One headline says the market is overvalued and ready to correct, i.e. topping. Another headline states the market has plenty of upside left before any major correction, i.e. trending. My theme from earlier this week seems to be playing out in front of me in the headlines. Who is right and who is wrong? For me it is not a matter of who is right or wrong, but a matter of finding the opportunities in the discrepancies. We have found several over the last month in REITs and now in Financials. They were both in bottoming patterns or what fundamentals would say is undervalued. They have made solid moves within their short term trends and offered a reasonable return for the risk taken. On the other side of the coin we are concerned with the levels that technology has attained during the last month. The semiconductors have experienced a great run since the low in February gaining over 12%. Are they overvalued fundamentally? Time will tell, but as an asset class you would lean towards the yes answer. Technically they are showing signs of a climax run or topping. When it is all said an done, both sides will be right, but how and/or when we get their is the question we are really grappling with.
If we step back, take a deep breath and focus on the objective at hand it will bring some clarity to the process or approach we should take short term. With simple in mind, below are four steps I take to filter ideas both technically or fundamentally to determine what opportunities fit with my style of investing or trading.
First, timeline is the key question we have to address when discussing the future of the market and what direction it will take based on our beliefs. The various opinions in the headlines many times are derived from the time horizon the writer is looking at relative to the opinion expressed. For our purposes here let’s focus on the next 30-90 days. In this window you are a trader not an investor. Thus, you have to keep that in mind as you evaluate existing positions, future positions or desire positions. For example, we own Facebook as a long term position. If over the defined period of 30-90 days we believe the downside risk is 10% that would put the stock at $63. How does that change my view of the stock? It doesn’t really from a longer term perspective. In other words the fundamentals of the stock will not change barring any unforeseen announcements. However, if the anxiety of the 10% move bothers me I should hedge the position. I may buy the $70 puts for June or July. That way if the stock move down 10% in value the option should offset the decline in value keeping even in the portfolio. This is trading (short term) around a long term position to maintain value. The key is to know your timeline of both the position to be managed and the approach/strategy you want to take now.
Second, What is the problem? In other words, what do we think will go wrong or right? In the current situation, stocks are overvalued, it is a bubble blowing market (their words, not mine), and the economic picture is weakening. Thus, stocks should decline in value 3-10% depending on the catalyst. Define where the opportunity is in light of the problem and develop a plan. In this case we are prognosticating the market selling or moving lower. Therefore, we would want to develop some type of short or selling strategy to capture the move in the market as it takes place. Combining the projected problem with the timeline put into place the best strategy to implement to capture the resulting move.
Third, define your risk relative to the strategy to be deployed. Currently we are long stocks, and if the perceived risk is stocks moving lower, at what level do we act? Remember the first rule is to understand your timeline relative to the event and the position you are addressing. Then you address how to manage the risk going forward. We could use stops against the position at a specific level, or build a hedge to protect the downside, or just sell to position at a specific price and capture the gain. There are plenty of choices, our job is to define the best course of action relative to the objective. Equally, it is important to know that their will always be contradictory point of views in the media and from friends. Do your best to avoid the news and banter from others. In other words find a way to drown out the noise. Emotions play games with our actions, especially when it come to risk management or the threat of losing money. Know your risk going in and then manage the risk going forward.
Fourth, define your target. It is equally important to manage profits as it is to manage risk. If the current objective is the protect the downside risk relative to the market selling lower, then we will have to know at what point we want to lock in our profit. There are too many ways to accomplish this that explaining them would take to long. A simple approach is to sell at the defined target, or ladder out of the position going forward at key levels. An example would be if you hit the target to sell half and hold the other half with a stop 3% below the current price, and then defining how to exit the other half of the position. It take equal effort to manage profits as it does to manage losses.
Last, execute your plan. This is where the real work begins as an investor. Some of us are great planners and poor at implementation. Know where you strengths and weaknesses lie and work to build practices that get the job done. This is why I find the use of electronic trade orders so effective. I can put the order in when the scenario set up that have planned out, it happens without my intervention. For example if I want to own Bank of America at $15, I can place my order as a buy-stop at $15 for the number of shares I want to own. When the price is hit it is done… without me having to hit the enter key. The goal is to not just build a plan based on what we believe now, but execute the plan going forward. Find what works for you to accomplish the goal.
In the end it is not so much about who was right or wrong about the current market environment, and what will happen going forward, but how we make money from what we know and/or believe to be true.