Let's Get Serious About Reducing Risk

 |  Includes: EEM, EFA, ICF, TIP, TLT, VEU, VNQ, VTI, VWO
by: Lowell Herr

Most readers of ITA Wealth Management remember the dotcom crash of 2001 and 2002. If that memory faded, the devastating bear market of 2008 and early 2009 is still with us - unless one was a shepherd in Patagonia.

I assume there are more than a few readers who still recall the bear market of the mid-1970s, and the long wait until the market suddenly woke up on August 12th of 1982 - only to crash again in October of 1987. According to statistics compiled by Benoit Mandelbrot, these major bear events should occur approximately once every 300 years.

However, they began to appear about once every 30 years and that time is now compressed to a severe bear market every few years. I doubt any of us expect to see the period between bear markets expand as long as investment banks can socialize losses and privatize profits. As small individual investors, we need to ratchet up our risk defenses and that is where a number of technical indicators come into play.

As a starting point, we need a portfolio plan and one that makes a lot of sense is the Swensen Six. It is simple, but global in scope. There is an effort to hedge inflation with a 20% holding in real estate and another 15% in TIPs. There is a global component with 20% allocated to international investments. We might add international real estate to strengthen and diversify both inflation and global components. For now, we will keep the portfolio as simple as possible and stick with six ETFs.

As shown in past blog posts, adding a few carefully selected stocks has a number of positive benefits on the Swensen Six portfolio. One of the major advantages is to reduce risk. But even risk adverse stocks take a hit when the market sinks as it did in 2008. There was no place to hide as supply exceeded demand - and in a big way. Is there an alternative or do we stand by and let the bear markets crush us?

Examine the extensive Bullish Percent Indicator data table below. Pay particular attention to the NYSE column as that is our primary BPI data. Warning flags began to fly in the summer of 2007 as the market was over bought. The ball changed hands around July 27, 2007. Yes, this was early.

I included data down as far as 1/11/08 as there is a change in market behavior. Those signals were again early as is frequently the case with the Delta Factor. This is where the 195-Day EMA comes into play as it tends to lag in "calling" for market tops and bottoms.

What is going on with the numbers in these columns? On 7/6/07 you see 70.27 in the NYSE column. That means 70.12% of the stocks in the NYSE were generating a bullish PnF graph. When the BPI topes 70%, it is time to get cautious as the supply is drying up compared to the demand. Buyers will finally become exhausted and will will eventually see an oversold market.

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Delta Factor: What was the Delta Factor projecting on 9/21/2007? Since there is no record for VEU, VWO, and VNQ going back an additional three years to 9/21/2004, I substituted EFA, EEM, and ICF to represent developed international markets, emerging markets, and domestic REITs. Note the "blood" projected by both the Delta and Delta Factor columns. EEM, while a Hold, is no gem as the best days were past. Just check the historical performance for those clues. While a few months early with a dire projection, the "Delta Factor" was correct.

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Here we have two technical indicators warning us of pending storms. These are the "red in morning" sailors warning, types of signals. Remember, supply and demand controls the stock market.