THE FUTURE OF RISK
Today was the day. It was the point in time when investors decided to shed the negative myopia that has been with us since August. It has been replaced with a reluctant acceptance that perhaps equities can go up for more than a few days at a time. An opinion that early October may have indeed been a solid enough point to see us rally through the end of the year. An admission by fund managers that in an effort to avoid risk completely for fear of driving a taxi for a paycheck, perhaps the abundance of cash in the portfolio was a bit excessive.
All of these realizations were caused by the massive gap up we saw in the morning that never was retraced as most seemed to expect. Furthermore, it was the last straw for those who were holding out bearish hope of an opportunity to buy lower. You could see the market forcing the hand of both frightened buyers and short-sellers on this day.
What is astounding to me about professionals in this business is that during points at which your risk is extremely well-defined and simple to quantify they are the most fearful. However, at points when the risk becomes extremely difficult to quantify and is more or less open ended, the buying begins. Often time it is driven by group think. The comfort of having a posse of investors hold your hand serves to dull the fear.
The well-defined and simple to quantify point to buy was early October. This is my article from October 3rd http://www.zenpenny.com/?p=2636, one day before the bottom. It's an important read because it goes into the mentality you need to have at important turning points. It is true that at points where the vast majority of investors are most fearful are often times the best points to initiate positions. The risk/reward becomes very easy to quantify because you can set in stone EXACTLY what the market should do from that point on.
Now take a look at where we are now. If you are the poor fund manager who needs to initiate exposure here, how do you quantify your risk? How do you know when you are wrong? The truth is....you don't. You are so far away from a favorable point to buy that any normal pullback within such a rapid ascent will seem like the end of the world. The end result: You get rinsed at or near the bottom. The moves the market can make from here are open ended. The risk profile has changed dramatically.
With that said, I moved to a 60% invested position all in QQQ. I have stayed away from individual stocks during the second half of the year. I have no intention of going back for the time being. QQQ keeps it simple and I am able to capture the gains I want.
I liquidated the position in FAS today, not because I am bearish, but rather out of the discipline of bringing home some big gainers during monstrous rallies like this. There is a fine line between allowing profits to run and being a greedy pig. I've crossed it before in 2004 when I was running my hedge fund and pulled in a 45% gain during the first two weeks of January, following a 70%+ gain in 2003. I let the profits run. 2004 ended up being a down year and in 2006 I shut the doors to my fund. The problem wasn't only being greedy, there were numerous things I missed between 2004-2006. Being a pig didn't help, however. I like to think I am beyond that point now.
I would be very careful with new long positions from this point forward. You have to start becoming selective with the individual names you choose, whether a stock or ETF. I believe that we will begin pulling back next week. The depth and character of that pullback will tell a lot about how November will end up. I expect November to be bullish. I will call it how I see it, however, without allowing my bias to stand in the way of the proper assessment of the market.
Keep in mind that after buying into the October 4th reversal, I did move to a 100% cash position on October 12th in order to assess the pullback and make sure that I didn't give away the profits. I began adding risk again on October 19th, after the market proved that it didn't have any devious plans to resume the bear market trend. I may do something similar here over the next several days.
As always, I will keep you updated as to what I see, hear and smell from the market.
