Investors Must Adapt or Die

One of the great things about the stock market game is that it is always changing. Just about the time your ego tells you that you’ve got the game licked – boom – the game changes completely. One minute you may be on top of the world calling every wiggle and giggle in the market perfectly and the next, well, you’re wondering why on earth your account is red when the market is sporting a big green number. And although I’ve said this a time or twenty over the past few years, THIS is why I prefer a systems-driven approach over the subjective, manager discretion approach to managing the market.

The dramatic changes seen in the market environment over the past few years are perfect examples of my point this fine Tuesday morning. At the beginning of 2011, stock market bulls were riding the wave of Bernanke & Co’s QE2 and it looked like nothing could stop the runaway bull train. From August 30, 2010 through February 14, 2011 (a period of 25 weeks), I count only five red bars on my weekly S&P 500 chart. And during this run for the roses, the S&P gained more than 26%.

But then things got messy. And after that, they got ugly. A quick little bear market ensued and the S&P fell nearly 20% on a closing basis. And after that, well, just about the time everyone became convinced that the sky was indeed falling, a bull romp of nearly 24% began – much to the chagrin of the glass is nearly empty camp.

The point is that the 26% run, the 20% decline, and the 24% rally all came on the heels of an emotional period in the market. And during each of these moves, the team controlling the ball had pronounced that they were the new masters of the universe – only to be humbled in spectacular fashion by the move that followed.

So, what are the lessons to be learned from the ever changing markets we’ve seen over the past four or five years? First and foremost, it is vital to check your ego at the door each morning. This game isn’t about being right, it’s about “getting it right.” Next, investors need to understand that nobody “gets it right” all the time and that some markets are just plain hard. Thus, you can only “get” what is available to be “gotten.” Then it is vital to understand that you WILL make mistakes along the way. While it would be nice to avoid as many mistakes as possible, the game is really about how you deal with your mistakes. (I.E. Do you take losses or just ride positions into the dirt, mistaking conviction for stubbornness?)

Perhaps the two biggest lessons I’ve learned over the last five years are (1) you MUST remain flexible and (2) you MUST be able to, and then know how to adapt to a changing environment. It is for this reason that I’ve spent nearly every second of my time available for research on developing systems that can adapt to changing markets.

To be sure, there is no one single investment strategy that is going to be right all the time (no, there is still no “holy grail” out there). And there isn’t any single system that will adapt to a changing market on its own. However, it is certainly logical to say that if we can unemotionally identify the environment, then we ought to be able to identify the appropriate management strategies to apply to the situation. As such, the trick is to identify which management strategies to apply, and when.

In looking at vast amounts of research and data, the lesson that I’ve learned is that adopting different management strategies/system based on time frames holds considerable promise. For example, there are times (such as the current move up, the move after QE2, and the run off of the March 2009 bottom) when just riding the trend is the way to go. As such, once a trend “proves itself” you can give the bulls some room to work by employing a longer-term trend-following system. But there are other times, such as the nightmare that occurred during the mid-August through mid-December of 2011, where a short-term trading approach was about the only way to succeed.

In short, I’ve learned that there are times to use very short-term indicators, there are times to use longer-term indicators, and there are times to use time-frames that are in between. The trick, of course, is to come up with indicators or rules that tell you when to be uber-short-term, when to be long-term, and when to use something more intermediate-term.

To sum up, the lessons learned from the quickly changing market environments that we’ve seen over the past five years is that investors must adapt or die. I’m sure that my method of adapting to the market environment by adjusting my time-frame isn’t perfect, but since we’re all in this together, I thought I’d share what I believe to be a pretty decent approach.

Turning to this morning… While the Greek bailout deal finally got done, it appears that European traders are implementing a “sell the news” strategy this morning as Europe’s stock markets are down across the board. However, those markets did put up strong gains while our markets were closed on Monday. Thus, it will be interesting to see how traders in the U.S. play the news. There is also a fair amount of blue-chip earnings to review today.

On the Economic front… There are no reports scheduled for release before the opening bell.

David Moenning
Editor:  Short-Term Market Manager