Josh Brown, who I tremendously respect, made an interesting comment on Twitter about going to cash in times of turmoil:
2 questions for those who take their 401(k)’s to cash: 1. What if you’re wrong? When do you buy? 2. What if you’re right? When do you buy?
— Downtown Josh Brown (@ReformedBroker) January 8, 2016
In this case, he does not refer to hedge funds or individual trading accounts, but to people’s retirement savings.
I can see why he would suggest that most investors should not go to cash and should continue the course of dollar-cost averaging each month:
First, past history shows that many investors are not very good at timing the market. Here’s Joel Greenblatt in the book Hedge Fund Market Wizards by Jack Schwager:
The single best-performing mutual fund for the entire decade was up 18 percent a year, on average, during a period when the market was flat, yet the average investor in that fund lost 8 percent. That is because every time the fund did well, people piled in, and every time it underperformed, people redeemed. The timing of the money flows was so bad that investors, on average, turned a fund that was making 18 percent a year into a losing investment. I think that says it all. Institutions make the same mistakes as smaller investors.
Second, achieving average returns would be a great success for many investors.
And third, many investors are likely to be reluctant to buy at higher prices. Psychologically, it is difficult to buy an asset at $200 if you sold it at $170. In life as in markets, if you want to achieve bigger than average results, you often have to do things that are psychologically challenging for the majority of people. If it was easy, everyone would do it and the potential reward would be much smaller.
These are all good arguments, but constantly staying 100% invested and diversified is not the perfect solution for many.
1. Some don’t invest in well-diversified ETFs and own individual stocks in their 401k in order to achieve higher returns.
2. Those that are well diversified geographically and in terms of market cap and non-correlated assets, also go through deep drawdowns because correlations often go to 1.00 during deep market correction. It doesn’t matter if you own Apple or Snapple. Your portfolio is getting hit during market panic. When your portfolio goes through a deep drawdown, you are very likely to panic and sell near the lows. What happens when you sell near the lows? You lose your confidence and you don’t take advantage of the recovery.
3. If you manage to minimize drawdowns during deep market corrections, you will be able to grow your capital faster and be in a better psychological position take advantage of much lower panic prices.
If you are an investor that prefers to ride some trends in a long-term perspective, you need to learn how to hedge. One simple way to hedge long-term holdings is to buy some short-term protection (put options or put spreads) when your stocks start to show signs of distribution and close below their 50dma.
If you are a trader, it is very simple. You diligently take your losses and make sure that they are small, so the size of your winners can overshadow them. As George Soros was famously quoted by Druckenmiller – “it is not important whether you are right or wrong, but how much money do you make when you are right and how much money do you lose when you are wrong”.
Is market timing possible? I believe it is. It is not an exact science, but there’s a process to the madness. There are some clear signs in the market that hint when it makes sense to raise cash, hedge and go net short – distribution days in major stock indexes, price action in market leaders, changes in market breadth, changes in trading results, etc. I wrote about them in more detail in my book Crash – How to Protect and Grow Capital during Corrections.
To answer Josh’s question about “when do you get back”
There are a few things we will be watching ranked in terms of importance:
￼1. Stocks setting up on the long side are starting to break out and following
￼through. These are the next market leaders that we want to own
2. Multiple days of heavy buying in the major indexes: up 1.5% on bigger
than the average 50-day volume; the signal is much stronger if indexes
finish near the high of their daily range. Sustainable bottoms are formed by
heavy buying, not heavy selling.
3. A retest of the momentum low with a smaller number of stocks making
new 20-day lows or larger number of stocks trading above their 20-day
moving averages – with other words, a retest with some form of market
breadth divergence. Retests are not always necessary for a bottom to form.
They matter from a psychological perspective because they flush out the last
remaining weak hands in the market, which makes the recovery smoother
￼4. The major indexes close back above their 200-day moving averages and
￼stay there. They start to move higher.
￼We could gradually increase our long market exposure depending on how
￼many of those points are met: 25% when point 1 is met; 50% when 1 & 2,
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