During our Investment Team meetings, we have been discussing at length our ratchet strategy. According to Dictionary.com, a ratchet can be “a steady progression up or down: the upward ratchet of oil prices.” So, what does a ratchet strategy mean to us?
We’ve believed the market was due for a breather for many months now, and over the last month and a half the markets have finally started to correct. As of yesterday the S&P 500 Index closed 6.64% below its high price of 1419 on April 2. As we explained in this month’s Pinnacle Monthly market review, we want to use the correction to invest the portfolios back to neutral or benchmark levels of risk (and perhaps move risk above benchmark risk if the market correction is steep enough). However, to properly implement the strategy, we need to be patient and not buy too soon. Our most recent performance data suggests we’re still slightly below benchmark risk, so we’ll probably continue to beat our performance benchmarks as the equity markets move lower. This is where the ratchet — or the buy stop-limit, as our trader friendly crowd would call it — comes into play.
Instead of just drawing one line in the sand below the current S&P 500 Index price (or any individual security price), and buying regardless of market momentum or changing fundamentals, we’re moving the stop-limit price in a steady progression lower as prices fall. The stop-limit price floats above the current market price. This protect us from missing a rally in prices if the decline suddenly reverses, but just as importantly, allows us to ride the market lower if prices continue to fall. As the correction deepens, we continue to ratchet our buy prices lower, meaning that we’re locking in the lower prices when we decide to buy.
We are using the S&P 500 as our ratchet guide. To the right is a chart of the S&P 500 from December 31, 2010 to present. The white line is the near term support/resistance line for the index as it represents the 2011 peaks and the March 2012 lows. Now that the S&P 500 is below that level (1342), we have set our first ratchet at that number. If the S&P 500 climbs back above 1342, we’ll move back to neutral. If the market keeps falling, we’ll look to move down the ratchet and capture the price decline. The next levels would be roughly 1315, represented by the green trend line, and 1278 which is the 200 Day Moving Average (these levels are up for discussion among the team if the market continues to fall).
We’re also using this strategy with our TLT (20+ year treasury) position. Treasuries are providing a nice defense against stock market declines, although yields at 1.76% on the ten year and 2.91% on the thirty year can hardly be considered great values. Therefore we have set the ratchet at $116 to protect our downside, and if the TLT continues higher, we’ll discuss locking in more gains as we ratchet our stop higher.