War is the realm of uncertainty; three quarters of the factors on which action in war is based are wrapped in a fog of greater or lesser uncertainty.
– Carl von Clausewitz
Repeat after me… “I don’t know what’s going to happen next in the stock market.”
Relax. Take a deep breath. Let it sink in. Say it again.
You undoubtedly have some ideas and beliefs about what you think is coming. It’s good to know what those ideas are. But you can’t mistake your ideas for the likely outcome. You’ve got to be prepared for multiple possible outcomes.
Once you accept that uncertainty is unavoidable and you stop clamoring after a false certainty, you’ll find it very liberating and empowering.
Uncertainty often leads to anxiety, but there is no law that says that it has to be so. I’ve found that the more uncertainty I can embrace, the richer life becomes. I’ve found it to be true in relationships, in business, and in investing.
As Mark Twain famously said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
There is a war going on in the financial markets right now… and with war comes the fog of war. The bulls and the bears are doing battle. The outcome is unknown.
And that’s ok. We can deal with it.
In times of heightened uncertainty, it’s good to pay extra attention. In the world of military tactics, there’s a name for this – situational awareness.
Scott Stewart of Stratfor wrote an excellent short article on this a few years ago. It’s available online under the title of A Practical Guide to Situational Awareness. In the article he defines situational awareness as “being aware of one’s surroundings and identifying potential threats and dangerous situations.” He makes the critical point that situational awareness is more of a mindset than it is a hard skill.
Stock market situational awareness is exactly what I’m advocating here today. The battlefield is heating up. Uncertainty is increasing. Possible outcomes are multiplying. It’s time to raise the alert level.
In the stock market, we call this volatility – and volatility has become central to what TradeStops is all about.
It was just a couple of years ago that we expanded our approach to trailing stops by incorporating volatility. We’ve known for over a decade now that even simple percentage trailing stops are a powerful tool in helping individual investors improve their returns. They help us to overcome the negative effects of loss aversion – our tendency to care more about our losers than our winners.
Quick aside, I came across this interesting and instructive story on NPR about how loss aversion has recently been shown to even impact national employment policies. (The audio is more fun than the text.) The critical take away for me was, “You should fight longer and harder in those areas that you expect to gain more.” Yep.
But back to our main story… once we introduced volatility into how we determined optimal trailing stops, it opened up a whole new world – a world of enhanced investor situational awareness – in which volatility serves a sixth sense for us in the markets.
It helps us to know where to set our stops (VQ trailing stops and Smart Trailing Stops). It helps us to decide how much money to put into any investment (position sizing). It help us to know what new investments might complement our existing portfolio by lowering the overall volatility of the portfolio.
And now it’s helping us to understand what’s going on in the broader financial markets as well.
As I wrote last week, serious damage has been done in every sector of the stock market. The last time that we saw all 9 sector ETFs stopped out at the same time was in the fall of 2008 – right before the market fell another 40%.
It’s still too early tell if the this is just a sustained heart murmur or if the stock market is on the verge of full cardiac arrest but there’s no doubt that it’s time for extra vigilance and caution.
At the beginning of last week we had seen sharp counter-trend rallies all over the place. All of the major market averages had hit their Smart Trailing Stops and then bounced right back above them.
After another week of market action, it’s clear that our patient isn’t likely to be jumping right back out of bed anytime soon.
This chart of the S&P 500 is representative of nearly all of the charts that I’ve been looking at lately:
After bouncing back up above its Smart Trailing Stop, the S&P 500 is now thrashing around its critical boundary and looking like it’s ready for another leg down. Ominously, the Smart Moving Average continues to roll over. I’ve highlighted it in the red oval on the above chart.
I’ll have more for you in the coming days and weeks on what our new proprietary indicators are telling us about both crisis and opportunity in the broad market, different sectors and even some individual stocks.
In the meantime, practice some of your own stock market situational awareness by reviewing your own portfolio and making sure that you’ve got a plan in place should disaster strike. There is definitely a hurricane brewing. It’s just not clear yet if it is going to come ashore.
To being prepared,
Richard M. Smith, PhD