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Are You A Market Environmentalist?

Daily State of the Markets
Monday Morning - March 19, 2012

Good Morning. As I've mentioned a time or twenty over the years, the primary purpose of my Daily State of the Markets column is to try and identify the driving forces behind the market's current mood. I figure that if I can understand why things are happening in the short-term, I shouldn't be taken by surprise by how the market acts over longer periods of time. And understanding why the market does what it does makes it a heck of a lot easier to stay in tune with the current environment.

Before we get to a quick summary of what is driving the current action this morning, I'd like to take a step back and emphasize again how important it is to be able to adapt to a changing environment. In my humble opinion, identifying the environment is the first step in the investment process. So, the very first question investors need to ask themselves each morning is, what type of market am I dealing with? For example, is this a bull or a bear? Is the market trending in either direction? How's the volatility? What's the driving force right now (news, data, earnings, etc)?

In short, knowing the answers to these questions will help you identify the best strategy to employ for a given environment. I know this sounds incredibly simplistic. But it should be fairly obvious to everyone that has been in the game over the past five years that you need to employ a different strategy in a bear phase (when return OF your money is the most important part of the game) than you do in a bull market (where return ON your money is the focus). This is where the "risk on/risk off" concept came from. In other words, it can be financial suicide to employ the same strategy in both up and down markets.

Along these lines, another incredibly important aspect of playing the game successfully is identifying when the market environment changes. As I wrote last week, the average hedge fund is dramatically underperforming the S&P 500 so far this year. The reason here is simple - the environment made a U-turn in December and caught throngs of managers leaning the wrong direction. And since everyone and their grandmother was so sure that the European debt mess was going to take down the world, these managers have been unable to capture much of the current joyride to the upside.

A friend of mine blew himself right out of the business a couple years back because he was unable to see the change in the environment. My friend had a great trading strategy where he would buy his favorite metal stocks and then write covered calls on them whenever they became overbought. He basically printed money from 2004 through early 2008 as his trading account ballooned. And because he was doing so well over what felt like a long period of time, he began to "lever up" his trades by using his margin account.

However, as you can probably guess, my friend did not have a good risk management strategy. His system worked well, very well in fact, during a bull market environment. But when the environment changed in 2008 my friend failed to change with it. Since he wrote calls on the positions he owned, he didn't cut losses on the underlying stock positions in his strategy. He figured that the stocks would come back soon enough and the big decline that was occurring was just another opportunity to collect the premiums from the calls being sold. But, of course, he was wrong. And given that there was a healthy dose of margin involved, my friend saw his account get wiped out.

The moral of the story is pretty simple... Investors need to employ strategies that can (a) handle both up and down markets, and then (b) be able to adapt to changing markets quickly. Employing such an approach doesn't mean you won't ever lose money. But it does mean that you shouldn't incur losses so large that you can't recover. As Warren Buffett so famously said, "Rule number one in investing is never lose big money. And then rule number two is to never ever forget rule number one!"

Although I am quickly running out of time this morning, I do want to get to the current environment. In my humble opinion, we currently have a cyclical bull market on our hands. And the good news is that the average cyclical bull market that occurs within the context of a secular bear market (we believe that the current secular bear began in 2000) lasts about a year. So, while there are no guarantees that this view is correct or that history will either rhyme or repeat, this tells us to utilize bull market strategies right now such as buying the dips. However, with last year's cyclical bear still fresh in our minds, we're not putting our foot to the floor in terms of leverage right now.

Turning to this morning... European markets are sagging a bit this morning and U.S. futures are following suit, suggesting a modestly down open on Wall Street. However, the story of the day is Apple's conference call to discuss what the company plans to do with its nearly $100 billion cash horde. Apple will begin the call at 7:00 am eastern.

On the Economic front... There are no important economic reports scheduled for release before the bell today but we will get the NAHB Housing Market Index at 10:00 am.

Thought for the day... "What the wise man does in the beginning the fool does in the end," -- Warren Buffett

Pre-Game Indicators

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

  • Major Foreign Markets:
    • Australia: +0.38%
    • Shanghai: +0.22%
    • Hong Kong: -0.95%
    • Japan: +0.12%
    • France: -0.58%
    • Germany: -0.56%
    • Italy: +0.16%
    • Spain: +0.73%
    • London: -0.32%
  • Crude Oil Futures: +$0.03 to $107.09
  • Gold: +$0.20 to $1656.00
  • Dollar: lower against the pound higher vs. yen and euro
  • 10-Year Bond Yield: Currently trading at 2.278%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -2.27
    • Dow Jones Industrial Average: -21
    • NASDAQ Composite: +2.32

Positions in stocks mentioned: AAPL

For more of Mr. Moenning's thoughts and research, visit

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Disclosure: I am long AAPL.