To stop, or not to stop.
That is the question.
Whether ‘tis nobler in the mind to suffer the slings and arrows of outrageous “fortune losses” (in the market when the Dow falls by 807 points in a day).
Or to take Arms against a Sea of troubles. And by opposing (with stop limits and other ways to reduce market risk and protect your principle), end them.
I’m pretty sure that’s how the 3rd Act soliloquy in Hamlet starts.
But to be honest, most people slept through that class.
On Thursday, we received a friendly reminder from Mr. Market.
Something many people had forgotten after the previous two-week run that drove tech stocks to the moon.
Stocks can actually go down.
The Dow shed 807 points. The Nasdaq lost nearly 5%.
We hadn’t seen any significant selling since early June, so many people were caught completely off guard.
Which brings us to an interesting decision that many investors have to make.
Should they use tools like trailing stops, puts, or other hedging tools to reduce their exposure to down days like yesterday? Or do these tools carry risk as well?
I’m going to discuss this at greater length.
But first, let’s talk about yesterday’s downturn.
Why did we finally see some broad market selling?
That question is not as important to some people as it is to me.
Following yesterday’s downturn, Nobel prize-winning economist Paul Krugman fired out this Tweet claiming that anyone who knew why markets fell has “no ideas what they’re talking about.”
This is quite a statement.
Because – on its merits – it almost encourages people not to question the irrationality of what’s happening in the market. A lot of people had feelings about Krugman’s take, so be sure to check out the Twitter thread.
No one truly knows why the market goes up or down on any given day.
However, markets are a collective force of ideas and opinions. Price action is driven by both rational and irrational sentiment.
And every now and then, people look around and realize that sometimes valuations don’t justify themselves against underlying fundamentals or economic conditions.
A large institutional investor who owns a lot of Tesla or Apple – and sees that RSI is surging and buying orders are dropping – this is a red flag.
So, they want to be FIRST to exit the position and take the profits.
Someone else notices. And selling ensues. This transfers to other tech stocks. Was it rational that Apple was worth more than the entire value of the FTSE 100 – the 100 largest British companies combined?
Or are people paying attention to the economic recovery?
That economic numbers are weakening, and despite two weeks of epic wins, it might have been time for some profit taking.
Without some sort of intervention by a dysfunctional Congress, the actual economy could reverse course altogether in the weeks ahead.
Of course, the market has been stripped from underlying economic fundamentals for a decade thanks to cheap money, zero-percent interest rates, and the Fed’s support.
But the economy still matters to sentiment for many people making decisions.
The headline unemployment number fell, and even continuing claims went down.
But if we look beyond the headlines, the employment situation is much worse than Wall Street is talking about right now. If we add up all available unemployment benefits, including the emergency pandemic relief for gig workers, the total number of people claiming benefits rose by 2 million to more than 29 million people.
The Federal Reserve doesn’t help matters. The latest economic reports released Wednesday afternoon pointed out that using instances of furloughed workers being laid off permanently as demand remained soft.
Should I go on?
Or should we listen to Krugman and not even have a discussion?
The Economy is In Trouble
If we keep digging, we see that one-third of all renters in the United States have not paid rent in August. While Trump’s eviction order may keep them off the streets until the year’s end, it does nothing to help the landlord pay the mortgage on the property.
Even as those who can flee the cities are creating new housing demand, many of the laid-off homeowners are having difficulty paying the mortgage.
About 8.2% of all loans outstanding at the end of the second quarter of 2020, according to the Mortgage Bankers Association’s National Delinquency Survey. We haven’t seen those kinds of numbers in over a decade.
The talking heads and 1% types still love the economy as stock and real estate prices have recovered.
A significant percentage of the working folks are not quite as happy about everything right now.
The other reason discussed for yesterday’s selloff was the fact that the leading technology stocks had reached nosebleed valuations and needed to pull back.
I have been pointing out how flat out freaking insane the market was since day one of the rally back in March. Now the crazy-ass chickens may be coming home to roost.
Not only were these stocks at high valuations, the technical picture was pretty extended as well.
The tech-heavy NASDAQ 100 ETF (QQQ) opened the day more than 30% above its 200-day moving average. The Relative Strength Index was above 80, indicating that the market was enormously overbought and due for a pullback.
Using the Right Protection
No one can properly explain the sole reason why a sell off occurred.
But a more important question emerges: “What can we do to protect ourselves from these types of moves?”
One method people use is to set trailing stops on their positions.
You may recall that a stop-loss order is just an order to sell the stock you own if it falls to a specific price.
A trailing stop moves up right along with the stock.
They pick a preset level. Maybe it’s 10% or 15% and set a stop-loss order that far below the purchase price. As the stock moves higher, they adjust the stop-loss order, so the maximum loss from the highs since they bought shares remains around the preset limit.
This, with a shorter-term orientation, will want to set the trailing stop order even tighter. Somewhere between 5% and 7% has always been popular with the more trading-oriented stock traders I know.
There are pros and cons to using stop losses.
The pros are pretty obvious.
Most of the time, using a trailing stop will help you limit losses and protect any gains you make in individual stocks or ETFs.
If the stock hits the preset price, your stock is sold automatically, and the cash put back in your account.
If the stock falls further, you are out with your money protected.
That sounds great, but there can be some risks to using a stop-loss strategy.
Dodging a False Dip
How angry will you be if a stock falls to your trigger price and then quickly recovers and roars to new all-time highs?
I ask that question because if you use trailing stops, this will happen to you at some point in time.
For example, let’s look at Zoom Communications (ZM).
Back in March, the stock was at about $161.
If you had a 15% trailing stop, your sell order would have been at about $137.
The stock hit that level pretty quickly, and you would have been thrilled to have saved yourself from a big lass as the stock quickly fell to about $110 in early April.
Zoom quickly reversed course and has almost quadrupled off that level in just a few months.
Yes, you could have bought back in, but that’s an intellectually tricky thing to do for most of us. If you are going to use trailing stops, have specific rules for when you will buy back in after being stopped out of a company you really like.
You also have to be vigilant and remember to change your order as the stock moves higher.
Stocks can go down. It might be because of a weakening recovery.
It might be because stocks are overbought.
It might be because traders took a minute to think about how ugly this election season could be.
We don’t know the reasons in advance.
Trailing stops can help you protect your account balance but be aware of potential drawbacks and have rules to deal with the cons of the strategy.
We’ll chat more this weekend.