Today's Market: Hold on Tight!

by: Leigh Drogen

Today will be interesting, but I don’t think I would use the word fun to describe it. As I said over the weekend, your goal should be to not blow up and give back hard fought gains from the past few months. Playing defense is what separates those of us who can make gains on the way up and keep them, versus those of us who can make gains on the way up and give most back on the way down. Momentum in the market and individual stocks ends abruptly, it’s just a fact of what goes on in this strategy. We call it stairs up and elevator down.

One aspect of my strategy that I believe is very important, is that I manage risk more tightly as the trend progresses. Early on in the trend stops should be set a little wider as the market tries to find its footing. At the same time you should be using smaller position sizes. You need to give stocks wider stops at the beginning of the trend to let them shake around a bit. Now that the intermediate term trend is quite mature, your stops should be much tighter, but position sizes higher. We are in a little more of a hit and run market now. I have made mistakes over the past week trying to let big breakouts run in a market that is tired, and I’ve paid for it seeing huge gains in Power-One (NASDAQ:PWER) and iRobot (NASDAQ:IRBT), just to name two, snatched from me. If these breakouts had occurred at the beginning of the trend it would have been wise to let them run, but now as we are long into it, selling out was the right move.

Position sizes should be larger as we are looking for shorter term trades right now, but your stops should be closer. If a stock doesn’t act the way you think it should within the first few days, cut it and move on. The risk reward is just not there right now to be putting on longer term positions as we did in August. The chance that the trend ends here on the intermediate term time frame is greater than it has been over the past few months. That doesn’t mean it will, but we are here to play odds, not predictions.

Make sure to be light into the Federal Reserve announcement today, there’s no need to be a hero. I don’t like to trade on days like this (correction, there haven’t and won’t be many days like this when the Federal Reserve decides to buy almost 1 trillion dollars of assets).

Let’s let the dust settle over the next 48 hours and see where the market stands. We have enough high beta exposure that we won’t be missing out on the long side and enough alpha and absolute return this quarter that I’m not scared of under performing a market that rips the next few days. On the other side, I’ve done the calculation on what would happen if I was stopped out of every remaining position, and I’m more than willing to give that up for the piece of mind that I won’t give a lot back after a few great months. If we get whipsawed, so be it, it’s worth it to protect our gains.

In regards to what many including myself believe will happen today at the Federal Reserve meeting. Look, as I’ve said before it’s not our job to make policy, it’s our job to react to it and profit from whatever policy is made. It’s ok to complain and have an opinion, I sure as hell do. So here’s mine.

I have been of the belief all along that the Federal Reserve’s policy of inflating our way out of a debt fueled economic mess is not only wrong but possibly criminal. There were better ways for our government to save the financial system in those darkest of days, including the nationalization of the banks. Instead, we gave money to the banks and told them to go by assets, so that they could repair their balance sheets on their own. It worked, thank god, but it wasn’t the only way, and it only put off what is inevitable. The market at some point has to find equilibrium, and no matter how much free money you give to banks and asset managers to buy assets with, it’s not going change the state of the economy structurally.

They have succeeded at killing the dollar and raising the price of real assets so that the banks are no longer insolvent. But now they find themselves in a situation they can’t fix artificially. Our economy is structurally broken for the middle and lower class. Now I’m not here to fight some kind of class war, in fact I’ll take the stance that it’s not the government’s job to set up the economy to benefit any specific class, that is just a direct result of who votes at the end of the day. Companies are making a lot of money right now, but they are doing it without a good portion of the employable workforce. I don’t see this as a problem for the economy per se, but it’s definitely a social problem and a political problem, and it’s going to be a huge business problem soon when the rage against corporate America intensifies as none, and I mean none, of our politicians have the means to change the equation here beyond astronomically higher taxes for corporations.

So in response to a structural change in the economy (higher efficiency with less jobs needed), the Fed is going to do quantitative easing. Does this make any sense? It’s not that the economy is broke, it’s not, the global economy is humming again, in fact we’re starting to see a good deal of inflation around the world, look at what India and Australia did with their rates the other day. It’s not a problem of the economy anymore, it’s a structural issue with employment that you can’t change.

The Fed monetizing the debt will likely set off a currency war, and we have already seen the beginning of that in our spat with China. Oh one other thing, destroying the dollar is not going to increase exports significantly. Once again, there is a structural change that has taken place, because of globalization we are not set up correctly in terms of labor costs to make things anymore, it’s just a fact. We still produce a lot of high end stuff, but the % of GDP that manufacturing contributes to our economy is going to keep falling. We just can’t produce goods cheap enough here. And as you’ve seen, even with our service economy, better software can replace a lot of people and drive profits for corporations, a great thing for the economy, but a bad thing for the unskilled labor force.

Our government can try all they want to take shortcuts through this structural change, but none of them will work long term. We will most likely be Japan.

If they want to do the right thing, be honest that the economy has structurally changed, don’t vilify corporations for doing exactly what they are supposed to do, make profits and increase productivity, focus on educating our country for this new globalized economy where everyone has to compete with a little Chinese man who has been studying for 20 hours a day, stop killing the dollar, stop trying to inflate our way out of this mess, raise interest rates so that the average guy can make a few bucks on his savings account, stop trying to blame China, and be honest with the American people about the structural changes.

My advice to you out there, buy some gold and get an education, because I doubt our government or Federal Reserve is smart or willing enough to do these things. If you don’t, you risk being left behind in the jobless stagflationary economy we have. Myself, I will trade the tape and attempt to be part of the corporate economy that is making money hand over fist right now. What else can we do?