Message to institutional traders, hedge fund traders and portfolio managers: Could you do me a favor?
Please ring a bell, wave a flag, or even post a quick message on Twitter: “Hey market players . . . listen up! In upcoming weeks, we market movers plan to fold some, and raise cash. Expect a market drawdown soon.”
The movers and shakers on Wall Street, however, are not known for sharing their strategies up front. So, it’s left to us—individual traders and investors—to prepare for the market’s next downturn. (Please remember that small corrections are good things. The market needs to move down in order to move higher.)
The market is looking toppy, at least in the short-term. In 2017, the S&P 500 Index has run up a dazzling 21%. And if we check back to the S&P’s March 2009 low of 666.79, we can see that in the past nine years, the benchmark has gained more than 299%.
Indeed, these have been sweet times for U.S. traders and investors. Our market has soared in a textbook-perfect uptrend, giddily sailing past geopolitical scrabbles, terrorist threats and interest rate hikes. Indeed, we have not even experienced a three-percent pullback in the past twelve months.
While we celebrate our profits, however, we must remain attentive and disciplined. We must remember that the capital markets of industrialized nations move in cycles—rolling up and down. And the U.S. markets are stretched pretty tight. If you check out the monthly chart of the S&P 500 below, you’ll see what I mean.
S&P 500 Index – Monthly Chart
Chart courtesy MetaStock
As you can see on this price chart, the S&P is soaring high above its 12-month moving average. The 14-month Relative Strength Index (RSI) logs in at 86 (over 70 is considered “overbought”), signaling a nosebleed-altitude market. So, is it time to become cautious?
We don’t run outside and shutter our homes in the middle of a hurricane. We hang the shutters and make other preparations before the storm hits. Just so, experience has taught me that the time to prepare for a potential upcoming market retracement is before it arrives. I do so by 1) managing risk in my current portfolio, and 2) researching new opportunities so that after the dip, I’ll be ready for the market’s next upswing.
For me, that means taking steps to:
- Pinpoint current positions where I plan to grab profits if the market rolls over.
- Establish firm protective stops with my broker on remaining positions, especially on over-valued growth stocks. (In a market drawdown, growth stocks tend to fall from 1 ½ to 2 ½ times faster than value stocks.)
- Investigate unloved, undervalued companies that have suffered from sector underperformance or poor fundamentals, but that have the potential to rise “Phoenix-like” out of their ashes and regain profitability when the market once again moves higher. Develop a “watch list” of the most promising candidates.
The odds are low that the next market downturn will evolve into a bear market (defined as drawdown from recent highs of 20% or more). That said, I suspect this market is due for at least a brief breather in the upcoming weeks.
So, let’s be attentive and wise. Absent ringing bells, raised flags, and warning posts that a market downturn may loom ahead, let’s take a few moments now to manage risk in our current positions and plan for future opportunities.
Until next time, keep green on your screen!