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Offense vs. Defense


"Look into the basic objective of a football game and you'll see what I mean. An offensive team is put on the field and given the responsibility to move the ball forward and score points. But a defensive team is also out there trying to counteract every offensive move."
- Jack Tatum with Bill Kushner, from the book "They Call Me Assassin"

Apart from offense and defense, and all the Xs and Os, football is ultimately about discipline. And discipline is neither exciting nor fun. It is what it is. My belief is that a disciplined approach must contain a grounding element of consistency. Understand, consistency does not preclude an adaptive approach, and an adaptive trading style can be both rigorous and disciplined. But an adaptive approach is much different than an ad hoc approach, and an ad hoc approach is almost by definition an undisciplined approach.

I often think of my process in terms of a football game. It is driven by the following:

I. A broad thesis. This is simply an opinion on the elements and conditions in which the game is being played. For example, a thesis that is based on a revival of the structural bull market would be something like a football season where every game is played indoors under perfect conditions. A structural bear market would be more like a football season where the field conditions are constantly changing, usually from bad to worse.

This broad thesis will influence the types of a plays I attempt to run, but as we will see, it will have no bearing on which team I send out on the field. If my team has the ball I have to run some offensive plays. Like the original #32 said above, an offensive team has the responsibility to move the ball forward and attempt to score.

II. Market indicators. The market indicators I use are divided into three tiers: short-term, intermediate-term, and long-term. The long-term is the most important, and ultimately controls which team is on the field, but the short and intermediate-term indicators exercise weight over the play calling. If all three tiers are positive then the offense will be on the field and I'll be running plays within the context of my broad thesis. If all three tiers are negative the defense will be on the field trying to prevent the team (in this case, the market) from scoring.

Many times the tiers are mixed, as they are now. The short and long-term are positive, but the intermediate-term is negative. Since the weight of the evidence of the indicators is positive, my strategy as a coach will be to maintain an offensive bias, but temper the aggressiveness of the plays I call. This can be accomplished in a variety if ways. A two-sided approach is one way. A hedged approach is another way. Yet another way would be to simply reduce long exposure. The right way is the way that accomplishes a disciplined approach within the context of the size of your playbook. Someone who plays both sides of the market will have a larger playbook than someone who cannot.

Here is an example of a breakdown in discipline that is quite common, even for professionals, and one that occurs frequently at times such as these. In this overly simplified example the process, based on the outline above, is for a long-only investor who simply hedges his market exposure based on the status of the indicators. [Note: this is in no way a recommendation to follow this process, it's just an illustration to help me make a point.]

For this investor, if all three indicators are positive the exposure is 100%. If one of three indicators moves to negative the investor moves to a 33% hedged position. If two of three indicators turn negative the hedge is 66%, and so on. This investor, like everyone, over the past two months has been watching carefully the trading range of the S&P 500 (SPX). He feels comfortable with his hedge because he's simply following his game plan and the SPX isn't going anywhere anyway. Remember, two of the three indicators are positive so even with the partial hedge he still has comfortable market exposure. Following yesterday's breakout in the SPX, however, this investor's discomfort level jumps a notch. Suddenly a 33% hedged position makes him feel shamefully under-invested. He decides to immediately remove the 33% hedge. The SPX has broken out, there is no reason to keep the hedge on, he reasons. Meanwhile, his indicators have not changed; only two of the three tiers are positive. In other words, his original decision-making tool has been switched and the SPX has now displaced the market indicator-driven approach as a driver in the process. See how easy it is to make a subtle shift in the decision-making process? Maybe more to the point, see how easy it is to justify a shift in the decision-making process?

Perhaps this displacement in the decision-making process will yield positive results. That is beside the point. Remember when the U.S. dollar was the focus? Remember when falling interest rates were the focus? What about when "corporate visibility" was the focus? The larger point is that in a disciplined approach the decision-making tools must be constant because the market's focus is always shifting. An undisciplined approach will at different times latch on to different decision drivers. None of this, of course, is to suggest that discipline is easy. After all, if it were easy, everyone would do it.
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