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Why Tactical Isn't Working - Part VII (The Solutions) image

This morning I'd like to finish what has turned out to be a rather lengthy series on why tactical management strategies have not been living up to expectations over the last several years.

Last time, we talked about the role that "the machines" play in the stock market and the impact they've had on intraday volatility. The key point was that, in my opinion, the character of the stock market has changed rather dramatically over the past few years and I believe this is one of the primary reasons that tactical/technical strategies have struggled.

I also pointed out that I wasn't alone in my view. As Exhibit A in my argument, I provided a quote from Ned Davis, a 40-year stock market veteran and founder of one of the country's best-known institutional research firms, Ned Davis Research Group. In a note to clients, Ned recently wrote, "This is not the stock market I grew up with."

And yet, Mr. Davis continues to possess an enviable record of investing success - yes, even in recent times. What's the secret to his of success, you ask? Having been a client of NDR's since the early 1990's I believe the answer is that Ned employs a flexible approach and is able to adapt to the environment when it changes.

For example, one of Ned's key tenets to managing money over the years has been to "trust the thrust." The thinking here is that when the market experiences a "thrust" - meaning that either price, breadth, or volume is completely lopsided for an extended period of time - it is an indication that the market has experienced a sea change and that the trend of the market will now be in direction of the thrust signal.

However, given that many thrust signals, especially price thrusts, now occur much, much more frequently than in the past, Ned has changed his tune from "trust the thrust," to "trust, but verify." In short, one of the game's best known tactical managers says you have to change the way you play these days.

Which brings us to the final chapter in this series - what managers and investors using a tactical/technical approach can do about the changes to the market's character.

Some Possible Answers

Before we proceed, let me make a couple things very clear. First, there is rarely a single answer to any market dilemma. And this one is no exception.

Second, what follows is merely one man's opinion regarding potential solutions to the problems that tactical/technical managers have encountered in recent years.

But, I should also say that I have been working on this very dilemma for since the end of 2011. And while I don't have a silver bullet solution, I would like to offer some my thoughts and findings on the topic. What follows are a handful of ideas on adjustments that investors/advisors/managers may want to consider in order to lessen the impact of the market's increased intraday volatility and the change in character.

Rely Less on Pure Trend/Momentum Indicators

One of the big problems tactical managers have faced since the high-speed trading era set in is it has become increasingly difficult to identify when a trend is meaningful. In the "old days," managers would look for a surge in price that was accompanied by strong momentum (something we affectionately refer to as "oomph"). If there was some "oomph" along with a big move in price, it was a sign that buyers were anxious to get in and that there was strong demand for stocks. As such, the move was likely to continue.

However, in today's game, it seems that all the moves are accompanied by momentum. This is due to the fact that the majority of trading today is done by the machines. As a result, there is no emotion involved. No rush to get "in" or "out." No, algorithms are simply implementing their millisecond trading schemes over and over again until the closing bell rings.

The bottom line is that traditional trend indicators such as moving averages, crossovers, support/resistance zones etc., wind up getting fooled by the "mindless" computer moves. And because of this, tactical managers may want to consider placing less emphasis on price trend indicators - especially from a short-term perspective.

Extend Your Time-Frame

In my humble opinion, the short-term action in the market has become less and less important. Look at the number of sideways trading ranges and "V-Bottoms" that have occurred since 2011. Short-term trends get reversed at the drop of a hat - often without any obvious catalyst. Then once a trading range is established, the indices have tended to move violently up and down within the range.

In essence, stocks move hard in one direction one day and then often reverse course and go the other way the next. A downtrend can morph into a uptrend in short order and vice versa. Thus, you may want to start looking at the shorter-term movement as "noise" - instead of an important "signal" to make a move.

For this reason, I have all but eliminated reliance on shorter-term trend indicators. The indicators have become unreliable and the whipsaws have become more severe (which, unfortunately is a recipe for big losses). And since, from my seat, the ultimate goal is to stay on the right side of the market's big, important moves, I now spend more of my time looking at weekly charts and longer-term price indicators/models.

Make Incremental Moves

One of the oldest rules in the trading game is to "do less" and/or "trade smaller" when things aren't going your way. This is the premise for the next big adjustment to consider.

Given that a great many indicators have either ceased working altogether or are far less effective in today's market, the idea here is to implement the "do less/trade smaller" rule. So, instead of bombing into the market with everything you've got when a signal is given, it makes more sense to make "smaller" moves.

For me, this has meant creating an "exposure-based" approach. Instead of relying on a single model or indicator, think about using 10-15 models/indicators, with each indicator controlling a set percentage of exposure to the market. For example, if there are 10 indicators, each time an indicator flashes a signal, the exposure is increased/decreased by 10%.

To be sure, this will increase the amount of trading you do. And there will be a bunch of little moves that don't really amount to much. But, again, since the goal is to be mostly long when the bulls are running and then try to preserve capital when the bears come to town, using an array of indicators and an incremental approach makes sense. Well, to me, anyway.

Learn to Identify Trending/Mean-Reverting Environments

Make no mistake about it; trying to define the type of "trading environment" or "mode" of the market can be very tricky. But the basic idea here is to try and "use the right tool for the job."

The premise is simple. If the market is in a "trending" mode, it makes sense to (a) employ trend-following indicators and (b) lengthen your time-frame. After all, the trend is your friend, right? And then, when the market finds itself in a sideways, back-and-forth, "mean-reverting" mode, using mean reversion indicators, swing trading techniques, oscillators, channels, and sentiment indicators would seem to be the way to go.

While this appear to be an exceptionally sensible approach to the market - and one that just might make work in today's world - there is a rather large fly in the ointment.

The problem is this. You can be wrong - twice. First, you can get the trading environment wrong. This means you will likely be using the wrong indicators for the environment. Which brings us to the second problem. As you might suspect, if you get the environment wrong, there is a good chance that effectiveness of the indicators used will also be reduced.

For this reason, I like to use a "best out of three" or "confirm" approach when trying to determine the trading environment. As you can probably guess, I employ three different models - each designed to indicate whether the market is in a trending or mean-reverting mode. And I require two out of three to agree in order before a decision is made.

Modernize Diversification Techniques

Finally, we come to what I see as possibly the best solution to the "tactical dilemma." So let's cut to the chase. Instead of putting all of your investing eggs in the tactical methodology basket, I believe it makes sense to utilize what I will deem a more modern approach to portfolio diversification.

Here's the deal. There are many different investing methodologies such as passive allocation, strategic investing, tactical management, equity/bond selection, liquid alternatives, etc. The problem is that many advisors and investors like to "take a stand" on a single methodology and espouse why the XYZ approach is the BEST way to invest.

But what I've learned in my nearly 30-year career as a money manager is (a) THERE IS NO ONE SINGLE BEST WAY TO INVEST! and (b) most every methodology/strategy/manager WILL UNDERPERFORM or be out of favor (or worse) at times.

So, why not plan for this reality? Instead of trying to figure out the BEST way to invest, why not utilize multiple investing methodologies, multiple strategies, and multiple managers?

The crux of such an approach is to try and limit the damage to one's overall portfolio when a particular methodology/strategy/manager falls out of favor or underperforms for a couple years. For example, while tactical has indeed struggled since 2008, a longer-term strategic approach has performed well. Thus, doesn't it make sense to use more than one methodology in your portfolio?

So, what's the best way to solve the tactical dilemma these days? For me, it's using a more modern approach to diversification. Instead of putting all your eggs in the tactical basket, the idea is to incorporate several methodologies/strategies/managers in your portfolio. And in my humble opinion, THIS represents the best solution I can come up with to try and combat changing market environments and the new, new normal.

Publishing Note: I am traveling the rest of the week. Thus, reports will be published as my schedule permits.

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of German/European Banks
      2. The State of Global Central Bank Policies
      3. The State of U.S. Economic Growth

Thought For The Day:

Never forget that the first rule of life, medicine (and money management) is to do no harm...

 

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

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Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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