STP Algo Trader - Market Insights

The stock market appears as if it may be stabilizing these last few weeks.

Not only has it gone higher and recovered a fair amount of its prior losses, but we have also seen several breadth signals.

One of these is the Zweig Breadth Thrust indicator. Legendary investor and author Martin Zweig created this indicator.

We won't detail this indicator in this note, but it is triggered when the market goes from overwhelming selling volume to overwhelming buying volume in just 10 days. It works because it indicates that the selling in the market may not be sustainable.

Once it is triggered, the stock market is almost always higher a year later.

This is a good sign for the markets, but we are clearly not out of the storm yet. The damage that has been done has been too severe to believe that the market will "V" right out of it.

This is why we triggered our “Bull Switch” here at Signal Trader Pro two weeks ago. Not only did we exit several older signals, but we also raised the bar for new positions substantially.

This has resulted in us going from over 150 position recommendations to roughly 30. We are also now seeing successful exits from these recommendations as the market recovers.

One of the most common questions we get from our subscribers is how they should allocate capital to these positions. What size positions and how many?

With the stock market now in a higher volatility environment, this allocation of capital becomes even more important.

Over our three decades as an active manager, we have developed a successful – and simple – strategy to allocate capital.

We like to think of our "fully invested" portfolio as having twenty positions. This means that if we were 100% invested, each of these positions would be roughly 5% of capital.

We are, however, willing to use some leverage. This means we might go to twenty-five or even thirty positions and take our "gross" invested position as high as 150%.

In Wall Street terms, a "gross" invested position means the total investments divided by the initial capital. If we held $150 in stocks with an original portfolio size of $100, we would be 150% invested.

This is how we use leverage to augment our returns.

The way we look at these types of market environments is with the market RSI in the middle ground – between 40 and 60 – we want to be less than 50% invested. Perhaps even only one-third invested.

Then, when the stock market gets to deeply oversold levels, we can lean heavily into new positions.

We have spoken in the past about our rule of “3.5%.” This is where we want to be an active buyer of stocks every day that the S&P 500 trades off at least -3.5%.

If we started with seven positions (35% invested) then we would look to add 2 or 3 additional positions at each -3.5% point. This means that we would add twelve to fifteen positions with the stock market down -20%. That would take us back to a fully invested position.

Some investors will look to use options or other offsets versus their equity holdings. We don’t like this strategy, especially in a very volatile market.

Having any exposure except cash leaves you vulnerable to dislocations. Remember that in this high-volatility environment, prices of all assets can surprise investors. All of the assets except cash!

This is how we use our cash holding to manage our risks and simplify our investment strategy.

What happens if the market doesn’t sell off -20%?

We will still be adding positions, but not as aggressively. We don't mind being patient and waiting for extreme weakness in a volatile market.

What does this mean if the stock market does indeed “V” out and go towards old highs?

We will have left some money on the table, but we would rather wait for an uptrend to be reestablished and confirmed before investing more aggressively.

Using cash as the fulcrum for your portfolio can allow you to take advantage of market weakness while also managing your risk.

We’d love to hear from you! Let us know your thoughts in the comments section online or at [email protected]

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