By David Moenning
Chief Investment Strategist, StateoftheMarkets.com
Although I run the risk of restating the obvious, it appears to me that the current market has gotten more than a little sloppy lately.
Thus, unless one of our two teams can really get something going in the near term, the current consolidation phase is likely to continue. You see with earnings season just getting underway and a great deal of uncertainty remaining with regard to the situation in Europe, it may be tough for the bulls to make a concerted push higher. And yet at the same time, our furry friends in the bear camp don't seem to be able to do much with their opportunities of late. Thus, unless something changes right quick, the consolidation will remain in play.
History also supports the idea that the current consolidation phase could continue for a while. According to the computers at Ned Davis Research, the initial blasts of new mini bull markets have similar tendencies. First, the bulls tend to run for about six months before encountering any significant difficulty. Second, the new mini bulls tend to last about two years. But at about the six-month mark, the rally tends to stall out as a consolidation phase sets in. And in looking at what we've had over the past six months, so far at least, this mini bull appears to be proceeding according to script.
So, given that the current bull had its six-month birthday on April 2nd and has been moving sideways ever since, I thought it might be a good idea to review the best approaches to a consolidation phase.
In my experience, there are a handful of ways to play a consolidation. And since one could be with us for a while (don't forget that the Presidential Election Cycle also calls for a sideways period for a few months in the middle of the year), you might want to pick one and go with it for awhile.
For starters, one of the easiest things to do is to simply take your ball and go home for a while. In English, this means that one way to play the odds of an extended consolidation phase is to just sit in cash until one of the two teams shows that they truly have possession of the ball.
Next, for those that like to hold their favorite stocks such as Apple (AAPL), Google (GOOG), McDonalds (MCD), or Chipotle (CMG), you can move to a "hedged bull" position during the market's sloppy phase. Step one is to sort through your portfolio and raise some cash by cutting the laggards. Next, you apply a hedge that will profit when and if the market falls. Since volatility tends to pick up during these types of environment, you might want to try to "get long some volatility" via the VXX, VXZ, or TVIX. Or you could protect your longs by adding some inverse ETFs such as the SH or SDS. And for those that enjoy the more complex trade, you can simply short the SPDR (SPY) in the portfolio.
How much you want to hedge is of course up to you. However, given that this consolidation is coming in the early stages of a new bull market (albeit a "mini bull") the projected downside is lower than what we've seen over the past two "Sell in May and Go Away" periods. As such, hedging 25% - 50% of the longs you want to hold ought to do the trick.
Another popular strategy for the traders among us, involves "riding the range." This approach involves buying the low end of the trading range (currently at either 1360 or 1340) and then selling the top end of the range, which arguably is either in the 1385-1400 or 1420 zone. My guess is that the top end of the range will become more defined with time. Until then, it might be a good idea to keep an eye on the sentiment and overbought indicators for clues as to when the tide will turn down. But it will suffice to say that the bulls probably won't be able to break on through to the other side without some help from the economic data, earnings or the Fed.
And finally, there is the short-term trend-following approach that has proven successful in this type of environment. Since the moves that occur inside of a consolidation phase tend to be shorter and sharper than those seen in a "trending" environment, you need shorten up your indicators in this type of market. Similar to the way a professional baseball player will shorten up his swing when the count is full, traders need to be more sensitive to trend changes in trading ranges.
One of my favorites here is to start with a weighted 5-day moving average that is moved forward two periods. Using the crosses of this type of moving average will ensure that you are on the right side of the trend fairly early. The only drawback, obviously, is that such an approach tends to produce a lot of whipsaws. And it is for this reason that I like to lengthen out the M.A. when a trend develops. For example, if SPX can stay above my nifty 5-day for 10 days then I'll give it a little room and watch the 10-day MA, etc.
So, with the market moving fast and furious of late, it is important to (a) recognize the environment that you're in and then (b) to know what tools or strategies you are going to implement. And hopefully, the four ways to play a consolidation phase presented will give you some ideas.