Defensive Action Initiated

We don't want the market to go down a lot, we want to be prepared and insulated if it does go down a lot.

Today I started the process of taking defensive action for most clients by buying a small position in AGFiQ U.S. Market Neutral Anti-Beta Fund (BTAL). In cases where the Pacer Trendpilot U.S. Large Cap ETF (PTLC) makes up a large percentage of the equity portion of the portfolio I did not buy BTAL. I've mentioned BTAL several times, noting that I was likely to use it on the next go around. BTAL is a long/short fund; it goes long low beta (low volatility) names and shorts high beta names such that it doesn't look like the stock market, ETFReplay.com show it has a negative correlation to the SPDR S&P 500 (SPY), which is an investable proxy for the S&P 500 Index, so it can go up when the market goes down, it has some history of that and so hopefully that will be the case now if the market does actually go down a lot.

I've cited the following chart of the S&P 500 a couple of times as being a cause for concern that the market has started to rollover slowly.;

A reader left the following comment for me on one of my posts at Seeking Alpha;

By my back of the envelope calculations and not including dividends; the S&P 500 was -3.89% in February, -2.69% in March, but +0.27% in April. So, down 2% for 3 months in a row came close, but did not quite happen by just a small margin. Comments?

I answered that the 2% rule is more of a corroboration that a bear has started and that it happens very infrequently. What I did not say is that I do believe the 2% rule which is an average 2% decline in the S&P 500 three months in a row, was invoked. Average his numbers together and you get 2.10% per month over three months. This is something of an interpretation and I am being conservative but it corroborates the chart pasted above and that chart worked in December 2007. I could not front run this trade in my answer to that reader but I took time last week to mull it over and pulled the trigger today. Long time readers know my belief that bear markets start slowly, giving plenty of time for defensive action meaning taking a few extra days to sort this out still allows the opportunity to avoid the full brunt of a large decline which my objective with this sort of action.

The reason for BTAL and not an inverse fund is that the 2% rule kicking in before the S&P 500 breached its 200 DMA is a little different from how it usually works out. I would expect BTAL to be less of a drag if this turns out to be wrong.

In past posts I have mentioned many clients owning PTLC which will switch from fully invested in equities to t-bills when its underlying index closes below its 200 day moving average for five days in a row which of course gives clients one defensive component without having to place trade. I believe that PTLC plus BTAL would go a long way to helping insulate against a decline. Also, most clients own the GLD ETF which tends to have a low to negative correlation to equities so that could further help manage a large decline.

I would set the expectation of taking more defensive action if things deteriorate further. In no particular order I would look at adding an inverse fund and possibly selling one or two holdings. It is important to remember that it doesn't take a whole lot to change how a portfolio behaves. If the market ends up cutting in half or the like, individual names held should be expected to go down a lot but the focus needs to be the bottom line number of the portfolio. If an investor can successfully avoid the full brunt of a large decline they are less likely to succumb to emotion, portfolio withdrawals are less problematic and it creates the opportunity for long term outperformance when the market recovers.

It is important to understand that a bear market may not have started, we won't know for a couple of months. Things have happened that are consistent with how previous bear markets have started. If a bear has not started then BTAL would be a small drag on the portfolio, the portfolio would still benefit if stocks rocketed higher from here. Being wrong would be better, we don't want the market to go down a lot, we want to be prepared and insulated if it does go down a lot.

One final reminder in case it turns out a bear market has started. Bear markets are all the same, they go down a lot and scare a lot of people, then they stop going down and then they go on to make a new high. The only variable is how long that all takes.

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