Re-evaluate Your Existing Portfolio After the Selloff

Why the market dropped is irrelevant. The fact is that it did, meaning that traders of all size and stripe must revisit and re-evaluate their strategies in response to the move. As usual, I think the best place to start is with one's existing portfolio. After all, to get to where you're going, you need to start with where you are — right here, right now.

First off, I don't jump out of my entire book. Nobody likes to lose money. But when a security moves from being a 12% gain to a 9% gain, I just don't see that as much cause for panic or alarm. Corrections, of which last week's decline doesn't yet even qualify, are a normal part of healthy, functioning markets. Any security that's on its way to a 50% gain is likely to have a few sharp declines along the way.

For example, my fund's position in RMR Asia Pacific Real Estate fund (RAP) has declined quite sharply in recent days on heavy volume. And maybe if I had initially purchased shares at the $26.50 the stock traded at in early February, I'd be cutting my losses at the recent $22.10. But a stock's position in your portfolio should be equally as influential to your decision making as the price action itself. Given the fact I still hold a reasonable (2%-5%) position size at a win, I don't see a reason to exit the trade just yet.

I don't, however, intend on adding additional exposure. Here at Tradecraft, we are staunch believers that the best indicator of the market is the market. And right now, given the most recent information, it's apparent that the market is flashing a cautionary signal, especially for real estate securities. The thrashing that befuddled home builders and now subprime lenders doesn't appear to be an isolated phenomenon. Given its concentration on Asian commercial property, the RMR fund isn't exactly a proxy for home prices or even mortgage debt, but it's part of an increasingly weak sector, and until the price action improves, that alone should put one on guard for further declines.

It also helps to review your portfolio during periods of market volatility to glean insight into strategies that are working, most of which you likely won't see profiled above the fold in your local business section. As we've written about before, it's immensely beneficial to determine how the "herd" is investing and make sure you are employing a different approach.

So when the public is lamenting a drop in the Dow, I like to examine what less-than-obvious securities might have enjoyed a bid amid the widespread weakness in stocks. For example, I was surprised to see that, even as bonds were rallying sharply on a flight-to-quality bid, many bank-loan funds such as Eaton Vance Senior Income Trust (EVF) and Nuveen Senior Income Fund (NSL) also held up. Considering these funds hold higher risk, floating-rate debt, such relative outperformance seems counterintuitive. Regardless, it gives me the confidence to maintain the exposures as part of a diversified portfolio.

In addition, while the headlines last week were uniformly about the Dow's decline, many foreign-currency products benefited from an equally dramatic move lower in the value of the U.S. dollar — especially relative to the Japanese yen, which rallied more than 3%. What makes the drop in the dollar even more notable is that it occurred even as gold, which has historically been negatively correlated with the dollar, plunged right along with stocks.

For an investor looking to tweak his portfolio given the recent decline in equities, I think the strength in foreign-currency products should inspire one to finally consider adding exposure to this still under-followed thesis. We've talked about this idea for a while, going back to last summer when Rydex's innovative CurrencyShares were first introduced. But at the risk of sounding repetitive, it doesn't yet appear to me as if the trade has been played out. As the markets were melting down, only a handful of strategies worked: being short, being long volatility and being short the dollar.

Beyond positions in individual currencies, traders might consider using one of two new ETFs released by the innovative folks at PowerShares and Deutsche Bank. The PowerShares DB U.S. Dollar Bullish Fund (UUP) and the PowerShares DB U.S. Dollar Bearish Fund (UDN) are based on movements in the U.S. Dollar Index, which charts the dollar relative to six major currencies. The biggest components are the euro (57.6%), the yen (13.6%) and the British pound (11.9%), along with single-digit allocations to the Canadian dollar (9.1%), Swedish krona (4.2%) and Swiss franc (3.6%).

Trading it couldn't be simpler: If you believe the dollar will rise in value, you buy UUP. If you believe it will fall, you buy UDN. These can be used as outright position trades as well as countertrend hedges used with other securities.

Volumes are still light but markets are generally tight with a few thousand shares on each side of a five- to 15-cent bid/offer. If last week's action is any indication of the prevailing trend, this might continue to be the quiet trade that keeps investors afloat amid choppy market seas.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.