Keeping a Proper Perspective is Important.
When I started trading stocks over 30 years ago, I spent a lot of time looking for the ultimate "stock-trading-guru" to follow.
It didn't take long to discover that ALL of the analysts, forecasters, and stock-trading-gurus are sometimes wrong - just like the rest of us.
An example of this is a well-documented and well-reported blunder by a very successful fund manager who had the unpleasant duty of explaining to his investors how he lost $873 million on a single investment.
He prefaced his brief description of the mistake (and other losses) with; "Fortunately, my blunders usually involved relatively small acquisitions. Our large buys have generally worked out well and, in a few cases, more than well. I have not, however, made my last mistake in purchasing either businesses or stocks. Not everything works out as planned."
This was not an inexperienced investor. It was Warren Buffet.
If the most successful investor in history is still making mistakes, so too will the rest of us.
Today, I spend a lot of time analyzing the analysts and making my own educated guesses as to who is guessing correctly and who is guessing incorrectly. That's where my research begins.
When you trade your dollars for shares - or trade your shares back for dollars - you are engaged in educated guessing.
All of us, occasionally, guess incorrectly.
I, for example, might be guessing incorrectly in my decision to take profits and build my cash position NOW. If the market continues higher, I will be leaving money on the table.
I will, however, live to fight another day... with healthy profits and a strong cash position.
There are Many Who are Guessing that a Pull-back or Correction is Near.
All of us know a few Perma-Bears who consistently forecast that "the end is near." All of us know a few Perma-Bulls who consistently forecast the DOW to hit 30,000... "soon!"
More and more, though, I'm seeing credible reports with good arguments that justify getting prepared for a significant pull-back or correction. These arguments include:
1) US dollar strength is hurting the earnings (and thereby growth) of many companies.
2) Emerging Markets (Russia, India, China) as well as Developed Markets (Europe, Japan) are luring traders with bargain-priced stocks - many trading well-south of 15 times earnings.
3) The Federal Reserve has clearly signaled that they are pursuing "normalization." They are giving us plenty of notice that the proverbial punch bowl will be emptied, washed, and returned to the tool box.
4) The "summer doldrums" are near. Though this is unscientific, there is a seasonal factor when MANY STOCK TRADERS go to the proverbial "sidelines" and trading volume falls. It's called "Sell in May and go away!"
I remain long-term bullish on stocks, but in light of these four factors (and others) it seems prudent to be SHORT-TERM cautious.
Pull-backs and corrections are just part of the stock trading landscape.
Only hindsight will reveal if I am right or wrong about the need for short-term caution.
Inverse Stock ETFs Can Provide a Good Hedge.
I think of these as insurance policies.
They are useful in softening the blow if the market corrects.
Granted, there will be losses if the market continues higher. They do, however, provide peace of mind as well as some handy cash if the market corrects and you sell them at the bottom.
There are many Inverse Stock ETFs from which to choose.
I suggest choosing those benchmarked with the major indexes (DOW, S&P, NASDAQ) and those that enjoy high trading volume. Google "Inverse Stock ETFs" and you'll find many.
"Weeding-the-Garden" is Prudent. CASH is a Position, Too!
All of us have a few poorly performing positions in our portfolio. I call them weeds.
Like weeds in a backyard garden, they take up space (dead money) and deny nutrients (your cash) that could be added to the productive plants.
I am now closing the poorly performing positions that could soon become big losers.
On two or three of these, I will be taking minor losses.
Losses can be discouraging and possibly damaging to the ego for some. For me, it's a necessary move to protect against further losses. Furthermore, the cash can be better utilized elsewhere and/or used to buy them back later at better prices.
I am taking profits from those that have performed well but could be hit hard by a pull-back or correction.
It is difficult for me to sell shares that have done well. Some of these, though, have significant downside risk when (if it happens) everyone "runs for the exit."
Generally, if a good position is more than fully-valued (trading above 20 to 30 times earnings per share) it's a good candidate for profit-taking.
These positions will not be closed. Reducing them by 20 to 50 percent, however, not only builds my cash position but significantly reduces my average-cost-per-share on the remaining shares.
These are proven winners that will be first on my list for repurchase when I'm confident that the pull-back or correction (if it happens) has completed.
I am now hedging my long-term "keeper" positions.
Among my best guesses, there are long-term keepers. These, I purchased at bargain prices, locked in a strong & consistently rising dividend, and expect them to stand up well to any pull-backs and corrections in the broader stock market.
The most recent example of this is Chevron Corporation (NYSE:CVX). I nailed it at the bottom of the most recent plunge and bought 100 shares at $102. It could fall further in a pull-back or correction (especially if there is further downside for crude oil) but, I locked in a dividend of over 4%.
I seriously doubt if my local bank can match that return on a $10,000 Certificate of Deposit. Furthermore, federal deposit insurance aside, I consider Chevron to be a stronger entity than my local bank AND Chevron has a long history of consistently rising dividends.
Rather than shorting them individually or using options, I feel more comfortable using the Inverse Stock ETFs that are benchmarked to the major indexes. That's an indirect, but effective, hedge.
If a pull-back or correction grows beyond a possibility to a likelihood, I may add on a double or triple X Inverse ETF as a speculative trade.
Sometimes I get greedy and the Leverage Inverse ETFs can provide substantial short-term profits.
Exercise your own due diligence on these. They can be dangerous.
If there is a Correction, a Strong Cash Position Enables Shopping for Bargains.
Few things are more frustrating than seeing a bargain-priced stock and not having the cash to take advantage of the opportunity.
If there is a significant pull-back or full correction, there will be many long-term bargains to be had. No one "knows for sure" what will happen next. However, the possibility is genuine and being prepared with a strong cash position is a smart strategy.
Keep in mind that this is only an educated guess AND I might be wrong.
I do feel comfortable offering two safe predictions:
1. If (if, if, if,) there is a significant pull-back or full correction, I predict that the Perma-Bulls will sheepishly offer a laundry list of explanations and return to shouting "buy, buy, buy," at the first dead-cat bounce.
2. If (if, if, if,) there is a significant pull-back or full correction, I predict that the Perma-Bears will be shouting, "I told you so!" and proceed to recommend going long on gold, a small farm, barbed wire fencing, assault rifles, and ammunition.
Between those two extremes, those of us who take reasonable precautions and build a strong cash position, will still be in good shape if there is no pull-back or correction.
On the other hand, we will be well prepared to go shopping for bargains if it happens.
Disclosure: The author is long CVX, LOW, BA, LMT.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.