are worth a closer look.
Trade Ideas
Without a clean breakout in the major indices it may continue to be a poor trading environment for multi-day holds. However, the stocks featured this week look primed to do well if the market cooperates. I also continue to like several trades from weeks past: Long BIDU, Long EGO, Long Small Caps (e.g. IWM), Short TLT/Long TBT assuming you are willing to manage the risk and not let them go too far against you.
When I look for trades, I am looking for stocks I think can move in the direction I want them to go quickly while limiting my downside if I am wrong. I expect to be wrong a decent amount of the time given the tight stops, but the idea is that the winners should more than pay for the losers. There is an opportunity cost to holding a position, as the capital allocated to it prevents you from using that capital in another position, so if I enter a stock and it doesn’t quickly do what I think it should I may cut it even though a stop or profit target isn’t hit. Likewise, I usually move my stop up to my breakeven point once the trade starts to go in my favor in order to prevent a winning trade to turn into a losing trade. Understandably, my trading strategy might not fit your trading/investing strategy, but the trades highlighted in this report are the kinds that I typically look for.
Current Open Positions in Personal Accounts (this changes daily): Long TLT Sep20’19 140 Puts, Long EGO Sep20’19 9 Calls, Long BIDU, Long ERX
LONG: PagSeguro Digital Ltd. (PAGS)
PAGS has been on fire this year and is already up almost 200% since its late December low. That alone might turn off some traders, but this is strictly a momentum play with the expectation that the hot Brazilian continues its streak. I like that it has multiple support lines around $47-$50, has been consolidating on low volume the last few weeks, and that it’s moving horizontally toward its 20-day exponential moving average, a pattern that often precedes another leg higher. A drop below $47 and it loses its appeal though.
LONG: Starbucks Corp. (SBUX)
SBUX is another proven performer this year that has held up very nicely during the market’s recent struggles. It likely was too extended after gapping up in late July on high volume, but the month of sideways action has helped cool off the stock and has brought the 20-day EMA back closer to the price. It has some support underneath it, too, and the hope is that it can break out above $100 and then keep going.
SHORT: Roku, Inc. (ROKU)
I don’t like to buy weakness or short strength unless I have a very good reason to do so, and ROKU’s trading action is getting a little crazy. The stock is now up almost 500% since late December and has gone almost vertical lately while the broad market is doing nothing. It’s not a trend I feel great about fading, but I do think ROKU has the potential to fall hard once the momentum runs out. That could be soon, too, considering it’s breaking above its very steep ascending resistance for a possible blow-off move (red dotted line) while its RSI indicator is nearing the peaks of this year (above panel). This is one where maybe buying puts is the better option to more clearly define your max risk instead of outright shorting it, but even just falling back down to its 20-day EMA would be a decent move.
Investing/trading involves substantial risk. The author and Saut Strategy LLC do not guarantee or otherwise promise as to any results that may be obtained from using this report. Past performance should not be considered indicative of future performance. No reader should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence, including carefully reviewing any prospectus and other public filings of the issuer. These commentaries, analyses, opinions, and recommendations represent the personal and subjective views of the author, and are subject to change at any time without notice.
The information provided in this report is obtained from sources which the author believes to be reliable. All charts are from stockcharts.com unless otherwise stated.
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