If an ETF you’re holding – whether it’s commodities, equities or something else – drops below its trend line or falls 8% off its high, let it go, no questions asked.
A lesser stop-loss, such as 5%, could be too low since markets often have a 3% to 5% correction before they move on and hit new highs. If your stop loss is too low, for example, at 3%, you’re going to be buying and selling more frequently, racking up commission fees in the process.
Ultimately, that eats up your returns. You also won’t be able to fully take advantage of the trends. Instead, you’ll be dealing with constant short-lived whipsaws. Sometimes there are volatile days in the middle of an overall uptrend, and it’s in your best interest to ride those out.
On the other hand, having a sell point that’s too high can also hurt you. Setting your sell point at 30% could mean that you lose a significant portion of money before you’re out. It also has you sitting in areas that might not be performing so well and missing out on up-and-coming areas that are beginning to trend.
What If You Missed The Safety Boat?
What should you do if you missed the 8% drop, and you’re down much further than that? Missing the sell point creates the conundrum above. That’s when I recommend the following:
- Sell 1/3 of your equity holdings and focus on the most aggressive positions—those that might be down 20-30% and trading 10-15% below their 200-day moving averages.
- If those holdings decline by another 5-7%, consider selling another third.
- Keep an eye on the 200-day average of these positions. As the trend lines continue to decline, there will be an excellent buying opportunity in the future when the markets eventually rebound.
Letting Go of a Winner Can Be Hard
It can be difficult to let go of a mover and shaker you’ve always had a soft spot for, but if you want to protect your money, you must. It’s like your parents always said when they were grounding you every other week: “This hurts me more than it hurts you.” But sometimes it has to be done for everyone’s good.
There are no guarantees that when you let a fund go, it’s not going to turn around and deliver the numbers again. But that doesn’t mean it won’t, either. It’s exactly why you have to remain as stoic as possible and stick to the plan and rationalize nothing.
What if you follow your exit strategy, and the ETFs you sell end up rebounding? Try this:
- Treat the newly available cash as “free agent” funds. Just because you sold an ETF doesn’t mean you’re obligated to buy it back when it rebounds.
- Look for ETFs that are above or rising above their trend lines.
- Look for ETFs with positive, relative strength. When markets rebound off a low, it’s usually those with the greatest momentum that enjoy sustained uptrends.
As you manage your own portfolio, you might feel a need to always have a set amount of money designated to a certain investment (i.e. small-cap, China or commodity). If this is the case, then the cash can be held until that certain investment goes above its 200-day moving average or gains 5% from its recent low.
With the recent volatility in the markets, we have seen some price swings in ETFs. One shouldn’t worry about the daily ETF price movement; having an investment plan is the priority. When there is a discipline in place, it can help guide investors through the volatile times.
If you’ve got nervous hands as your ETFs swing up one day and down the next, the best thing you could do is to just sit on them. However, if market swings become too unbearable, as witnessed in 2011, it might be safer to switch to cash positions and wait for the markets to settle down before becoming too invested.
Removing the emotions from your investing is one of the smartest things you can do.
And, as we’ve said, having a strategy and removing your feelings from your money is especially timely, considering the ups and downs can make you feel sick.
The Anatomy of a Bursting Bubble—Here and Abroad
Investors and economists often use history as gauge for what might happen today and in the future. Could we have studied the onset of a 14-year bear market in Japan to predict the dot-com crash and subsequent bear in the U.S.? And, what do both events say about today’s economy and markets?
Let’s take a look back.
In the 1980s, outsiders perceived Japan as a utopia because its people had the highest quality of life and longest life expectancy. In addition, Japan was the world’s largest creditor and had the highest GDP per capita. Many Americans feared that Japanese-made robots would eliminate their jobs. With the economy booming and the stock market climbing, skyscrapers filled the Tokyo and Osaka skies, causing real estate prices to skyrocket as well.
Between 1986 and 1988, the price of commercial land in greater Tokyo doubled. Real estate prices soared so much that Tokyo alone was worth more than the United States. Between 1955 and 1990, land prices in Japan appreciated by 70 times and stocks increased 100 times over. Large-scale stock speculation led to worldwide mania. Investors all over the world clamored for Japanese shares. These euphoric investors believed in a perpetual bull market. Luxury goods were purchased in large numbers by the newly wealthy.
Unfortunately, all excessively good things must end. To cool the inflated economy, the Japanese government raised rates. Within months, the Nikkei stock index crashed by more than 30,000 points. The Nikkei crashed this far because its value was inflated on false hopes and hype, not solid financials. Japanese housing prices plummeted for 14 straight years. At its height, the Nikkei stood at 40,000. The Nikkei sank to below 8,000 in 2003 and again in 2009.
Dot-com Déjà vu
Back at home, we experienced a similar crash, but one not nearly as lengthy or devastating as that of Japan’s: the dot-com crash, which began on March 11, 2000 and lasted until Oct. 9, 2002. From peak to valley, the Nasdaq lost 78% of its value as it fell from 5046.86 to 1114.11.
The U.S. military created the Internet decades before “dot-com” became a household word. Vastly underestimating how much people would want to be online, it began to catch on in 1995 with an estimated 18 million users. Soon, speculators were barely able to control their excitement over this new economy.
The first holes in this bubble came from the companies themselves: Many reported huge losses and some folded outright within months of their offering. In 1999, there were 457 IPOs, most of which were Internet- and technology-related. Of those 457 IPOs, 117 doubled in price on the first day of trading. In 2001, the number of IPOs shrank to 76, and none of them doubled on the first day of trading.
Many argue that the dot-com boom and bust was a case of too much too fast. Companies unable to decide on their corporate creed were given millions of dollars and told to grow to Microsoft size by tomorrow.
Unfortunately, economic and “unanticipated” risks will always be there. Investors hate uncertainty, and since we can’t always identify them in advance or eliminate them, there will be times when they affect the investment markets negatively.
If you follow a buy-and-hold strategy, you leave your portfolio vulnerable to any number of unknowns: oil spikes to $200/barrel, the Middle East erupts into war, The Fed makes a drastic move with interest rates. With an exit strategy, you’re prepared to cut losses or pocket profits when events send the markets lower.
Risks without Reward
During the 1990s, many investors believed that the stock markets would produce returns of 20% (or more) per year indefinitely, which was a part of the herd mentality back then. Same goes for the late 1970s and early ’80s, when investors thought bank certificates of deposit and fixed annuities would always have double-digit yields—two assumptions that were clearly wrong.
If your expectations for portfolio returns are too high, there is a very good chance your financial goals will not be met. And more importantly, this can lead to saving too little money to meet your retirement goals. Unfortunately, this can also lead to investing in securities and strategies that are far too risky in order to try to “turbo-charge” the returns.
On the flip side, there are investors who invest too conservatively and risk losing purchasing power to inflation. Investing too conservatively can also raise the odds of not meeting investment goals, as well as the risk of outliving your assets.
So, we find ourselves at another crossroads in the markets. Real estate exuberance, based on inflated prices, has gone sour along with values; financial institutions have turned from princes to frogs in a matter of months; consumer debt is at all-time highs, and investors grow increasingly frustrated with the lack of opportunities the current stock markets offer.
But investors who combine the flexibility, diversity and ease-of-use of ETFs with a disciplined buy-and-sell plan don’t have to fret about all the outside influences on the markets. You can turn a deaf ear to financial hype and keep emotions out of the investing equation.
That’s because the simple, technical indicator—the 200-day moving average—tells us precisely when to buy and when to sell. Even when it seems like the entire market is down, you can count on there being a trend-bucking ETF ripe for the picking. [Simple and Exponential Moving Averages]
What the Opportunities Look Like
The major U.S. equities Indices, the Dow Jones Industrial Average, Nasdaq Composite and the S&P 500, are all trading above their 200-day moving averages. Furthermore, their 50-day moving averages have crossed over their 200-day moving averages, forming a very bullish technical indicator known as the “Golden Cross.”
Meanwhile, commodities, sectors and most other asset classes are trading above their 200-day moving averages. This is a good time to start putting money back into the market as the trend is holding. But investors should keep their stop-loss on hand, in case the current bullish rally does turn sour.
Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own SPY.