Why My Trading Strategy Began Changing March 15

 |  Includes: DIA, SPY
by: Mark Thomas

For a swing trader like me who actively trades mostly mid- and large-cap stocks, the last five months have been as good as it gets. I have been using a shotgun approach in my trading style, just buying anything that was reasonably priced and selling when I had a profit. Up until the last three weeks, I would have on many long positions simultaneously and almost all of the time have been fully invested. In fact, as soon as I sold one long position for a profit, I would buy another. I would go long one value stock and within a few hours or maybe a few days at the most, I would sell for a quick 1.5%-2.5% profit. The markets have been so strong that I would just look down my watch list and find another stock to purchase almost immediately after selling the last one. Then I would just repeat the process again and again. This produced incredibly above-average results, which made me wonder -- I knew it had to end soon, the only question was when and how.

Then I noticed a few weeks ago that this trading strategy became more difficult and outsized gains became harder to achieve. About three weeks ago there was one night I went through my stock watch list and out of about 40 stocks that I watch closely and consider trading, there were only two or three that could still be bought. Months ago there were dozens, then maybe 10-15, and then maybe five to 10. That was around March 15, and that is when I now believe the market had, in essence, topped and is now consolidating. I believe a pullback has already begun of about 3%-5%, and I don't think a formal 10% correction is likely. I don't think most market participants are aware of this because the Dow and S&P 500 went on to a couple of new highs after this date. Since then, a rolling pullback has started to go from one sector to another. I trade mostly mid-cap stocks and I especially like the transportation sector, so it was much more obvious in the stocks I follow.

My theory for the reason that there is this decoupling between the mid- and small-cap stocks and the large-cap stocks is that this rally is now being driven exclusively by yield starved investors. Among the large-cap stocks themselves, the sectors with the highest yields and reliable dividends have continued to go higher. That explains why defensive sectors have been star performers this year even if we're not in the part of the economic cycle where they usually outperform. While this is a positive short-term for large-cap dividend investors, I think it is a warning to all investors. The distortions caused in the bond market have now seriously worked their way into stocks and that explains a lot of the rally in the last few months.

Now when any policy is distorting financial markets, it can last much longer, be much larger than you can estimate, and betting against it can lead to ruin. However, examine the chart provided below and you will notice that stocks have basically gone nowhere since March 15. Since then, only the Dow is up 0.33% and the S&P 500, mid- and small-cap indexes (MDY, IWM), and the Transportation Index (^DJT) all are down between 0.50% and 3.75%. At the same time, the PowerShares Dividend Achievers ETF (PWM) is up 1.25%, widely outperforming the other broad stock indexes, demonstrating the dramatic outperformance of above average dividend-yielding stocks.

Click to enlarge image.

Click to enlarge

This article is not designed to persuade you to abandon stocks for investing or shorter-term trading. However, since it is inevitable that we will not be making profits as easily as we have been and it is likely we will have a pullback, you should consider what I have been doing:

1. Not being as consistently exposed to the market.

2. Focus on your best ideas rather than buying many stocks.

3. Use tighter stops and monitor your risk management.

4. Make sure you're not overweight a certain sector.

5. Keep harvesting your profits when you have them.

6. Losing positions aren't tolerated.

7. Reduce position size for example from 10% to only 5% of my trading account.

Going forward, if the market does pull back I want to have a significant amount of cash. This will allow me to take advantage and buy the same stocks I have been trading for months now, but at lower prices than we have today. You have to deal with two emotions when trading: greed and fear. I think the time has come to be a little more fearful and less greedy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.