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Let's Review: A Trading Post Mortem

Daily State of the Markets
Tuesday, May 28, 2013

Good Morning. I should probably provide a disclaimer right off the bat for this morning's missive: I'm going to "talk my book" today. Specifically, I've decided to spend my pixels today doing a post mortem on the most recent trade in our Daily Decision (DD) service. I feel that our actions over the past month provide a decent example of the overall approach/strategy that we employ in managing the trends and the risks in the markets, and I thought I'd share. To be sure, we didn't "nail" this move. But if you are a subscriber, this review may help you understand why we took the actions we did. And if you are not involved with the service, then the discussion below might possibly provide an idea or two for your current investing/trading strategy.

To review, while there are never any guarantees in investing, my primary goal as a money manger is to keep our accounts on the correct side of the market's big moves. I've been a "risk manager" since I began managing client accounts in 1987 (the late Marty Zweig was an early influence) and it has been my experience over the years, that getting the big moves "right" - and then not screwing things up in between - is really the key to long-term success. Thus, we built our active risk management systems to focus on the type of moves that really make a difference.

Our most recent trade began on April 22nd, when our Market Environment Model (our "model of models" which includes 10 key models or indicators designed to tell us the status of the current market environment) went positive. When the model goes positive, our system tells us to buy a "leveraged long" position in the stock market. As such, we moved to a 2X Long position, which was accomplished via the purchase of 67% UPRO ETF.

The big-picture thinking is that when our Market Environment Model positive, it means that the odds have historically favored the bulls. And since our experience has been that this is a good time to be "leveraged," we entered this trade with a "leveraged" position.

However, it is important to understand that the market had already been in a strong uptrend for the five months prior to us entering the most recent trade. Thus, the risk factors were elevated for the buy signal due to the fact that the market had become "extended."

Our Market Environment Model picked up on the fact that trend was become long in the tooth and on April 25th, the model went back to a neutral (sentiment had become overly positive and our overbought indicators were screaming for attention). This told us to "reduce leverage" as history indicates that when the model is neutral, things can get "iffy" in the market - sometimes in a hurry. We were able to lock in profits of +4.5% on this part of the trade. We sold one-half of our position, which left us with an unleveraged 1X long S&P 500 position. Therefore, we were still riding the trend, but with a less aggressive position.

When our Environment Model is neutral, our strategy adapts to the changed environment by utilizing a trend-following system designed to keep us in tune with what the market "is doing" on a short-term basis. The goal here is to ensure that we will be "ready" for the next big move in the market. The trade-off is that such an approach means that we will get "whipsawed" a fair amount when in trend-following mode. But again, the benefits are (a) the system adapts to a changed environment and (b) we will be on the right side of the next move - and we will be there early. When the models are neutral, it is worth noting that this type of approach can be a bit frustrating as the short-term trend can whip back and forth before the next major move develops. However, I have found over the years that this is simply the price one must pay if you want to be on the right side of a major trend as it develops.

So, with our Environment Model neutral, our Short-Term Trend-Following system flashed a sell signal on Friday, May 24th. This wound up being a "sell to cash" signal (i.e. NOT a "sell short" signal - there is a difference!). Thus, we moved our accounts to cash.

I think one of the key points to review in our analysis of the recent trade is that we clearly reduced our leveraged exposure too soon (hindsight is indeed 20/20). However, as a manager, I'm okay with this. You see, the market had become a one-way joyride to the upside and experience has taught me that such moves tend to end badly. So, while the market actually continued higher and it would have been nice to enjoy the ride with a more leveraged position, the bottom line is we were "making money" during the rally and I don't mind that the system took some risk off the table during what appeared to be a higher-risk environment.

Looking ahead, as long as our Market Environment Model is neutral, we will continue to follow the Short-Term Trend-Following system and take less risk by using no leverage in the model. And then should our Market Environment Model move back up into the positive zone, we will then move to a leveraged position.

It is my sincere hope that this helps everyone understand the approach/strategy we employ in our systems.

Looking for a disciplined approach to managing stock market risk on a daily basis? Check Out My "Daily Decision" System. Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them "in" the stock market during bull markets and on the sidelines (or short) during bear markets.

Turning to This Morning...

The algos appear to be tied to the US Dollar/Japanese Yen trade these days. So, with the yen heading in the right direction overnight, the Asian and European markets have enjoyed a pop to the upside. U.S. futures have followed suit and are pointing to a strong open on Wall Street. And for those keeping score at home, should the S&P 500 finish in the green today, it would mark the 20th consecutive Tuesday the index finished higher.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: +1.22%
- Hong Kong: +1.05%
- Japan: +1.20%
- France: +1.42%
- Germany: +1.17%
- Italy: +1.74%
- Spain: +1.57%
- London: +1.65%

Crude Oil Futures: +$0.67 to $94.82

Gold: -$8.100 to $1378.50

Dollar: lower against the yen, euro and pound

10-Year Bond Yield: Currently trading at 2.044%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +14.59
- Dow Jones Industrial Average: +119
- NASDAQ Composite: +25.65

Thought For The Day...

"Everything that is great and inspiring is created by the individual who labors in freedom." Albert Einstein

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave


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