Cash versus Short?

NOTE:  This Trading alert was originally posted at Ritholtz Research & Analytics on Fri 7/14/2006 2:07 PM EDT; An email went out to subscribers alerting them shortly there after.

This is posted here not as investing advice, but
rather as an example of a trading call for potential subscribers. We
expect to post future advisories in a similar manner — after the call,
but in the correct chronological location on the blog.

I received a very interesting email from a subscriber yesterday evening:

“The call to sell half and move up the stop loss (BR – on 7/10)
worked out well. The prior stop losses had taken me out of most long positions –
but my question is this: Why go to cash as opposed to going short? If I had
shorted on the "sell half" call, I’d made a killing! My question is, why only go
halfway — if you are moving to cash, why not go short?”

This trader raises a great issue: When do you go short versus to cash?

Let’s start with what we said on Monday:

First: if you have been diligent with your stop losses, you may very
well have been stopped out of all your positions. That’s how it’s supposed to
work! The market took you out as it weakened.

If not, you may wish to sell some (half) of your remaining longs here, and
tighten the stops on the rest.

Prior to that, we noted on June 23rd that "Our view remains that last week
represented a "tradable low," which could run several weeks. Our guess is that
it peters out in July or so…
"

We eat our own cooking – meaning our fund (RCP) follows the same trading and
investing advice you receive. What this means in the real world is that we got
long after the June 13th Trading Alert. Each time we sent out an email advising
you to raise your stop losses, the fund did just that. We were stopped out of
the Nasdaq position on June 27th (detailed in the email alert of that day). All
the subsequent bloodshed in the Nasdaq happened without us.

Second, we were stopped out of our Dow positions on July 7. We had our
traders raise the stops throughout the July 4th week, and I came back from
holiday to discover that the fund was mostly (~93%) in cash. Having seen how
poorly the Nasdaq was trading relative to the Dow, we issued the “sell half”
call that day, but if you were following our guidance, your trading accounts
should have been mostly in cash by then anyway.

All this is well and good, but why not go short? Three reasons:

1) Primarily, its a question of risk versus reward. The June
13th trading buy call presented us with an opportunity to go long with what was
in my opinion minimal risk and a lot of potential upside. As of July 10, the
short side still presented a lot of risk relative to reward. I insist on better
than a 50/50 risk reward ratios; This way, we can be wrong (occasionally) but
still have make money overall.

2) The S&P 500 had bounced 5% in the month since our 6/13 “Buy ‘em” call.
Annualized, that would be a return of 60% per year! That’s obviously
unsustainable, and hence the move to cash was called for. But just because the
markets ran ahead of themselves doesn’t mean they will necessarily collapse
enough to make the risk of shorting worthwhile.

3) The August Fed meeting will once again, present an opportunity for the
chorus to sing “One & Done” – only this time, they may actually be correct
for a change. I expect this crowd to start making noise late July / early
August. Two weeks is to precise a window to comfortably be very short.

I suspect a better entry point for the short side is still in the future:
Here’s a hypothetical scenario we war-gamed: The market trades down, and
finds some support before month’s end. Perhaps the Israeli conflict cools, or
some decent earnings cause a rally. By August 1, the Fed chatter picks up. They
raise, but indicate that the market sell off has convinced them to pause. The
markets have a few strong days, and then begin a summer rally in earnest. By
“Back to school time,” the markets are appreciably higher. And that’s our
potential window.

I’m not suggesting this will happen precisely this way – it is only a mental
exercise – but it is a very possible and realistic scenario. If anything
remotely close to this comes to pass, then that will present us with an ideal
opportunity to trade from the short side in the Fall. Indeed, if my concept of a
Slow-Motion Slow-Down continues to play out, then Q3 earnings – and not Q2 –
will be the ones that greatly disappoint.

 

Keep those email questions and comments coming . . .

July 14, 2006

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What's been said:

Discussions found on the web:
  1. eightnine2718281828mu5 commented on Jul 17

    Do you think corp managements will actually report bad numbers in Q3?

    I think they’ll turn to creative accounting and footnotes to make top-line numbers look good. The hope is that the down-turn will be short-lived and they can bridge a small gap through sleight of hand.

  2. Scott Teresi commented on Jul 17

    What do they mean by “our fund (RCP)”? This isn’t a publicly-available mutual fund, is it? I can’t find any mention of it at ritholtz.com.

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