That's Not The Best Way To Look At It


Josh Brown from Ritholtz Wealth Management posted a video he made with Michael Batnick about the Dow Jones Industrial Average's recent flirtation with its 200 day moving average (DMA). They offer all sorts of data points about how many times the Dow has crossed over its 200 DMA and the futility in trying to trade this from the stand point of "chopping up" your portfolio. They also talk about other factors to consider including the slope of the 200 DMA, positive or negative and finally they do concede that bad things tend to happen below the 200 DMA.

This is a subject that is near and dear to my portfolio management process. While the Dow has been flirting with its 200 DMA, the broader, much broader, S&P 500 is not really flirting with its 200 DMA, getting closer but not there yet. The Dow's action is getting a lot of attention and appears to be the catalyst for they're making the video. You know this, Josh and Michael know this, anyone really engaged in markets knows the Dow is a meaningless benchmark. The big picture reason why I rely on the SPX' 200 DMA is to avoid the full brunt of large declines which hopefully reduces the odds that any client will succumb to any emotional response they might have to a decline in their portfolio. Missing the full brunt of a large decline can add years of outperformance to a portfolio. If your portfolio was down 25% in 2008 when the S&P 500 dropped 39%, then you have 14 percentage points of outperformance in your back pocket subject to how you re-equitize.

Jamal Carnette articulated the same point on Twitter as follows;

The most underappreciated characteristic of portfolio construction/asset management is outperforming the market in down days/weeks/years/etc. Much easier to double your investment when you don’t have to dig yourself out of a big hole.

Embedded in Josh and Michael's video appears to be the assumption that upon a breach of the 200 DMA investors are selling out completely and then getting completely back in when the index takes back the 200 DMA. I draw that conclusion because they talk about chopping up a portfolio using this indicator.

I've been writing about this exact topic for almost 14 years, getting completely out is a terrible idea, it will lead to big consequences when you're wrong, which will be often, it will be wildly inefficient from a tax perspective for taxable accounts and it gives a lot of money to the brokerage in terms of commissions paid. Bear markets have the tendency to start slowly, giving many months to get out. Six months after the peaks in 2000 and 2007 the S&P 500 was only down about 10%. I would put 10% in the down a little category and I always say down a little goes with the territory. You probably shouldn't be in equities if you are unable to tolerate down a little. That's not a knock, it is a serious comment, not everyone can ride the market down a little, equities might then be inappropriate for those folks.

If you can accept that bear markets start slowly then you realize you have plenty of time to reorient the portfolio into a defensive posture without ever selling everything. In early May I added a small position in AGFiQ US Market Neutral Anti-Beta (BTAL) for clients believing the 2% rule had been invoked (the S&P 500 averaging a 2% decline three months in a row). The fund generally has a negative correlation to the S&P 500 and that has mostly been true. When I first added the position the market went up some and BTAL went down some. In the last few days BTAL has come on strong and Yahoo Finance shows it to be ahead of the S&P 500 from the time I added it. So it started as a drag on returns but by virtue of an approximate 2% weighting, the impact was not great. If the market had immediately gone down after I bought and BTAL did what I hoped it would do then it would grow to hedge more of the portfolio.

It's one trade, it changes the correlation and volatility of the portfolio slightly and if it turns out to have absolutely been the wrong trade the consequence would be very small. For the record it is doing exactly what I hoped for (looks different than the market) but it is too early for this trade to be declared right or wrong.

We'll see if the market is actually rolling over soon enough, the case was stronger in early May, appeared to be rendered incorrect in late May and early June but might be rolling over again. If it does continue to deteriorate my next defensive trade would likely be to add a 2-3% weighting in an inverse fund, BTAL is a long/short strategy. An inverse fund would have more of a negative correlation to the S&P 500 and the portfolio and would also grow to hedge more of the portfolio when/if the market goes down. I maintain a position in the Merger Fund (MERFX) and SPDR Gold Trust (GLD) as diversifiers.

Just the two small additions, BTAL and an inverse fund, would insulate some against a large decline. I would ultimately do more than this but the point is that some protection can be put in place without creating total upheaval in your portfolio all while the S&P 500 might still be down just a little.

Following this out further, if things continued deteriorate I could sell a couple of holdings. I use a couple of sector funds in large weightings and selling one sector fund combined with the above would arguably, significantly reduce how much the portfolio moves like the broad market. During the last bear market I walked readers through what I did and when I did it. I have started to do so this time in disclosing the BTAL trade and as mentioned in previous posts, if a bear market has not started, that is preferable outcome. BTAL is a small position, if the market rockets higher from here clients will participate in the rally and benefit from it.