I have read several articles this past week about how to protect oneself in the event of another flash crash. I am writing this article in response.
First, I should note that I am an academic studying behavioral finance as well as an investment manager that uses a quantitative models based on behavioral finance.
Let us take a look at the issue from a psychological viewpoint first and then examine the data.
One of the strongest behavioral biases is that investors put too much weight on the recent past and tend to forget what happened throughout history. The flash crash only happened less than one year ago. Therefore, this event is still fresh in investor's minds. Events such as a flash crash occur when least expected. The fact that investors believe a similar event will occur is evidence it will not occur. Again, investors are putting too much weight on the recent past when making predictions about the future.
Another behavioral bias is, of course, overreaction. When information is difficult to process quickly, markets overreact. It is difficult to determine what is exactly going on in the Middle East and Japan. Therefore, investors expect the worse first and then when information comes in, markets rebound.
Now let's take a look at some data. When we look at our behavioral and agent-based models, we notice two very different worlds when comparing today to May 2010.
In Table 1 we display the rankings based on our model output as of May 3, 2010 and the subsequent returns for the next two months. The markets ranked at the top as of May 2010 are similar to the current BFIA measure for the United States. As of May 3, 2010, our U.S. measure was signaling that the U.S. market was still risky and therefore was ranked 27 out of the 33 markets we follow.
|Table 1: BFIA Rankings on 05/03/2010|
|ETF||Market||BFIA Rank (as of May 3rd, 2010)||Return 5/10-6/10|
The markets that were ranked high as of May 3, 2010, fell on average 6.2%. Take out South Korea and the average falls to 3.75%. No Flash Crash for these markets. Also, South Korea outperformed the U.S. for the rest of the year.
Currently, the U.S. is operating in a similar environment to the top BFIA markets in May 2010. This signals that even though the U.S markets may drift lower (as I have written in several articles already) we do not see an imminent 15% market correction.
Keeping in mind the individual investor's risk aversion, we recommend two possibilities. One to sit tight. If you have not raised cash yet, wait for the market to rebound. Given the overreaction of recent news, I predict a 2-3% up week in the next week or two. At that time it would be prudent to raise cash ahead of May.
Or one could use the opportunity to buy before markets rebound. Based on recent model results the markets that are currently ranked high are the following. They are listed along with some ETF choices:
U.S. High Yield Corporate Bonds: (NYSEARCA:HYG)
United States: (NYSEARCA:IWM)
Even with the most recent sell off in energy it is still ranked high. Natural Resources are also still ranked high based on our long-term measures. However, our short-term measures are indicating to hold off for now. This could be noise or a fundamental shift. We believe it is noise for now and that is why we are not selling our natural resource holdings but are buying more.
Two ETFs that are making bullish moves in our rankings are Brazil, (NYSEARCA:EWZ), and Emerging Market Debt, (NYSEARCA:EMB). These are also potential buys.
Do not let the fear bring out your behavioral tendancies to overreact and put too much on recent prices. Data suggests that the U.S. is strong for now. High yield investments, energy, the U.S., Russia, Brazil, and possibly natural resources are the only places our models like for now.
Disclosure: I am long HYG, RJN, RSX, VNQ, EWZ, EMB.