When To Undo A Defensive Strategy

by: Roger Nusbaum

Recently, a long question came in about when to undo a defensive strategy. In it, the reader joked that "I'm right, until I'm wrong" may not be the best plan. Click here to read the whole comment.

I can only try to answer this from the context of how I get defensive, what I have done before to get less defensive in the past, and to point out that I have no expectation of being exactly right with what I do.

The first thing I should mention is that at every turn I state that I do not make big bets. When I do get defensive, I start small so that the portfolio won't get whipsawed if the sentiment changes. Earlier this summer I sold one stock, and added about 1.5% to the double short fund with the willingness to do more if the market had deteriorated any further. Last summer, I did something similar, and my lead versus the benchmark unwound. This year it appears to have increased, and I believe, this is due to the snap back in certain parts of the market.

Even with all of the action that transpired this summer, I took very minimal action. The focus was to be disciplined to my defensive strategy, while at the same time realizing that the market was in a fast panic, and as a result, a lot of stock was being dumped into it. Some readers commented that this is what they had done, and I feel that this would be the wrong trade. I commented countless times this summer that it was a fast decline, and that fast declines snap back quickly.

Last year, I held the double short fund, and when the market snapped back the double short fund got smaller, and the rest of the portfolio got bigger. As a result, the position reduced itself along the way, but I did wait a little too long before adding a couple of new names into the portfolio. The decision to add was probably more gut than anything else, and was not very scientific.

The result for all of last year was about even with the market while sitting on a lot of cash and a little double short. What I said on the blog then, and have written about many times over the years (especially since it is the cornerstone of my ideas about how manage money), is to not let being wrong bring down your portfolio. I wrote that going into last year's double short purchase, and after the fact, is that finding that lagging a huge rally is not nearly as bad as missing one. I lagged for a while to be sure, but did not miss it.

It appears as though I am not lagging during the current snap back. When looking ahead, I have spoken about adding a financial name when the yield curve normalizes, and I also have a couple of other stocks that I have studied, and will probably buy soon as a way of deploying the above average cash position that I have disclosed owning.

If this summer had often devolved into down, and I should say no matter what emotion you might have felt we were nowhere close to down a lot, getting un-defensive would occur when the market takes back the 200 DMA. This time around the market was down a little and the breach of the 200 DMA was short lived. I don't have an exact answer to Rick's question because the way things have played out, my not making large bets, I have not needed to have one.

I am mostly in, have been mostly in, and have more names to buy, but am not sure when I will buy. The action taken this summer has left me underweight volatility, and is consistent with my opinion that we are very close to the end of the cycle. For now, this is where I want to be.

In conclusion, there are some objective market indicators at work, including a belief in moderation, and a big picture opinion of what I think is going on. In terms of portfolio execution, so far, it has been right. But, it could start being wrong at any time. As I mentioned yesterday, and many times last summer, if the market explodes higher, and I leave a few percentage points on the table being cautious (so lagging not missing), I would be thrilled.

I realize not everyone will like the answer, but for now, that is the only answer that I have.

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