I am neither a glutton for punishment or a sadist as many of those who frequent these parts seem to be. I do not believe in jumping around bull markets for fear of every dip, thinking I am smart enough to avoid any pain and brilliant enough to participate in only the pleasure. Bull markets should be left alone to create wealth in portfolio positions that have potential far beyond the opinion of any market pundit who cannot see outside of his or her grey box.
There does come a time, however, in every bull market where overwhelming evidence combined with an undeniably well-defined risk/reward scenario makes taking the other side of the trade too irresistible. By taking the other side of the trade, I do not mean getting short to the point that I can recite the posts on ZeroHedge while waiting for the world to descend into Viking rule. I also do not mean liquidating any of the long positions that continue to have upside potential that is unrealized by the market. Both of these options are too froggy for my taste. Jumping around excessively is a sign of a lack of understanding regarding the structure of your portfolio and the markets as a whole.
It may be time though to take a step back from an aggressively long position and hedge exposure to protect the gains that most investors seem to be sitting on early in 2013. I did just that at the close and a little bit afterhours, by initiating a hedge in TZA. The last time I put on a TZA hedge was on October 10th to a ringing chorus of boos and hisses from the studio audience.
Most of you who have been following along know that I control risk in the portfolios in a 100% systematic manner. All of (or most) of the hedges I have put on over the past couple of years have been a result of the system spitting out an instruction and my following the orders regardless of opinion. This hedge, however, was not a result of my system. All of my trend indicators are still quite a bit away from turning to the bearish side, although they have started to deteriorate this week.
Here are the reasons I am uncharacteristically early in initiating this hedge:
1. The 1520 area on the S&P has been something I have been discussing in the weekly reviews for a couple of weeks now. It was first mentioned on January 27th. And again this past Sunday. What I didn’t have at that time was a reference as to whether the market saw this as an important inflection point as I did. The action from this past Friday through today answered that question. Yes, the market is indeed paying attention. An explanation follows in the chart below:
click chart to enlarge
2. Wasted energy in the form of excessive volume at incorrect points in the market is beginning to rear its troublesome, wretched head. The timing of volume or rather, where it takes place within a market cycle is as important a component to market timing as anything having to do with price. Below you will see a chart of the Nasdaq Composite with a troublesome volume spike that took place today. Precisely in the wrong place, I should add:
3. The 1-2 month price target I listed on the SOX in late November has hit on the dot. I have this point as a cycle high for the SOX, which seems to be getting some confirmation from the major averages.
4. I enjoy the gym. It helps me eat Girl Scout cookies without any guilt. I can simply jump on a treadmill or lift some weights while Lil Wayne tells me about how difficult his life was growing up in New Orleans and how things are going really well for him now.
A famous West Coast hedge fund manager frequents my gym. I don’t want to mention his name because I don’t think that’s really appropriate. He’s mostly on the racquetball courts while I choose to spend my time grunting in the weight room.
During the peak of the Euro crisis in 2011 I would see him at the gym and it looked as if somebody had poured a hot bucket of urine on his favorite pet. He would walk crooked, completely expressionless and in obvious pain as a result of the market shellacking that most fund managers were taking at the time.
I just saw him tonight for the first time in sometime in the locker room. He looked like a schoolgirl who had just won tickets to a Justin Bieber contest. A new vibrancy, enthusiasm and smiling from ear to ear.
Completely anecdotal. Absolutely. However, it is a reflection of the comfort and joy among investors that the markets inherently hate so much.
5. It’s February. February is a month that has historically relished throwing investors curve balls that seem to last through the April-May period. February following an election cycle makes it all the worse. This from the stocktradersalmanac website:
February’s post-election year performance since 1950 is miserable, ranking dead last for DJIA, S&P 500, NASDAQ, Russell 1000 and Russell 2000. Average losses have been sizable: -1.6%, -2.0%, -4.4%, -2.2%, and -2.4% respectively. February 2001 and 2009 were exceptionally brutal. NASDAQ has not posted a post-election year February gain since 1985.
There you have it. 5 elegant reasons to start thinking defensively.