5 Reasons To Ratchet Up The Portfolio Risk Meter

by: Lowell Herr


Bullish percent indicators call for risk reduction measures.

Shiller CAPE warns of an overbought market.

Q-Ratio signals an overbought market.

"Buffett Ratio" is two standard deviations above its mean.

The Position Sizing risk reduction model demonstrates how to deal with current market risk.

Portfolio management pays considerable attention to return, and too little thought is given to controlling portfolio risk. Below are metrics identifying why the current market is considered to be overbought and how one can stay in the market, yet monitor and control portfolio risks.

Bullish Percent Indicators: The following two screenshots lay out a strong case for an overbought or rich equity market. The first table identifies seven major market indexes. Of these seven, I consider the New York Stock Exchange (NYSE) and Nasdaq to be the most important. On the left side of the table are the percentages of the stocks showing bullish Point and Figure (PNF) graphs. For example, 64.69% of the stocks within the NYSE are currently showing bullish signs. Over on the right side of the table, we have the most recent movements. The DJIA, as an example, is moving down (Os in right-hand column), while 80% of the stocks are bullish. When the bullish percentage is 70% or above, the index is considered to be overbought. When the bullish percentage drops to 30% or below, the signal turns the cell green and it is a buying opportunity. The last buy signals were flashed in January and February 2016. As you might expect, major buy signals showed up in February and March 2009.

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Sector BPI: Breaking the market into sectors identifies what portions of the equity market merit special attention. Currently, seven of the ten sectors are overbought, or listed at 70% or higher. While some corrections are taking place, the current levels are telling investors that the probability of a market correction is higher than the possibility the market will move higher. Let it be known that the market can rise and stay higher for quite some time when either the indexes or sectors have BPI values above 70%.

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Shiller CAPE Value: A popular market valuation number is Dr. Robert Shiller's P/E Ratio. With a current value of 25.9 versus the mean of 16.7, this is a rich market and one that should move investors to seriously monitor portfolio risk.

Q-Ratio: The Q-Ratio (0.97) is a measure of the market value of a company divided by its replacement cost. How expensive are stocks relative to the replacement value of the corporate assets. Use this link to view historical graphs and glean more information as to how to interpret this ratio.

Market Cap to GPD: Here we have a favorite metric of Warren Buffett. The current value of 112.9% is two standard deviations above its mean of 69.7%. Anything over 100% is a warning or a probability signal the market is more likely to decline in the future versus trend upward.

Price Regression To S&P 500 Trend: This indicator examines the pricing trend versus the S&P 500 trend. Check the graph in this link showing the long-term price trend of the S&P 500. Note the 1966 and 1982 dates as well as the more recent inflection points. This price regression indicator underscores what is going on in the prior indicators.

It is insufficient to point out metrics that point to a rich market without providing any guidance as to how one might reduce portfolio risk. Assume we use the Baker's Dozen as our example portfolio.

Tranche Momentum Recommendations: As of 6/17/2016, the Tranche Momentum Model highlights a REIT (NYSEARCA:REM) and a commodity (NYSEARCA:DBC) as the two ETFs for best buys from this group of securities. For an investor unwilling to place nearly 50% of the portfolio in commodities, there are alternatives, but I won't go into that in this article. Keep in mind that despite concentrating the portfolio in two or three securities, these are ETFs, so one is well diversified due to the number of companies held in these ETFs.

While the following table makes recommendations for populating the portfolio, it does little to help with the problem of risk reduction. For that help, we move down to the final screenshot.

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Position Sizing Risk Recommendations: The following worksheet, known as Position Sizing, contains two important options the end user can adjust depending on risk concerns. The first is the SD Multiplier. It is currently set to 1.7. The SD Multiplier controls the Probability of Stop percentage, and that column is now filled as 8.9%. The second option the end user can control is the Max Trade Position Risk, currently set to 1.8%. That percentage is generally adjusted so the Maximum Portfolio Risk is 6% or lower. With the 1.8% setting, this portfolio has an overall risk of 5.4%. That is the percentage risk it carries until the next time the portfolio is reviewed. If this is too high, then lower the 1.8% setting to something lower. Keep in mind that lower risk also lowers the probability of a respectable return.

The Current Portfolio Risk is 5.15% or 5.2%, and if one follows the recommendations, found under Shares, the Suggested Portfolio Risk drops to 4.7%. If this is too high, lower the Maximum Trade Position Risk to a level in keeping with an appropriate comfort zone.

Without running to cash, one can control risk knowing this is an overextended market. One more comment. If you look at the Stop Loss column in the following table, you will see percentages associated with each ETF. For example, the Stop Loss for REM is 5.6%. For securities held in a portfolio, set either stop loss orders or Trailing Stop Loss Orders (TSLOs) using these percentages. Protection of capital is important given current market conditions.

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Disclosure: I am/we are long DBC, REM, PHO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.