It’s hard to believe that the S&P 500 Index has been flat as a pancake since the start of the new millennium – in fact, we are still below the S&P’s starting price of 1,470 at the beginning of 2000. The Index had its ups and downs, but when you connect the dots, it didn’t make any headway.
It’s even harder for index investors who relied on this large-cap benchmark to grow their retirement savings. To think, a portfolio with $100,000 allocated to the S&P 500 hardly budged at all. That’s a lot of wasted time and missed opportunities.
That’s why we advocate following trends and actively managing our portfolios using exchange traded funds. Whether the broad market travels sideways or falls, a trend is always in the making. [What is an ETF?]
Actually, the term “sideways market” is somewhat misleading. There’s plenty of market activity, but it’s in the form of a sharp downward move, and then a slow recovery period back to its original price level. Only the best and luckiest of timers can get in at the lows and exit at the highs. Otherwise, it can be a very frustrating experience, even for seasoned vets.
Surviving the Dry Season
A quick review of history shows that there have been dry spells in the market lasting 10 years or more. For example, an investment in stocks making up the S&P 500 Index during the periods from 1929 through 1942 (13 years) and 1966 through 1982 (16 years) would have amounted to no more than a break-even investment.
In this most recent sideways move, the S&P 500 has fallen off its high of about 1560 prior to the precipitous drop in 2008 after the financial crisis brought the broader index down below 700, or more than a 50% plunge. On the flipside, the S&P 500 has powered through the past couple of years and is now trading around 1350, more than a 90% surge in gains off the low during the financial crisis.
Many financial advisors focus on your timeframe for growth, but it doesn’t matter if you have five years or 25 years left until retirement. You can’t afford to let your investments sit idle for extended periods. For instance, over the last 10 year period, the S&P 500 has only gained around 2.9% on an annualized basis. Worse yet, an idle investment does not take advantage of the beauty of compounded growth. [Using ETFs to Build a Diversified Portfolio]
No matter what the cause, the market’s recent lost decade underscores the inherent danger of the buy-and-hold strategy. Sure, the markets will likely rebound eventually, but that will be of little consolation to investors who need their money now for retirement or to those who may have bailed out of the markets at or near the bottom.
The volatile jerks during a sideways market often make investors believe that a market rally has taken hold during highs, only to experience disappointment when yet another sharp downturn occurs. Some who can’t stand the fluctuations get out of the market and sit on the sidelines, often without any plan for how to get back into the market later on.
Countering Volatility with ETFs
So what can an investor do? Well, an ETF investor who follows the trends and sticks to a sell discipline has a whole bunch of options.
With the growing list of available ETFs and ever-changing trends, we are convinced more than ever that a disciplined investment strategy is required to enhance portfolio returns, diversify and reduce downside risk.
Your strategy, like ours, should be to stick to a plan and not let your emotions take over. Once you start thinking with your heart or gut, it can be hard to kick-start your logic. Even neutralizing emotions will serve the trader well.
Specifically, you need to know what to buy, when to buy and, as importantly, when to sell.
Three Main Rules
Here are three rules that should help keep most ETF investors out of trouble:
- Maintain an 8% stop-loss on your ETFs.
- Keep an eye on the trend. If your ETF declines below its 50-day average, that’s not a good sign. If the same ETF declines below its 200-day average, sell.
- Don’t chase markets that are too hot. The last time many world markets and industry groups collectively hit new highs was in 2000 and again at the end of 2007. You know what happened then – the boom went bust. Keep your emotions in check.
The Business of Buying and Selling
The first and perhaps most important screening process for ETFs is knowing the 200-day moving average of each candidate—and where it stands in relation to it. Trend lines are so key that you should only invest in ETFs trading above their 200-day moving averages. You can find this information by checking any ETF’s information page on our ETF Résumé page
We look for uptrends, and then examine those trends using fundamental analysis. Once a position is entered, we stay in the investment until the trend turns sour or declines below its trend line. [Five Things You Need to Know About Trading ETFs]
In some cases, where trends have moved steeply to the upside, the corresponding ETF may be more than 10% above its moving average. In those cases, we impose an 8% stop-loss. If you buy an ETF trading 15% above its 200-day moving average, it’s best to sell if it drops 8% from a recent high. That way, you take control of when you are leaving position and preserve as much profit as you can.
You must remember that over time, the stock market and individual securities follow general trends and these trends are identifiable. The idea is that you want to be fully invested in stocks when the market is above its long-term trend line, or 200-day moving average. And you want to be safely positioned when the market is trending downward.
For example, below is a chart of the SPDR S&P 500 (NYSEArca: SPY) with its 200-day moving average. You may notice that the fund traded above the trend line between 1995 to mid-2000, at which point the tech bubble was collapsing and the bear market replaced the bull market. The S&P 500 stayed below its 200-day moving average and kept us out of the market from mid-2000 to mid-2003, then climbed back above trend from mid-2003 to late-2008. More recently, the trend following strategy is coming into play, once again, as the broader market has been steadily shifting above the trend line since the start of 2012, following the tumultuous and volatile 2011 market year.
How often we pull the trigger on building or unwinding a position all depends on the ETF and where that ETF lies in relationship to its own moving average and its performance off the high. By following a sell discipline, one can provide protection through locking in the upside performance while avoiding greater losses.
Resolve To Protect and Profit
Momentum can certainly turn on a dime. Just look at the health care sector in 1991 as an example. It was up 50% for that year, but the following year it was down 19%.
- Resolve to stick to your discipline. We know the past year has been rocky, and it is hard not to get emotional. We can’t predict the future, so we don’t know what’s in store for the rest of 2012. One way to avoid pulling every last hair out of your head in frustration over the uncertainty is to have a plan and adhere to it no matter what.
- Resolve to pay attention to the news. Political upheaval, major weather events and leadership changes are among the things that can indirectly affect your holdings. Don’t just isolate yourself to the business section.
- Resolve to pay attention to your investments. Are you coming up on a major life change, such as having children or entering the homestretch before retirement? Look at your portfolio and make sure it’s still working for you and the time horizon you have in mind.
- Resolve not to invest in something simply because it’s “hot.” That’s the best way to get burned. Invest because it fits your needs, interests and your portfolio.
Exiting an ETF… Safely and Profitably
If an ETF falls below its 200-day moving average, or if it drops 8% off its high without going below its 200-day average, sell it. It’s a rigorous discipline and is applied to all asset classes, sectors and global regions where there is ETF representation. It’s clear-cut, and you know exactly what your risk is.
However, if you don’t have an exit strategy, then your risk tolerance may not be as well-defined. It takes a high tolerance and lots of patience to suffer 20% or more in losses that some sectors and regions have experienced a few times over the last several years.
While we are clear proponents of having an exit strategy, we understand that there can be some confusion when certain ETFs drop quickly and then climb sharply. There’s a chance you might have sold a position that declined further after you sold it but then rebounded.
In this case, don’t beat yourself up over lost opportunity. Just stick to your plan, have no regrets, never look back and keep moving forward.
When this happens, remember that you can treat the cash you’ve acquired from previously selling an ETF as a “free agent.” This means that there’s no rule that says you must buy back the same ETF you sold if it’s performing well now. Shop around and see where new trends are developing. There might be a different ETF that’s an even better fit for your portfolio now.
Sharp market movements and subsequent ETF declines can unsettle many investors. However, with an exit strategy and specific stop-loss points, the drops can be less stressful for you as it prevents small losses from turning into there-goes-my-house losses.
There have always been and will always be bubbles, and the only sure way you can protect yourself is to have an exit strategy quickly on hand.