It seems like everyone I have spoken to in the last few months about the market has said some form of “it’s going to stop going up soon” or “get ready for a collapse.” But nobody has been definitive as to when to look for that collapse. They have just become “gun shy” about staying in as the market continues to rally higher.
The reason for this lack of confidence is that they are letting emotions get in the way of investment decisions. As far as minimizing those emotions, one way to look at it is to think of drawing a line in the sand. The line in the sand, once it is crossed, is a meaningful change in the outlook going forward, and could cause the investor to change their investment choices out of the stock market to protect gains. First, we need to define what we look for when identifying the line in the sand. (For more, see: When to Sell Stocks.)
Mechanics of the Markets
The real question is where to draw this line in the sand and when to move the line. To understand this, one must first understand the mechanics of the markets. Markets move up when there are more buyers than sellers and markets level out when they are relatively even. The relative balance between buyers and sellers is showing that the market has found a fair price, and markets are typically in search of resuming that fair price.
A lack of sellers and an abundance of buyers at a price point creates a good floor to draw that line. The rationale behind this is that once price drops below the fair price value area, more sellers will pile on and it can create strong moves down. This "line in the sand" is a distance far enough from price that it will not “wiggle” out longer-term investors but is also close enough that longer-term investors will not suffer catastrophic losses if the market moves against them. By continuing to move prices as the market goes up, investors can lock in profits and control catastrophic losses.
Note: This example shows that price rose from the area of relative balance and tested that area a few times before finally rising. This means that an investor could capitalize on the upward movement while not being wiggled out with some pretty big pullbacks. In mid-2015, from June to the end of August, the markets dropped 15%, which may have wiggled out those that kept their line too tight, possibly causing them to miss the 37% rally since that pullback happened.
Note: This example shows that price created a new area of relative balance and then continued to rise. Once new relative balance was established and price rallied from there, the new line in the sand could be created. Interestingly enough, the line in the sand was tested during the U.S. presidential election and the rally since the election has created a new line in the sand.
Note: This final example illustrates the current line in the sand from where we stand as of brand new all-time market highs. Having this line in the sand gives an investor some knowledge of how much they are at risk of losing in case of a market decline. It could even give them an opportunity to exit the stock market before catastrophic losses will wipe them out.
Where to Draw the Line
Using the SPDR S&P 500 exchange-traded fund (SPY) as a proxy for the S&P 500, our current line in the sand is about $230 per share. At around the $230 per share mark there is a significant area of fair price, and once price drops below that level we could see a strong drop.
Why don’t more investment professionals advocate this concept of drawing a line in the sand? It could be because they may not truly understand how to implement these strategies and more importantly how to educate their clients on them. Take time to know your line in the sand because what it could also do is help to minimize the emotion in your investment decisions. The emotions of fear and greed are typically the two emotions most often associated with the stock market, and fear most often overpowers greed.
The reason many investors get overcome with emotion is because they do not have a repeatable system for locking in investment gains. By having a systemized approach to locking in profits and preserving capital in downside moves, an investor may not be as “gun shy” about staying in a strong market. If you want to keep less and less emotion in your investments, do more and more systemized protection of your portfolio by drawing the line in the sand. (For more, see: Logic: The Antidote to Emotional Investing.)