I recently explained why many investors become “boiled frogs.”
Namely, they focus on the S&P 500 index rather than its individual components.
They’re also slow to prepare for a down market. They wait until the market has already lost 20%, the official definition of a bear market, before trimming down their exposure. By then, it’s already too late.
So today, let’s talk about a better way…
It starts with a simple concept: adaptation is the key to surviving change. I learnrned the intimate details of this truth as a biology major in college. But even non-science types should be familiar with this idea thanks to Charles Darwin’s quote: “
It’s not the strongest species that survives, nor the most intelligent. It’s the one that is most adaptable to change.”
Politicians get criticized for changing their opinion on a topic, as if conviction in one’s beliefs is more important than anything else. But scientists are required – by the ethics of their profession – to change their minds, theories and research actions when new information comes along. Even if it makes them look like a “flip-flopper.”
Naturally, as an analyst, I side with the modus operandi of the scientists.
After all, the stock market doesn’t pay anyone for their opinions or convictions. It only pays investors for being on the right side of the prevailing trend. And because that trend is constantly changing, investors must adapt constantly or else go the way of the dodo.
So when I designed Cycle 9 Alert three years ago, I made certain it would be able to adapt to a variety of (constantly changing) market conditions – bullish, bearish and all the shades of grey in between.
At the time, I realized I had two options for ensuring my service could play both sides of the market. One was an “All or Nothing” approach. This would have involved a simple rule like this:
- If the S&P 500 index is in a bull market, consider only bullish positions.
- If the S&P 500 index is in a bear market, consider only bearish positions.
This approach has the advantage of being clear and simple. But it’s imprecise and unable to adapt quickly and efficiently.
This is where we find the frogs slowly boiling in water. You see, the stock market doesn’t flip from a bull market to a bear market in an instant. Instead, the process is agonizingly slow. And the change comes about in a slippery way – so it’s difficult to detect it’s happening, until after it’s already happened. It’s why the frog doesn’t jump from the pot… and why many investors hold hemorrhaging stock portfolios for far too long.
This chart proves my point…
Here, I’ve plotted what percentage of the nine U.S. stock sectors were in a bullish trend over each of the last 12 months.
Twelve months ago… all nine sectors were bullish.
Ten months ago… eight out of nine were bullish.
Five months ago… seven out of nine were bullish.
Four months ago… only five out of nine sectors were holding a bullish trend.
And then, a month ago… all nine sectors were in a bearish trend!
That’s what a pot of slow-boiling water looks like. And that’s why I engineered Cycle 9 Alert to have a more advanced adaptation mechanism – rather than a rudimentary “on/off” switch based on an aggregate stock index, or an arbitrary definition of a bear market.
At the risk of mixing analogies, Cycle 9 Alert’s adaptation mechanism works much like a mountain bike.
Mountain bikes don’t have just two gears – one for flat terrain, and one for steep inclines. Although that bike would work just fine for me here in Florida, where a single-speed beach cruiser does the trick, I certainly wouldn’t take it to the Colorado ranch that my wife and I visited last year. The mountains were insane!
Most mountain bikes have between 21 and 27 gears. This gives the rider much more flexibility – to quickly and efficiently adapt to subtle changes in terrain and incline. Instead of simply gearing the bike for either “flat” or “mountain” terrain, the rider can better adapt to all shades of grey in between.
Cycle 9 works much the same. We aren’t limited to just two “gears” – 100% bullish or 100% bearish.
That’s because, instead of applying my trend-following rules to an aggregate stock market index (i.e. the S&P 500), I apply them individually, to individual sectors and stocks. This looks like:
- If <this particular stock> is in a bullish trend, consider a bullish position.
- If <this particular stock> is in a bearish trend, consider a bearish position.
This construction gives us unlimited access to the market’s shades of grey – when it’s neither 100% bullish, nor 100% bearish. And it allows us to gradually adjust our positioning since, as the chart above shows, market conditions change gradually, not instantaneously.
To good profits,
Adam O’Dell, CMT
Chief Investment Strategist, Dent Research