By Chris Conway
Economic uncertainty in the US and Europe has resulted in fear dominating the market these last few weeks. In the flight to safety, almost all equities suffer. We have seen this before and we will see it again. While these broad and dramatic market moves can wreak havoc on ones nerves and peace of mind, they inevitably produce some great buying opportunities. Wouldn’t you love to pick up shares in Google (NASDAQ:GOOG), Ford (NYSE:F) or General Electric (NYSE:GE) on the cheap? The challenge is to be in a position to buy once the dust settles.
A great way to position yourself to take advantage of these down drafts is to be well-diversified and to follow a sector rotation strategy which includes a money market fund as one of your sectors. Sectors do not always move in tandem (in fact some sectors are negatively correlated) and some sectors, such as technology, are more volatile than others.
As a result, when fear ravages some sectors, others often hold up quite well and leave you in a position to shift some assets from the relatively unscathed sectors to the ravaged sectors and take advantage of the artificially low prices.
A key to following this approach is to rebalance your portfolio once the ravaged sectors have recovered so you don’t become overly concentrated on one particular sector and are once again positioned to take advantage of a future buying opportunity.
Could you have taken action ahead of the pullback to be in a better position to take advantage of it?
Hindsight is 20/20 and no one knows where the market is heading on any given day, but investors continue to leverage many market indicators in an attempt manage probabilities and improve their odds. The CBOE Volatility Index, VIX, is one such metric which measures the general volatility in the S&P 500 and is commonly used as an indicator of overall market risk.
As seen in the chart below, the VIX did spike on August 4th jumping from a previous close of 23.38 to a high of 32.07. However, the VIX is viewed by many as a reflection of real time market moves and therefore does not provide much forewarning.
click to enlarge images
An alternative indicator is the SmartStops Risk Barometer IndexTM (SRBI) TM published by SmartStops.net. The SRBI is derived from the SmartStops individual equity short term risk signals which watch for abnormal price movements to categorize equities as being in a state of normal or above normal risk.
Because equity and market declines are often preceded by abnormal price movements, the SRBI is viewed by many as a predictive indicator. As seen in the S&P 500 SRBI chart below, the above normal risk percentage crossed above the 100 day average on July 18th resulting in an SRBI above 1.0 indicating that the market risk was increasing.
The above normal risk ratio has been on the rise all spring moving from just under 20% to over 40% and the current S&P 500 SRBI is 1.56 indicating an above normal risk environment.
By comparing the current and historical “above normal risk” ratios for different sectors and their resulting SRBI’s, investors can be proactive and take protective action as risk increases in one sector by rotating to a lower risk sector or rotating into a money market fund.
For example, based on the SRBI charts below rotating out of Telecommunications and into Energy at the end of June or early July would have been prudent.
SmartStops currently publishes SRBI data on the S&P 500 (GSPC) and the Dow 30 (DJI) as well as on ten market sectors including Basic Materials, Consumer Goods, Consumer Services, Energy, Financials, Healthcare, Industrials, Technology, Telecommunications and Utilities (click to view current SRBIs).
In conclusion, when fear rules the market, take advantage of the opportunities presented to lower your cost basis and protect capital by proactively rotating between sectors and investment vehicles
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.