10 Steps To Be Ready For The Next Market Pullback
If you turned on TV or went on the internet and the report was that Bank of America stock had pulled back by $1.59 from the recent high, whether it was in a day or a few weeks, what would your reaction be? Probably like most of us, no big deal and it may not even register. What if the report was that the Dow Jones Industrial Average, the Dow, had corrected by 1,300 points from the recent high, whether today or over a few days or weeks, how would you react to that? Quite a few would be taken back by that 1,300 point move, and the online and TV media would no doubt be running stories about "the big pullback" and "Markets in Crisis" 24/7. (I monitor the S & P 500 and not the Dow, but mainstream America and the general media seems to pay closer attention to the Dow.)
The fact is, they are the exact same pullback - in percentage terms. Bank of America closed yesterday, January 23 at $31.92, so a 5% "pullback" equals $1.59 and a 10% pullback is $3.19. The chart above of the Dow shows lines drawn at 5% and 10% pullbacks respectively.
The Dow closed yesterday at 26,210, so a 5% pullback is 1,310 points, and a 10% pullback is 2,620 points, which even to me "sound" like big numbers. The numbers, in percentage term however are the same, 5% - 10%. Obviously time frames do matter. A 5% - 10% pullback in one day may have much more significance, both from a technical and psychological perspective, than a 5-10% pullback over a few weeks or months.
The fact still remains however that a 1,300 point pullback in the Dow would cause many to pay attention, even though in percentage terms it does not seem so severe. It reality, that price level takes us back to January 2, 2018 price levels (three weeks ago) and not even down to the 50 day moving average, ( a widely held intermediate-term trend measure).
So how do you think you would react? Fear, panic, no reaction, go online and look for more information to help form a conclusion? The fact of the matter is that as investors and traders we always have to be prepared for the fact that a 5 - 10% pullback, or more, can always be just around the corner, whether it is a one day event or a 6 month event. They will not ring a bell for us and say, "now is the time to get your risk in order". So with markets at persistent all time highs, and with many, including myself very long, (but according to my plan and not over-exposed for my standards) how should we approach account management?
To put things into context, I have been trading since 1997 and have seen the Nasdaq triple and then lose 80% of its value between 1998 and 2002. I have seen household names like Cisco and Intel go up 5% a day for what seemed like a year and trade at triple digit PEs, and then watch them trade down 80%+. I've watched Wall Street and media favorites like Enron trade from $80 to eventually zero , and "safe, widows and orphans" stocks like Lucent trade from $72ish to zero. I have seen Wall Street legend Bear Stearns company open at $2 after trading in the $60s weeks before, seen Lehman Brothers go bust and talked to friends at Merrill Lynch as their life savings traded down 95% to the low $2 range. So I have seen some volatility and surprises in my time.
This blog is by no means any type of a market call or prediction. Those who have followed me online for any period of time know that I do not make market calls or predictions and I simple trade the price on the screen in front of me. There is however right now a considerable amount of dialogue being devoted to how long it has been since we have had a "5% pullback". Very intelligent and experienced traders and money managers have weighed on on every side of the equation. Some say to buy everything now, some say to sell everything now, some are on the fence. The media shows chart after to chart discussing it.
I wrote this blog for the members of my website to share with my them my thoughts, analysis and experience of having traded through similar situations before over the past two decades amd to answer some questions that they may have. I take a calcaluted, systematic approach to portoflio and position management. I don't just manage one position at a time, I tie it all together in a much more comprehensive, strategic approach.
Following are some of my thoughts:
A few basic facts:
- Regardless of today's price action, markets change direction at any time.
- If you "think" you have too much money at risk, you usually do, dialing in some risk can help.
- The longer we go without any type of meaningful pullback, the odds are the pullback can be deeper to work off excess momentum.
- Account structure of getting exposure right always supersedes position signals.
- Worrying over the direction of the markets every day is not a good way to manage money.
- At the end of the day, there are no guarantees and any outcome is always possible.
- Set your stops and honor them.
With that being said, here are a few ideas:
1. Follow a Trading Plan and Ignore Predictions
Before putting money to work, traders and investors should have a comprehensive, written trading plan to follow, which should outline big picture topics like how much to risk in the account, how much to risk per position, how to measure overall risk levels, as well as entry and exit signals/plans. Everyone has a different comfort level for volatility and drawdowns. It is my belief that traders can handle unlimited volatility...on the upside. The drawdowns can be fast and furious, so you don't want to wait until the persistent selling begins to figure out your course of action.
It doesn't matter if a Billionaire hedge fund manager says that markets will "melt up" and holding cash is "stupid", or that another equally well known Guru says the same markets will drop 40%. They are just opinions, not facts, they can be wrong, they may change their views tomorrow, they can likely better afford to be more wrong that us non-billionaires can be and they will not replace your potentially lost capital if they "get it wrong". I am not going to put one more or one less dollar to work based on what anyone else says. I accept that my results are solely mine and I follow my plan.
2. Accept the Fact That Drawdowns and Volatility Are a Natural Market Event
We have had very cooperative one way markets for the most part the last few years. For many that started trading after 2009, they have seen mostly blue skies. For those of us who have been through a few major bear markets, (I started trading in 1997), we know what downside volatility looks like. This is one of the benefits of having traded through major downturns. Once we accept that market drawdowns are inevitable and technically constructive, we can learn to not be in fear of them, but accept them for what they are, a common and normal event.
3. Understand Your Time Frame & Respect Risk - Markets go where they go
Someone with longer term time frames should welcome pullbacks as an opportunity to put new money to work, following some type of price based signal. Shorter term traders, of which I am not one, may tend to raise cash faster, but they have to get it right twice, sell at the right time, and then buy it back at the right time, very few can do this consistently well. This goes not only for the overall account, but for each position as well. My experience is that bigger time frames equal bigger winners.
Small pullbacks can turn into big pullbacks and big pullbacks can turn into bear markets, sometimes quickly. Not all pullbacks correct quickly, and there is no guarantee where they stop. Follow strict risk control measures and have stops in place to protect against bigger declines. Know what and when you are getting out before hand, and never chase prices down.
4. Timing "The Top" Can Be Difficult
I know of many people personally who got all out of the markets years ago because they thought it was "too high" and prices "didn't make sense". Those people have missed out on a significant wealth building opportunity because they likely followed emotions and not some type of rational program. Prices don't need to be justified, they are what they are. If your risk and position sizing is right, you have protection in place . Price based exit signals will telegraph weakness and exits when necessary.
5. Be Careful Trying to Short the Uptrend
One of the unfortunate worst outcomes is for someone who goes through a major bull market and loses money. The fact is that shorting in any market is a very low-win rate strategy and should be left to very experienced professionals. The true "smart money" trades with major trend. The trend is made up of millions of participants worldwide overseeing literally trillions of dollars. Vanguard alone has over $4.5 Trillion under management. If the major trend is in one direction, those fighting it stand very little chance of success. Cash is a good hedge and trading the short side has different characteristics than the long side. It can always work
6. You Will Never Be 100% "Right"
In my evolution as a trader, I have learned to avoid the all or nothing propositions and am content striving to get it 80- 90% right. As I have said for years, I will definitely be long at the very top and know that I am going to give back some gains when the long term trend starts to reverse. I am content to give back the last 5 - 10% or so to have captured the triple digit gains along the way. Which leads us to #7.
7. When in Doubt, Move Some Out
Cash is the only true hedge. I approach it like this - let's assume that we get it wrong. Would you rather have less money at work and markets move higher, or more money at work and markets move lower? This is always the best approach. I always defer to having a few less dollars at risk and let the upside take care of itself. One reason I do not trade on margin or use triple levered stock ETFs. Scaling using some kind of shorter term Moving average like the 20 day moving average is a systematic price based way to reduce exposure. You will likely never get it exactly to the penny so accept the strategy for what it is - a scaled approach.
8. Core vs. Non-Core Positions
While all of my positions are managed via price and exits and all are eligible for sale, when roads get bumpy, I determine what stocks I want to eliminate first. Core positions to me are mega cap global industry leaders, like an Apple or a JP Morgan, I plan to hold these through various market conditions and earnings reports until the exit is signaled. A non-core name may be a more volatile, mid cap name like an AK Steel or Mosaic. If I need to "raise cash" for the accounts I will look to get it from these non-core names first.
Account structure and risk controls (cash levels) takes precedent over the individual position signal. What this means if you want to raise cash, I would look at second tier names first. Single stocks are usually much, much more volatile in drawdowns than ETFs are as well, and stops will often get run and reversed. In the ETFs space, it easier to scale some from the exposure and still keep some open. If you have $10,000 in 5 different ETFs it is easy to raise 20% in cash just by taking $2,000 from each position. You still have your position but less at risk. I would not go into account overhaul mode and try to scale some from 20 positions.
9. Have a Buy List Ready, but Do Not Chase Downtrends or Average Down
Slow and steady wins the race. It is tempting after watching a stock or ETF trade higher for weeks without you to want to buy the first days pullback. At times it is best to wait until you get the technical signal, maybe an MA test, before just running in. If you do buy and it continues lower, follow your stops and do not average down into the trade. I never saw anyone got broke from having less exposure, but I have seen people go broke from fighting the tape and continuing to average down into a loser based on some kind of revenge trade that they will prove the market wrong. It never works. One bad position can set you back significantly.
10. Wrap Up
Pullbacks happen, drawdowns happen, markets go down as well as go up. The media and Twitter will rattle you in drawdowns. It is better to have your plan in place today and make the necessary adjustments now, if any are necessary at all and get your risk in line, then to wait until the selling starts and then make emotional decisions.
If you think you have too much at risk, you usually do, if you aren't sure. assume you will "be wrong" and ask which outcome you prefer. Very few people get in at the very bottom or get out at the exact top. Understand your time frame and continue to have stops in place if downtrends persist. Don't rush in to buy right away and certainly don't average down into downtrends. Account management done correctly is a lifetime process, not a short term event.
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