Reader Question

A reader asked for a recap of how I use the 200 DMA in deciding on defense and offense.

The big macro is that demand for equities is either healthy or it is unhealthy. If it is healthy you should be in. If it is unhealthy you should be out. In practical terms 100% in or 100% out does not work, the real world application is that you focus on growing the account when demand for equities is healthy and you focus on protecting assets when demand is unhealthy.

There are multiple ways to gage health of demand and while they might have slightly different trigger points they are close enough to each other. I think the 200 DMA, all by itself, is the simplest way to go, as opposed to some sort of moving average cross over. Taking some sort of defensive action should help avoid a chunk of down a lot, no guarantees of course.

The reader asks if I use this approach with sectors. Short answer; no. I believe in maintaining a diversified portfolio which means always having some exposure to each of the big ten S&P 500 sectors. My process for deciding underweights and overweights is derived from a combo of how sectors have usually behaved at similar points in previous cycles, an assessment of current events and anything else I might know about like the yield curve and financials or interest rates and utilities. Also a part of this part of the process would be the increased exposure to things that don't necessarily correlate to the stock market.

Next he asks something about 200 day in a macro versus micro context but candidly I don't think I understand this part of the comment. What I'll say is that I am trying to make this as simple as possible. If demand for equities as measured in the manner described is unhealthy then I will take some sort of defensive action. I will reduce or take off the defense when demand gets healthy again. The goal with this is not down zero in a bear market just down less.

Lastly the reader asks about why I think this bear market will be normal, is there some way that I quantify my opinion. First I should disclose that I don't need to be right about this. I disclosed, almost in real time, the defensive action I took in 2007 toward my goal and consistent with my exit strategy. If the market continues much lower, past what most would consider as being a normal bear, and I do nothing else, the double short will grow versus the rest of the account thus neutralizing more an more of the portfolio.

I've outlined in many previous posts how similar the end of this cycle looked to past cycle-ends in terms of market action and sentiment about how different it is this time around. Last summer very few people were worried about a bear market, which is typical, and now many people are worried about how different this is because of housing, inflation, housing, deleveraging and so on.

No matter what your level of concern or bearishness, I am telling you that this time is different has pervaded every time at the end of cycle. When Iraq invaded Kuwait in 1990 the market swooned and the fear was enormous said the guy who was trying to open accounts at the time by cold calling for 12 hours a day.

If it is different, fine, I'm confident in the steps taken that I wrote about last year but right here right now we are well within normal but no I do not have a specific way I quantify my opinion. Having been through these before and somehow the fact the I remember what the sentiment is like every time contributes to my opinion.