Scaling Fixes Imperfection & Game Plan 2019


Summary

Scaling into or out of positions when changing asset allocations eliminates the need to be perfect on trades.

If you scaled out of equity heavy asset allocation from late July to late September, then scaled back in from late October to late December, you’ll be fine.

Panic selling at the end of a correction turns temporary losses into permanent losses.

I preach scaling into and out of positions and asset allocations ad infinitum. There is a simple reason. Trading perfection is impossible with any sustainability. Yes, we will sometimes nail a trade almost perfectly, but the idea that is what we are trying to do is completely and utterly wrong. 

When we know that a stock, an asset class or an entire market is overvalued, then we need to pay special attention to money flow indicators. As inflows get weaker, the chance for a downturn becomes stronger. Once inflows turn to outflows, then we are confident a correction will occur. 

See the following chart for some examples: 

SPY CMF

Repeatedly we learned that money flow leads stock prices. We should also have learned that sometimes the moves are so fast, we are using 20-day measuring stick, that sometimes there is not much we can do about it. 

These so-called elevator drops are why I almost always carry 10-25% in cash. If we experience an elevator correction, we have cash to use when assets we like are cheap – so called “optionality.” 

It is easy to hold 10-25% cash when we realize that a 100% equity portfolio has performed almost identically to an 80%/20% equity/bond portfolio the past century. With interest rates so low until the recent bond trade that some made recently, holding cash was essentially similar to holding bonds. We are close to back to that level again. (If the 10-year UST approaches 3% again, then subbing some bonds for cash would make sense again in my opinion as I don’t think rates go much higher than that for a decade or two.)

We also learned that significant asset allocation changes really don’t happen that often. Even in a very volatile year, there have really only been 4 asset allocation changes: 

  1. January scale out of equities reducing equity allocation and increasing cash.
  2. February scale into equities increasing equity allocation and reducing cash. 
  3. August-September scale out of equities reducing equity allocation and increasing cash.
  4. November-December  scale into equities increasing equity allocation and reducing cash. 

Even done imperfectly with about three-quarters of our money, the final quarter really not ever changing much, that scaling in and scaling out should leave you with a market beating return once the indexes get near the old highs again. Once there are new highs and a breakout, presuming you haven’t given away too much time value on many calls, you should be very profitable. 

2019 Game Plan – Part 1

On Friday afternoon, I will have my futile forecast out for 2019. I encourage you to read my forecast for 2018. It was pretty accurate, even if imperfect. The 2019 forecast will be the topic of Friday’s webinar.

In the first quarter we will likely see some of the missing money flow back into markets:

  • We will see hedge funds getting checks from people who had been liquidated funds. Much of that money will get invested after this correction. 
  • We could see foreign investment pick up again, particularly if there is a trade deal and there are some upticks in oil futures.
  • Pension money is being reallocated from bonds to stocks now, that won’t last long, but it’s a hunk. Other institutions will take their bond profits over time as well. 
  • In Q1 is when retirement plan money hits from employer contributions. 
  • We could even see the Fed back off on QT – that would send markets screaming higher. 
  • Speaking of central bank money, China is stimulating and I find it hard to believe that the ECB will really tighten. 

We want to be ahead of that and in coming days the CMF chart will likely show that shift in money flow. Today’s rally might be the very beginning. The trough level of CMF is telling enough. It is either at a pivot point or very close. 

So, right now, I want to be a buyer (of the dips) of our core stocks and the PowerShares QQQ ETF (QQQ) – set buy orders a bit below yesterday’s close in most cases and let it hit you. You should have already started doing this and be close to the end of scaling in. 

If you are still sitting on big cash, then you need to move it a little faster. Buy the dips or whatever it is you’re risk tolerance allows you to do. But make no mistake, money flow is likely turning up and that means prices will follow.

We are seeing oil executives buy their own stock. At the same time, we know that a million barrels per month from Saudi Arabia and Canada are not coming to the U.S. for a while. The oil markets will tighten in H1 2019, probably dramatically. We saw the first signs today. I like January 2020 calls on the SPDR S&P Oil & Gas E&P ETF (XOP). Buy just outside the money and try to get bid prices or a bit below on volatility. I believe U.S. oil inventory drawdowns will get more pronounced as January rolls along. Feel free to wait to verify, but don’t be unwilling to accept the news as it comes in if it comes in as I think.

As we test the old highs in the stock market, at that point we will want to scale out of most of our leverage. Of course, we need to keep an eye on money flow. If it turns down, then we have to sell quicker. We can always get back in.

2019 Game Plan – Part 2

While my futile forecast was pretty good last year, it wasn’t perfect and we didn’t trade it great. In fact, we traded it about as bad as we could and will still come out of it okay. In 2019, I want to be better than that though. Volatility is back and that means opportunity. 

I repeat, keep an eye on money flow. I am subscribed to Chaikin Analytics, but I don’t think you need to be. It’s over two grand and I don’t like some of their 20-factor formula. I am using a software that I will introduce you to in February (which will be particularly useful for swing traders) that you can use – it’ll be the same one I’m using and will allow you a lot of flexibility to run your own tests and do your own screening. 

Once we get some more facts on the fundamental side, i.e. will we see a significant growth slowdown or not, then we will know a bit more about whether to be more concerned with FOGYAK or FOMO. 

By summer we’ll know if we should liquidate our oil holdings. We are likely to get out of leverage as H2 2019 could be a lot like H2 2018 as Permian plays pump up production in summer. While that won’t help inventories right away, as drive season ends, we’ll see stabilization of oil inventories and possibly builds.

Like 2018, I think we’ll get 4-6 asset allocation changes of significance. Scale in, scale out, over 4-8 week periods with some small buys and put sales a month or two out at lower prices. Ebb and flow. You don’t have to be perfect.

Disclosure: I am/we are long QQQ, XOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.