ARE YOU TRADING AGAINST THE ENVIRONMENT?

Welcome to a new year, and possibly a completely different market environment.

Last year kicked off with the meme stocks but ended up being marked mainly by the “Great Rotation” into cyclicals and economically sensitive stocks as well as the almost obsessive coverage of the 10-year yield by the financial media.

The economy did its best to reopen in spite of supply-chain bottlenecks, labor market disruptions and a pandemic that just wouldn’t go away. The Fed remained highly accommodative for most of the year but suddenly pivoted in December to a more hawkish stance citing a wave of inflation that turned out not to be transitory after all. 

In spite of the rotation into cyclicals, AAPL, MSFT and GOOGL continued to almost single-handedly lead the markets higher thanks to their knack for providing investors with the prospects of both growth and defensiveness, not to mention the sheer weighting they enjoy in the popular index ETFs.

The S&P 500 and Nasdaq 100 marched higher while small caps bounced around in a range for nearly the entire year. Volatility remained elevated relative to levels seen over the past several years but meaningful spikes were almost non-existent, most likely because pullbacks were generally led by big-money rotations and therefore didn’t seem to invoke any real fear or uncertainty.

Emboldened by the super-easy Fed and having never actually experienced a real market selloff, many of those who entered the markets after the pandemic crash of 2020 remained willing to constantly “buy the dip.” And all year long we kept hearing about how new cash was either coming in or ready to come in from the sidelines.

There was still nowhere else to put your money in 2021 where you could get any kind of meaningful yield other than the stock market.

Have you entered 2022 wondering if it’s going to be a different story? Or are you just hoping it’ll be the same environment and therefore planning to stick to the same trades that worked in 2021?

What if you’re wrong? What if the 2022 environment starts to change so much that last year’s trades stop working? What if they actually start to lose large amounts of money? Are you going to just throw your hands in the air and blame the new market environment for being too tough? Are you going to blame your underperformance on your trades? Are you going to complain that the market is simply rigged against you?

Or are you going to accept that the environment has changed and adapt to it?

If you’re a trader who wants to give yourself a fighting chance at achieving any level of consistent success, i.e., make more money than you lose in 2022, you absolutely have to answer yes to that last question. 

As Billy Beane said to his stubborn scout in Moneyball, “Adapt or die!”

If you’re not willing to adapt and the environment changes to a significant enough degree then it’s almost surely going to be a very tough 2022 for you. Why? It goes back to what we learned as children: you can’t fit square pegs into round roles.

What if big tech companies like Apple, Microsoft and Alphabet stop growing at the rate they’ve enjoyed for years now and the buying momentum slows down? What if earnings across the board aren’t as strong as in recent years? What if they actually undershoot estimates or end up being much weaker than expected? Do you think you’ll make as much money – or any money for that matter – buying every dip?

What if the Fed isn’t willing to pivot back to high levels of accommodation if the economy begins to show signs of weakening and the markets start to sell off? I mean, can they really afford to pivot back to being super accommodative in the face of persistent inflation?

In other words, do you have a plan in case we’re in for a choppier, more stagnant market in 2022?

What about a nasty selloff? We haven’t really had one since February through March of 2020 after all. Do you have a plan for a bear market?

What if we get different environments at different times of the year like in 2018? The S&P 500 sold off quickly and ferociously in the first quarter of that year, spent the next two quarters marching back to highs and then dropped 15% in the fourth quarter. Are you prepared for such sudden and meaningful turns?

Okay, so let’s slow down a bit here and get ourselves organized for the task at hand. The first question to ask yourself is, do I have a trustworthy way of determining what kind of market I’m in?

In order to adequately identify your market environment you have to build a process that will help keep you aware of the trends and developments in the markets and in the economy. The best way to do this in my opinion is by blending market fundamentals with price action (technicals).

My process involves using watch lists, scanning services and web sites, keeping up with news and watching price action across many different time frames.

My “macro” watch list is populated with sector and index exchange-traded funds (ETFs) like XLK, XLY, SMH, XLB, SPY, QQQ, etc., and sorted so that I can see what’s strong and what’s not on a daily basis. This gives me an idea of both real-time and ongoing risk tolerance and market sentiment.

On the Groups page at www.finviz.com I can view the list of sectors and industries where money has been flowing to and from on a daily, weekly and monthly basis. This helps me understand how the money is rotating through the markets, which helps me determine whether risk tolerance and sentiment might be changing.

Currently the main financial news outlets are CNBC and Bloomberg, of course, but there are many different news outlets to choose from. I watch financial media and subscribe to newsletters not for stock tips but to keep up on news and events affecting publicly traded companies as well as the economy. On top of this I rely on news flows provided by my brokers throughout the day, which is something almost any broker provides.

Watching price action on intraday, daily, weekly and monthly time frames across several different indexes, stocks and sectors is extremely important because many times it’s trying to tell you something. This involves learning technical analysis, of course, and I highly recommend doing this. There are many places on the Internet to find free instruction and there’s no substitute for experience. Just start looking at charts every day until you begin to understand what the patterns might be telling you. And, just as importantly, work to gain an understanding of the underlying elements that drive price action.

Building your own process is a process itself so I recommend getting started right away. Make sure your focus is not on finding a process that validates your opinions and desires but instead on identifying in an objective way where the money is flowing, what the market sentiment currently is and whether either or both may be changing. 

Be aware of what exactly may be affecting the markets most significantly at that particular time, like Fed comments or sudden gyrations in the 10-year yield. Know about events coming up that might affect the markets, like Fed decisions or economic announcements regarding jobs and inflation. 

Be willing to remain flexible and to follow the path with edge, meaning the path that may give you the best chance to make money.

In mid- to late spring 2021 I took action from the information gathered through my process to start allocating risk to cyclical stocks and was able to build capital from the rotation, staying flexible enough to keep some risk with strategies that took advantage of money still going into tech.

I acted on the information through short- to intermediate-term equities trading strategies and short-term option spreads, which are both part of my overall approach. And this leads us to the next question you have to ask yourself as you build your process: do I have strategies I can implement that allow me to take advantage of almost any kind of market environment?

Market environments are never exactly the same but it’s good to have strategies that can take advantage of uptrending, rangebound and bear markets and then be willing to tweak them based on the unique characteristics of the current environment.

Depending on the vehicles and strategies you prefer to trade (swing or intraday in equities, long options, option spreads, automated systems, futures, etc.) you want to establish clear trading plans designed to take advantage of your current environment that you’re absolutely willing to follow. Being proactive and prepared gives you the best chance at consistent success.

And, most importantly, make managing your risk the number one priority. If the environment shifts back quickly or suddenly turns against you the only defense you have is to make sure the amount you risk is always in your comfort zone and that you’re willing to take your stops. Always have a what if just in case the shift in market environment turns out to be too slight or too fleeting or even completely different than you’d thought.

Ultimately, just make sure you don’t catch yourself uttering things like, “It’s a really tough environment. That’s why I’m not making money.” If you catch yourself saying or even thinking this and don’t take action to change this mindset and to adjust your approach then you need to consider finding another career because this one probably isn’t for you.

Just remember that whether or not 2022 is the same, similar or completely different than 2021 is not in your control so it’s no use complaining about it.

You have no control over whether or not Apple, Microsoft and Alphabet make as much as they did last year or whether new market participants continue to buy the dip or whether cash will continue to come in from the sidelines or whether the Fed aggressively raises rates through the year. So you have to focus on the things that are in your control.

What’s in your control? How you choose and then implement your trading strategies. That’s it. That’s all you’ve got.

So if you’re in to New Year’s resolutions make yours to replace any stubbornness you’re experiencing with a willingness to be flexible. That’s what consistently profitable traders do. The others simply continue to lose money, phase themselves out of the game or both.

Adapt or die!