When it comes to risk management, most traders and investors think only in terms of stop losses, position sizing and profit protection tactics. There is no doubt that these are essential elements of the puzzle, but before we even get to them, we need to realize that there are two aspects of risk management that are equally important and often ignored – proper equity selection and market health.
Successful investing (or trading) is about improving the odds of success. If you want to catch a lot of fish, you have to fish at a pond with a lot of fish. If you want to catch big market winners, you have to look for them in a place that has historically produced big winners.
Most people struggle, because they are fishing from the wrong pond or at the wrong time.
3 out of 4 stocks eventually decline 75% or more from their IPO prices before they go bankrupt. While underperforming the indexes, all of them spend a lot of time on the 52-week low list. By not fishing there, you are improving your odds substantially.
It is true that occasionally, some stocks stage massive comebacks from their 52-week lows. Some recent examples include $FSLR, $RIMM, $NFLX, but for the most part they are the exception, not the rule. If their comeback is for real, they will eventually hit new 52-week highs again and from proper bases. Look at the homebuilders and construction materials stocks. They struggled between 2007 and 2010. All of them severely underperformed in that market period. Many lost 90% of market cap from their 2006 highs. At the beginning of 2012, many of them started breaking out from proper bases to new 52-week highs. They haven’t looked back ever since.
Only 1 in 4 stocks outperform the S & P 500 during their life time. The biggest winners spend the majority of their time on the 52-week high list. Fishing from that pond improves the odds of success.
It is true that sooner or later all trends end – often when there is not a single cloud in the sky and everything seems perfect or with other words when stocks are near multi-year highs. It is also true that tops are clear only in hindsight. Market usually gives plenty of signs of a trend change and enough time to exit. Besides, not every breakout to a new 52-week high is a valid buy signal. Only the ones from proper technical setups are.
If you want to catch a lot of fish, you are likely to do much better if you go fishing when the weather is nice as opposed to when there is a storm outside.
The success rate of all market approaches is cyclical. It has to. It is the only way they could remain profitable over time. Being able to recognize the type of the current market environment is an invaluable skill.
The real safety in the market is derived from proper timing. Most breakouts fail in high-correlation corrective markets. Most breakouts follow trough in low-correlation “market of stocks” environment.
There are different ways to measure market health. Some look at sentiment, some count the number of distribution days over the past few weeks, some pay attention to the direction of the 50 and 200dmas of the major market benchmarks and if the indexes are trading above or below them.
This is how I measure market health. Points 1 and 2 are essential. The rest of the points serve as confirmation signals:
1) Is there a large number of good risk/reward setups near 52-week highs; Notice that I mention number of setups near 52-week highs, not number of stocks near 52-week highs. There is a difference. Extreme readings in the latter often precede turning points in the market.
2) Are breakouts successful and following through
3) There is a sector rotation – just when a leading sector looks tired and poised for consolidation through price or time, another comes ahead and push the general market higher. Bull markets are typically low correlation market of stocks, that provide opportunities for both longs and shorts. It is easier to make money on the long side, of course. The market climbs the proverbial wall of worry. Surprises follow the direction of the established trend. If there is bad news, it is generally ignored by the market.
4) Risk-on assets are outperforming – small caps due to their size and recent IPOs due to their smaller float, shine
5) Defensive stocks are lagging – capital ignores lower beta assets for the benefit of fast moving momentum stocks; by defensive stocks, I refer to utilities, staples and Treasuries.