Saturday, July 4, 2015

Captial Rotation- Why and How

I often say you don't need to predict the market to make money. But what does that actually mean? If you don't predict which way the market is going to go how do you know where to position your funds to make money?

Well the answer is simple, rotation. This term is thrown around on Wall Street often, but all it means is a flow of money from one location into another. When money flows into one asset, that asset's price increases in value; demand is increasing. When money flows out of an asset, that asset's price decreases in value; demand is decreasing.

When the market is strong and rising, many new leading stocks will signal entries and we will buy them. This adds risk to our portfolio just when leading stocks are being bought and increasing in value. On the other hand when the market is weak many leading stocks will be breaking down and triggering exits. This raises cash levels in our accounts, and in a weakening environment fewer new opportunities present themselves. In other words, we flow into stocks as money is coming into them and we flow out of stocks when traders begin to sell, taking profits in those positions.

Rotation is a reactive strategy, not a predictive strategy. When opportunities are plentiful we will have heavier exposure to risk assets. When opportunities are scarce we will have lower exposure to stocks and therefore avoiding serious downside corrections in the market. This is why we dont have to guess, we can simply react to the market, listening to the price action of leading stocks.

How Rotation Manages Risk


100% Invested Portfolio
|
Market Pulls back
/                                 \
No Stop Trigger                             Stop Trigger 
|                                                    |
Hold Leading Position                Exit Lagging Position
                                                   |
                                                   Reduce Market Exposure
                                                             Raise Cash for New Potential Market Leaders


The flow chart above shows how rotation works in practice. We start with an invested portfolio of leading stocks. The market then undergoes a pullback, some of our positions may stop out and some may not. What this tells us is the positions that did not stop out are truly market leaders as they showed more strength during the decline. The positions that did stop out were showing additional weakness and no longer trading like market leaders; they're becoming market laggards. 

After a pullback in the market you should be left with only the strongest leading stocks and increased cash reserves to use on new "market leading" opportunities that may present themselves. This is a process that is on-going and is called rotation; money flows out of the weak and into the strong.  

Taking this theory to the logical extreme shows that if the market never pulls back and just rallies, we will be fully invested in the strongest stocks and make impressive returns. If the market just crashes we will only be left with cash reserves and no positions as all stocks are declining substantially.

What is interesting about this strategy is that the extreme scenario has been playing out since 2013. Had you been following a Relative Strength Rotation method you would have made strong gains and would have been heavily invested since 2013. If you have been a reader of this blog you know this has been our posture. Rotation rewards strong trending markets and it protects during weak and declining markets.  

-Exiting CSCO
Cisco has been under performing relative to the market since May and last week broke an 8-month uptrend vs $SPY. This week saw strong downside follow-through on that breakdown by gapping lower away from the 20 WMA.

CSCO Daily
The Daily chart shows the recent trading action nicely. I Tweeted out my exit Monday due to the lower low violation. The decline came on heavier than average volume and continued to slide into the end of the week. 

CSCO is a situation where it was our only current losing position and its recent relative weakness made it an easy source of funds as risk elevated in the market.

+Entering Short SP500

The Daily trend was invalidated this week with a convincing decline Monday morning and a very soft bounce attempt the rest of the week. The gap lower open Monday did substantial damage and created a lot of trapped buyers from higher prices. Those trapped bulls will be looking for exits to thier now losing positions should a bounce continue early next week. This will create added downside pressure in the near term. 

The weekly chart below shows the recent higher range that formed between 213 and 208. Each successive range that forms has been tighter than the last. Volatility contractions tend to lead to volatility expansions in the direction of the breakout. This week the SP500 broke out to the downside. Its possible lower prices are ahead.


This week's price action made the lowest close in the last 12-weeks and set new 50-Day lows. The SP500 is now below its 20 WMA. This is how rotation works; once too many stocks are rotated out of, the trends of the indices are no longer able to sustain themselves and succumb to the selling as well.

For risk management purposes if the market can regain Monday's high I would be more positive on the short-term direction of the market and look to exit this initial hedge position. The trapped buyers (overhead supply) should create enough pressure that closing above Monday's high will be difficult to accomplish. $208 on the SPY will be the first level I will be watching to see if buyers can regain. A close above 209.83 (Monday's high) and I will rotate back into cash.


This is the most vulnerable I have seen the market since 2012. The October decline was swift and nasty, but the price didn't have the volatility contraction prior to the drop like it does now. The current formation has the look of a strong launch pad for a move lower.

In light of this I have taken available cash and rotated it into a defensive position, Short the SP500. Our Lg-Cap portfolio is currently 80% long and 20% short. We are still positioned for longer term upside in the market, but with risk becoming more elevated we are also taking some protective measures should this pullback scenario play out.

As always we will continue to let the market tell us where it wants to go. We won't have to guess, we will simply take stop signals when they trigger, entry signals when they trigger, or we will sit tight on a large cash position. We rotate out of the weak and into the strong. If there are not any strong places to enter, simply wait patiently for a new opportunity to present itself.

For up to date charts throughout the week, please Follow on Stocktwits and Twitter @ZenTrends.

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