Editor’s Note: Regular readers know trading strategies aren’t our go-to beat here in the Diary. But with stocks hitting new all-time highs this week, plenty of readers are wondering “what now?”
That’s why we’re passing the baton to our weekend guest editor, master trader Jeff Clark. With markets like these, Jeff thinks readers should follow one simple rule: Have some cash.
“You must be fully invested during market rallies,” a concerned reader wrote me recently. “If you’re holding cash, you are going to underperform the market.”
The reader is making a point that is often preached by the majority of stockbrokers, money managers, and mutual fund salespeople.
“Don’t try to time the market,” they say. “Stay 100% invested, and you’ll keep up with the market’s returns over time.”
But the truth is – because of the various fees charged by those same stockbrokers, money managers, and mutual funds – if you stay 100% invested all the time, you will consistently underperform the market.
The only way to beat the market is to have cash available to buy stocks during the inevitable declines. And the only way to have that cash available is to slowly sell off positions as the market stretches into overbought territory.
Taking Money Off the Table
Let me try to explain how this works. Take a look at this chart of the S&P 500…
The S&P 500 first crossed above 2800 back on January 17, 2018. That was 15 months ago. Yesterday, the index closed at 2939. So, if you were 100% invested for that entire time, then you would’ve made just under 5% on your money.
But, if you routinely took some money off the table when conditions got overheated, then you would have avoided some of the large downdrafts in the market. And you would have had cash available to put to work when conditions got oversold.
The red arrows on the chart point to days when we published cautionary advice in my free newsletter, Market Minute (catch up here, here, and here). Technical indicators like the Volatility Index (VIX), the McClellan Oscillators (NYMO and NAMO), the CBOE Put/Call ratio (CPC), and others were warning of overbought conditions. So, it seemed prudent to raise a little cash.
Of course, we ran the risk of underperforming the market if stocks continued to rally – which they did following our exit in January last year, and have done since early February this year. But, when the market fell, as it did last February and last December, we had money available to put to work when the technical conditions reached oversold levels.
The blue arrows on the chart point to days when we published bullish advice in Market Minute (here and here). The technical indicators had reached extremely oversold levels. And, while we didn’t nail the exact bottom of the market decline, we were able to buy stocks at far cheaper prices than where we had sold them previously.
Selling even just a small portion of your portfolio into overbought conditions, and then buying back in when things get oversold, can have a very positive effect on your overall returns.
You Must Have Cash
Over the past few months I’ve been advising folks to raise cash. Many technical indicators are in overbought territory and they’re flashing warning signs.
Yet, the market has continued higher. So, if you followed my advice for the past few months, then you’re underperforming the broad stock market.
I suspect that’s a temporary condition. We’ll get a decent decline, sooner or later, that will give you the chance to buy stocks at lower prices than where they trade today.
But, in order to buy when that happens, you have to have cash.
Editor, Market Minute
P.S. As you can see above, my trading strategy is all about taking profits off the table and reducing risk.