Opened a Can of Worms Tuesday
Market exit and entry rules and why we should have them
I opened a can of worms with my post on Tuesday and I want to bring some peace, clarification, and resolution to some of the things I addressed in that post. If Tuesdays post and Wednesday’s rally threw you for a loop, you are going to want to read this.
I know I said I was going to get away from writing about the market, but this is an exception because the stock market volatility in the past month is one of those occasions that only happens once in a blue moon. As the provider of my family and an investor, I needed to pay attention to the market right now. Ray Dalio believes that we are in a once in a lifetime end of cycle period. The end of our current 100 year cycle could last another 5-20 years, but I has to end sometime. Ray Dalio has been studying 100-year market cycles for over 20 years. Today I want to write about the importance of exit strategy.
$450 billion is traded in the stock market every day. The U.S. stock market is worth $52 trillion. We can’t know everything that is going on in the world market, that is impossible, and it is completely beyond our control. Nobody knows if the stock market is going to go up or down today. You have a 50% chance today of the market going up or down, don’t let anyone tell you otherwise.
The stock market is not rational. The market is a bunch of people making independent decisions based on whatever information or feelings they are operating on in the moment, and as we have seen in the past week, the stock market is easily manipulated by politicians, private interests, day traders, the news media, etc. That has always been the case; and the easier it is to buy stocks—the more volatile the market becomes. That is true of any market.
The reason I exited the Nasdaq 100 (QQQ) in February is because it is (still) so overvalued, and I think there will be a better buying opportunity in the future. So far, I haven’t found anything I am willing to hold on to, and with this past week’s volatility, I am waiting it out on the sidelines until after this “storm” blows over, to see what happens. I wrote about that on Tuesday.
My Exit Rules
To keep emotions out of our buy and sell decisions in the market, it is important to have non-discretionary rules for exiting and reentering the market. Non-discretionary means, I set my emotions aside and follow these rules no matter what happens, even if I have a very strong feeling or reason to believe that the markets will rebound next week.
The world market moves with the U.S. market because the U.S. market is the biggest market, and the “index” is predominantly represented by the S&P 500— the 500 biggest companies in America.
I have two simple non-discretionary rules for exiting the S&P 500 index:
· The 25% trailing stop rule
· The 5% fractal wave rule
The 25% trailing stop rule is this; I exit the index (or an individual position) when the price of the index closes 25% below its 52-week high. The reason I do this is because of drawdown and recovery metrics.
The S&P 500 has delivered an average annual return of 10.13% since 1957, but the volatility during that time was far from average. If you had left your money in the S&P 500 in 2000 you would have seen a 51% drawdown by the end of 2002 and another drawdown of 58% from 2008-2009. It would have taken 13 years to recover from those two events; 15 years if you calculate for CPI inflation—and that is just to get back to zero. The drawdown in the early 1930s was 86% and took 25-30 years to recover. The Nasdaq 100 (QQQ) had an 83% drawdown between 2000-2002.
As you can see from the chart above, a 25% drawdown requires a 33% recovery to get back to even. In an average market, that might take 2-3 years, but it is doable. A 50% drawdown requires a 100% recovery which could take ten years. An 85% drawdown requires a 567% recovery. It could take you 50 years to recover from an 85% drawdown. That is why I put a 25% trailing stop alert on the index and exit the next day if it triggers, because I am not going to risk my capital based on a “feeling” that it will “probably” go right back up.
As of this writing and after yesterday’s big rally, the S&P 500 is at 5,307, which is only 14% down from its high of 6,147, but Tuesday it was 21% down at 4,851 and the QQQ was down 25%.
If you are still in the S&P 500 index and you want to wait to see if it hits -25%, I will not advise you against that. The reason I exited my S&P 500 position in my 401k on Monday not because of the 25% trailing stop rule but because of a different rule-
The 5% Fractal Wave Rule
I explain fractal wave patterns in my book. Essentially, a fractal geometric pattern is something we see in nature with trees, waves, earthquakes, etc. And we see it with the buy-sell decisions people make in the stock market.
On April 1st we saw the QQQ move 2.1% from high to low. 4/2 it was 2.9%, 4/3 5.6%. I generally recommend getting "out of the water" when the "waves" are over 5%... 4/4 6%, 4/7 9.3%, 4/8 7.7%, 4/9 11%... These big swings have only happened a few times in the past 25 years: 2000, 2008, 2020, and this past week. Maybe we hit the bottom Tuesday, maybe we didn't. These are big waves. The question I had to ask myself was, “Are you willing to risk a long recovery period just so you can play with the whales during a hurricane? That is why I am on the sideline. I don’t like the drama.
The stress of watching the stock market make these big swings and watching trillions of dollars get erased from people’s retirement funds is stressful. I would prefer to be out of the stock market altogether. I would buy bonds, if they kept up with inflation, but unfortunately there are very few things that have the potential to keep up with inflation right now, really just two: stocks and real estate.
I am taking this opportunity to learn more about real estate because I know that sitting on cash is the worst thing I can do with my capital. Maybe I will reenter the stock market in a few months, maybe I won’t. I mentioned Tuesday that I have a non-discretionary rule for reentering the stock market index, as well. I will give a more in-depth explanation of that another time.
One last thought: another reason I exited the market is because it is Great Lent, and we are going into Pascha (Easter). I don’t want any more stress or drama going into the holiest season of the year. I don’t want to be checking my stocks every day, and worrying about them at night. The stock market will still be there, having most of the same problems, in 90 days.
Have a blessed Holy Week!