Practising risk control in a runaway market

ValueTrend’s Keith Richards says: “We’re long the markets. But we’re holding our noses while doing so, and keeping a sharp eye on the potential for any negative developments.”

At ValueTrend we try to control risk in a variety of ways. They include:

Trend analysis: This trumps all other risk controls. We tend to be mid-term traders, so we watch weekly charts. If the market or a stock remains above its support zone, or, if it remains in an uptrend (higher highs, higher lows), we stay in the trade. We also keep an eye on the 200-day SMA (Simple Moving Average) in a trending stock. We sell if support is broken or the trend breaks—i.e., a lower high and low, and a break of 200-day SMA. We use a minimum 3-day rule to trigger a sell upon a breach of a trend or support.

Macro risk assessment: We pay attention to a variety of risk indicators compiled in our Bear-o-meter indicator. This indicator focuses on the US stock market (using Standard & Poor’s 500 Index (SPX)) due to its significance as the world’s leading stock market. Risk and reward are both ever-present in the markets. The Bear-o-meter measures the relative balance between these two realities. If we get a signal suggesting higher risk vs. reward, we adjust our cash holdings in the Equity Platform up or down, according to the Bear-o-meter’s current levels.

Sector weighting and position sizing: No matter how much we like a sector or stock, we realize that there is always a potential for our assessment to be incorrect. Or for unforeseeable bad things to happen. So we limit our risk by adhering to some rules. For example, in our Equity Platform we hold no more than 30 per cent in a sector (we actually rarely get close to that weighting), and no more than seven per cent in an individual stock. Our typical weightings are closer to 15 per cent in a sector and 3-5 per cent weightings in most of our stocks. So, should we get spanked by one of our positions, the impact is never devastating. Yet, our position sizing gives us enough of each position to earn a reasonable upside for the overall portfolio when the security rises.

A runaway market that is likely to correct

As many of my regular readers know, I try to get a Bear-o-meter report out each month. As noted above, it’s my way of assessing potential risk in the markets. It does not overshadow the trend. But we do take the risk readings provided by the Bear-o-meter seriously. For comparison, I thought I would look at a compilation of sentiment indicators that SentimenTrader.com uses. Many of the indicators in its compilation are found in the Bear-o-meter.

Take a look at SentimenTrader’s Optimism/Pessimism spread report. To quote Jason Goepfert on the indicator:

“This is the spread between the percentage of our indicators showing excessive optimism and those showing excessive pessimism. The higher the spread, the more likely stocks are seeing too much optimism and will struggle going forward.”

See where his compilation shows excessive optimism vs pessimism. Remember, pessimism is good—it indicates an oversold condition. Optimism, also a contrary indicator, indicates an overbought market. It seems that “buy” signals come in at around -0.2 on his compilation (excessive pessimism). The better “sell” indications start at around +0.4. The market has been flirting with the “sell” signal for a while. Investors are excessively optimistic right now.

To be fair, this indicator can stay overbought or oversold for many months at a time. A runaway market like 2017 had the indicator screaming “Sell” for the latter half of the year. Eventually, it proved correct. The SPX had several 20 per cent negative swings with little upside progress in 2018. Perhaps that’s where we are right now. A runaway market that is likely to correct—but that correction may take longer to materialize than one might suspect. So, as I noted above, the trend trumps all.

We’re long the markets. But we’re holding our noses while doing so, and keeping a sharp eye on the potential for any negative developments.

Keith Richards, President & Chief Portfolio Manager of ValueTrend Wealth Mgmt., can be contacted at krichards@valuetrend.ca. He may hold positions in the securities mentioned. The information provided is general in nature and does not represent investment advice. It is subject to change without notice and is based on the perspectives and opinions of the writer only. It may also contain projections or other “forward-looking statements.” There is significant risk that forward looking statements will not prove to be accurate and actual results, performance, or achievements could differ materially from any future results, performance, or achievements that may be expressed or implied by such forward-looking statements and you will not unduly rely on such forward-looking statements. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please consult an appropriate professional regarding your particular circumstances.

This is an edited version of an article that was originally published for subscribers in the January 2020/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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