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Posted by on Oct 20, 2014 in ETF Strategist

Time for Defense?

Time for Defense?

By: Roger Nusbaum, AdvisorShares ETF Strategist

As is always true, in looking at the market today there is a bull case and a bear case. The task for market participants who are inclined to tactically take defensive action is to weigh the risks at any given time as well as the potential for returns in deciding how to allocate.

For many years I’ve been writing about using the 200 day moving average a trigger point for defensive action which can mean reducing long exposure, adding a fund that sells short one way or another, buying puts (I’ve never bought puts in this capacity), adding funds that are designed to reduce the portfolio’s correlation to the stock market or any combination of the above.

The S&P 500 went below its 200 say moving average a few days ago and so if that is your chosen trigger point I would not ignore it but that does not mean sell everything, I’ve never advocated getting completely out.

In terms of reducing equity exposure it always good to monitor positions and their portfolio weighting. If you bought a stock with a 3% target weight and it has outperformed its way into a 5-6% weight then that is one to consider rebalancing down to the original target weight or close to it. If you own individual stocks then you’ve probably had some of those. Another sale candidate is a stock that you may have turned out to be wrong about. If you own stocks then you probably have some of those.

Funds that sell short can be very useful if the market is indeed headed lower because they will grow in size relative to the portfolio as their value goes up and the rest of the portfolio declines. Of course if this turns out to be a head fake (more on why that could be the case below) then a short fund will be more of a drag on the portfolio than cash raised with a couple of sales.

Funds designed to reduce correlation may not work as a standalone strategy. If you’re equity target is 70%, you’re fully invested at 70% and then you put 3% into a diversifier you may not see the defensive result you’re looking for but some level of reduced exposure combined with diversifiers very well could give the result you hope for, I believe it would.

There are several reasons why this time could be a head fake. One is that it just could be for no reason at all. That is not intended to be flippant but is an acknowledgment that no on truly knows what the market will do. The slope of the 200 day moving average for the S&P 500 is still sloping upwards. In 2011 there were several 200 DMA breaches with the slope being positive and so it surfaced that a negative or downward slope posed a bigger threat. This time around could be the real deal but the slope is a reason to not be too aggressive with selling.

Another reason this could be a head fake is that as we sit here right now the S&P 500 is down high single digits (as of when this was written early Thursday morning) in less than one month which is arguably a fast decline. Historically fast declines tend to snap back quickly it is the slow declines, the ones that don’t cause much of a reaction, that are the ones to really worry about.

“Fast decline” is not a reason to abandon whatever your discipline might be, I certainly have not, but it is important to have some contextual understanding of what could be going on as well as understanding the consequence of not taking enough defensive action.

If this is the big one and you somehow end up thinking you did not take enough defensive action then it is crucial to remember that whenever the next bear market comes, after it bottoms out it will then go on to make a new high. The variable is how long that will take. I made this comment repeatedly before, during and after the financial crisis. This was true after the Great Depression, the stagflation of the 1970s, the dot com bubble, the Great Recession, the next bear market/crisis, the one after that and so on. The biggest threat from a bear market is succumbing to emotion resulting in panicked, undisciplined selling and then watching the market make new highs from the sideline.