Less Is More

We don't have to be trading all the time. This is something I try to remind myself of when markets become less favorable. Sometimes the trends are not in our favor. We have to do our best to recognize those times and attempt to avoid taking too many losses.

When markets are volatile and in transition some strategies are simply going to struggle. If you force too many trades during these times you may end up dwindling away your capital. Some strategies thrive, but trend trading often does not. When markets are moving in one direction or the other, a trend strategy will clean up by letting winning trades run. In volatile range environments, like we are currently in, trend trades will see many more failures than normal.

Identifying when the market is favorable or not is a big part of being a successful investor. For the intermediate-term trend approach that we utilize with our Large Cap Portfolio, the current market is not offering many opportunities. When this is the case, the mantra "less is more" often comes to mind. I have found that limiting exposure and tightening new trade requirements helps tremendously during the difficult period.

Markets ebb and flow. They move from trending to non-trending phases and from uptrends to downtrends. Knowing the difference AND acting on it will go along way to improve your longer-term equity curve. My favorite indicator for intermediate trend is the 20 Week Moving Average. When the 20 WMA is rising the market tends to trade strongly for the bulls. However when the 20 WMA is declining weaker returns tend to accompany it.

The chart of the SP500 above shows the prior occurrences when the 20 WMA was trending lower. Since 2007 there have only been 5 times when the moving average turned from up-sloping to down-sloping.

2007 avoided the significant market collapse.
2010 digested the recovery rally by trading in a tight range for 19 weeks.
2011 the signal avoided the "Euro Crisis" which lasted from June through December.
2012 led to a 12-week consolidation.
2015 The 20 WMA has now been declining for 5 weeks.

Based on the prior periods (regardless of severity) we currently sit at the beginning of a new market environment. At best we are in a constructive consolidation that will then resume to new highs. At worst we are teetering on the ledge of a potential new downtrend and "bear market".

Here is a look at the same chart but shows the returns in the SP500 when this simple trend approach is used:

  I ran a very simple trend system. Signals were taken using two consecutive 20 WMA readings (weekly closes). If two consecutive readings were negative it marked a new downtrend, and if two were positive it marked an uptrend. What this quick and basic strategy did was astonishing. If you only held the SP500 during "uptrend cycles" the return since mid 2006 was 1,023 S&P points. This compares to the returns during "downtrend cycles" which was -522 points. 

By sticking to this remarkably simple strategy you would have outperformed the market by 60% while nearly eliminating any serious downside risk. People don't like to think investing can be this simple, but it can be. It can be if you let it. If you can remain calm and follow a system without being emotional, a simple trend strategy can be highly effective.

We can agree that while the market might not fall significantly from here (it could), the odds of significant upside are greatly diminished while this signal is in a downtrend.

Downtrends increase risk. When risk levels are elevated I prefer to take capital off the table. This is often a natural process where your stop levels are systematically hit by market weakness. Its imperative to protect the majority of your capital so that when conditions turn favorable again you will be confident and ready to deploy your funds into new potential market leaders.
  
Ways to limit exposure/risk in unfavorable markets:

-Trade less: Set limits for trades taken. Lower total portfolio heat, for example if you normally can take on 10% portfolio heat at any one time, reduce it to 5%

-Trade smaller size: instead of your normal 1% risk per trade, trade .5% or less

-Tighten Entry criteria: If you do continue to trade be extra particular in the setup you take. It should be extremely favorable in terms of risk/reward.

-Step away from the market for periods of time
We don't always have to be trading. In declining markets its often best to keep positions small, keep risk light, and take periodic breaks from the action. There will be very favorable trends in the future. We just need to do our best to make sure we survive the weak periods so we can take advantage of the next strong ones.

Our Large Cap Portfolio remains 90% cash, 10% Short AXP

AXP weakened a bit this week along with the broader market. Its trapped under large overhead supply, has a declining 20 WMA, and momentum (MACD) is in a clear bearish range.

This remains one of my favorite short ideas in the market.

Thanks for reading. For updates during the week please follow on Stocktwits and Twitter @ZenTrends.