The Importance of Investment Risk Management

August 29, 2014

How much could risk management be worth to you?

Video Covers:

  • CCM Market Model
  • Ten 2014 Charts
  • Thirteen Historical Charts
  • Don’t have a plan? Some ideas can be found in this article.

    After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.



    Still Relevant Big Picture Risk Management Articles - Weekend Reading.
    More links and charts on Twitter.

    Economy vs. Fed Rate Hikes

    August 28, 2014

    Confusion Continues

    The bad news is markets tend to get jittery when the Fed is preparing for a new interest rate cycle. The good news is the primary reason the Fed is contemplating raising interest rates is a strengthening U.S. economy. The question in the short run is:

    Will the economy be strong enough to offset the negative impact of higher rates?

    The odds of the answer being “yes” increased Thursday. From Reuters:

    Gross domestic product expanded at a 4.2 percent annual rate instead of the previously reported 4.0 percent pace, the Commerce Department said on Thursday. Both business spending and exports were revised higher, while a buildup in business inventories was smaller than previously estimated - a mix of growth that provides a stronger underpinning for the remainder of the year.

    Investment Implications – The Weight Of The Evidence

    As of Thursday’s close, the S&P 500 was up 8 points for the week. Therefore, despite some hesitation near the overly-talked-about S&P 500 level of 2000, the bigger picture has improved this week. We continue to hold a mix of U.S. stocks (SPY), leading sectors, such as healthcare (XLV), and a relatively small complementary stake in bonds (TLT). Friday’s economic calendar tells us to keep an open mind about how stocks close out the week:

  • European Inflation Data
  • Personal Income and Outlays
  • Chicago PMI
  • Consumer Sentiment
  • Friday’s Sleeper?

    Since it could impact the European Central Bank’s next move, we should not overlook Friday morning’s report on European prices. From MarketWatch:

    The euro-zone consumer-price index due Friday morning is not only expected to come in at a multi-year low, but could also hold the key for future monetary easing from the European Central Bank. ECB President Mario Draghi already hinted last Friday that full-on asset purchases could be in store if the euro-zone doesn’t move out of the low-inflation danger zone.

    Levels A, B, C, and D on the chart of the S&P 500 below may attract buyers if Friday’s data brings out the bears.

    QE Ending Or Just Getting Started?

    August 27, 2014

    ECB To Step Up As Fed Steps Back?

    While the Federal Reserve has laid out specific plans to end their quantitative easing (QE) program, a new season of QE may be getting ready to kick-off across the pond. From Reuters:

    The euro fell broadly on Wednesday, hitting a 19-month low against the Swiss franc, as speculation that the European Central Bank (ECB) will resort to quantitative easing was fueled by yet more bad news from the euro zone…ECB chief Mario Draghi fueled speculation that monetary policy would be further loosened in the euro zone over the weekend by saying the central bank would use “all the available instruments” to deal with the threat of deflation at the U.S. Federal Reserve’s annual conference in Jackson Hole. Developments on Wednesday only worsened the picture for the euro zone: data showed German consumer morale fell for the first time in 1-1/2 years, while Italy’s economy minister said the country must cut its growth forecast.

    Time To Jump On European Equities?

    Investors in the United States have seen QE’s impact on asset prices. With the ECB/quantitative-easing story beginning to gain more traction, European stocks (FEZ) have beaten the S&P 500 by over 2.0% this week (see upper right corner of chart below). However, European stocks have some work to do to reverse what has been a bearish trend relative to the S&P 500 in 2014.

    This Is The Look We Want

    If the 2014 chart above could morph into a look similar to the period shown below, our interest in European stocks would increase. For our time frame and approach to the markets, some patience remains in order to see the impact of any chess move by the ECB.

    Investment Implications – The Weight Of The Evidence

    If you are new to the concept of using observable evidence to manage risk, Anatomy Of A Stock Market Turn illustrates the approach by examining the S&P 500 between August 7 and August 26, 2014. Before we went to press, the S&P 500 was still drifting around 2,000, but with the weekly gain still above 10 points. Until the evidence changes in a meaningful way, we will continue to hold U.S. stocks (SPY), and leading sectors, such as healthcare (XLV), complimented by a small stake in bonds (TLT).

    Question image from Marco Bellucci via Flickr creative commons (image has been altered slightly).

    Anatomy Of A Stock Market Turn

    August 26, 2014

    Catch-22 Data Hits Tuesday

    Before we begin to examine the recent bottom in the stock market, investors were greeted with an eye-popping nugget of economic data Tuesday morning. From Reuters:

    The Commerce Department said on Tuesday durable goods orders, items ranging from toasters to aircraft that are meant to last three years or more, jumped 22.6 percent last month after an upwardly revised 2.7 percent increase in June. July’s increase was the largest on record and far outpaced economists’ forecasts for a 7.5 percent advance.

    While the record spike in durable goods was heavily impacted by aircraft orders and there were some concerning items in the report, a 22.6% gain is a 22.6% gain. The never seen before print on the economy falls into the good news/bad news category. The good news is the economy appears to be moving away from a tepid state. The bad news is today’s report will spark chatter about the Fed possibly pulling their first rate hike forward.

    Risk Is About Probabilities

    A reasonable standard for “how much to invest” is based on the probability of producing successful outcomes. Charts can help us monitor and assess investment probabilities. For example, the weekly chart of the S&P 500 (SPY) below shows a period with a very poor risk-reward profile.

    August 7: Not A Good Look

    The chart below shows the S&P 500 as of Thursday, August 7. The August 7 profile has similarities to the 2008 profile above, which told us the probability of bad things happening was higher on August 7 than it was on July 1.

    Probabilities Account For All Outcomes

    When we say “the probability of bad things happening has increased”, it does not imply the probability of good things happening is zero. Therefore, we use charts not as a forecasting tool, but rather a tool to monitor the probability of investment success. The same concepts are used to manage risk and reward in countless businesses. From Encyclopedia Britannica:

    Actuarial statements about the life expectancy for persons of a certain age describe the collective experience of a large number of individuals but do not purport to say what will happen to any particular person. Similarly, predictions about the chance of a genetic disease occurring in a child of parents having a known genetic makeup are statements about relative frequencies of occurrence in a large number of cases but are not predictions about a given individual.

    Support Called For Patience

    Using a probabilistic approach, after the close on August 7, we noted some patience was in order to see what happened at a nearby area of possible support. The chart below is dated August 7.

    Stocks did hold support and rallied 22 points on Friday, August 8. The big rally enabled the S&P 500 to post a gain of 6 points for the week.

    Weekly Gains Provided A Reference Point

    Stocks were green again the following week. The rally allowed us to add the lower blue trendline in the August 15 chart below, which set guideposts on the high end near 1968 (dotted-blue line) and on the low end near 1940 (solid blue line). Commentary on the chart from August 15 can be found in this video clip.

    Morphing Into A More Favorable Look

    After a 16 point gain on Monday, August 18, the weekly chart of the S&P 500 was looking less and less like the scary 2008 chart shown earlier.

    In fact, if we compare the August 18 chart above to a more favorable period for investors in 2009, we can see some similarities, which spoke to improving odds of investment success.

    Looking at the chart below as of Tuesday, August 26, another bullish hurdle was crossed when the index broke above 1967.

    Investment Implications – The Weight Of The Evidence

    Does the present day chart mean downside risks have left the building? No, the present day chart has been telling us the probabilities of success have been improving. Consequently, our market model has reduced cash and incrementally added to our stock positions (VTI) several times since the August 7 intraday low.

    Our approach from here will be the same; monitor the charts/probabilities and make adjustments as needed. Would a monitor and adjust approach have helped in 2008? You can decide after watching this video.

    “Because things are the way they are, things will not stay the way they are.”

    – Bertolt Brecht

    Brain image from Allan Ajifo via Flickr creative commons. Catch-22 image from Chris Drumm via Flickr creative commons.

    Rate Hike By June Still Only A 50-50 Bet

    August 25, 2014

    If the economy continues to improve, it is not a question of if, but when the Federal Reserve will begin to raise interest rates. Since markets set asset prices, it is prudent to keep an eye on market expectations relative to the timing of the first rate increase. From The Wall Street Journal:

    Futures contracts pegged to the federal funds rate, the rate most directly influenced by the Fed, saw little movement as well. Pricing on those contracts suggests traders see a 50% chance the Fed will tighten by next June, down from 60% in March. John Briggs, head of cross-asset strategy at RBS Americas, said Ms. Yellen’s remarks suggests the Fed is still on track to raise rates in the middle of 2015, “but the pace is going to be slow.” That, he says, will give continued support to stocks, which have rebounded repeatedly after modest pullbacks. “It’s the reason that dip in the stock market is only 3% or 5% and not 10%,” said Mr. Briggs.

    Obviously, market expectations can shift, but given what we know today, the odds of a rate hike catching the markets by surprise seem relatively low.

    The Big Picture

    Regular readers know we have been adding to our equity positions based on recent improvements in the market’s tolerance for risk. Several examples of observable shifts are covered in this week’s stock market video.

    After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.



    Yellen Holding Cards Close To Vest

    Jackson Hole was expected to provide some insight into which way Janet Yellen is leaning. The central bank conference may have provided more uncertainty, rather than clarity. From The Wall Street Journal:

    Encouraged by progress in the U.S. labor market, but uncertain if it is enough, the Federal Reserve Board chairwoman and other officials who gathered here for a central-bank conference left the public guessing about when they will start raising short-term interest rates… The discussion of wages in Jackson Hole was emblematic of the broader job-market puzzles Ms. Yellen is trying to solve. “The low rate of wage growth is, to me, another sign that the Fed’s job is not yet done,” Ms. Yellen said back in March. In Jackson Hole she had caveats.

    Investment Implications – The Weight Of The Evidence

    With the S&P 500 crossing 2000 during Monday’s session, it is difficult to place a high probability on any surprises from the Fed in the short-term. The next formal policy statement comes on September 17, meaning the market may focus on other issues for a time.

    Should we be concerned about interest rates? Yes, but as noted using recent underperformance of small caps, it is the weight of the evidence that ultimately determines the market’s path. Our market model called for another incremental add to the growth portion of our portfolios Monday. Until the evidence shifts, we will continue to maintain exposure to U.S. stocks (SPY), and leading sectors, such as healthcare (XLV). Tuesday brings a report on durable goods and the latest read on consumer confidence. The market will take a breather at some point. When it does, we can use points A, B, C, and D below as risk-management guideposts.

    In the chart above, point A comes in near 1984 on the S&P 500, point B near 1961, point C near 1941, and point D near 1920.

    Card image from fdecomite via Flickr creative commons.

    How Much Progress Did Stock Bulls Make?

    August 22, 2014

    What type of market battle are we fighting now?

    After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.



    Still Relevant Big Picture Risk Management Articles - Weekend Reading.
    More links and charts on Twitter.

    Should We Freak Out About Small Cap Underperformance?

    August 22, 2014

    Small Caps: The Hype

    If you follow the markets, it is difficult to escape the never-ending cries about the impending gloom and doom in the S&P 500 because small cap stocks have been lagging large cap stocks. Below are two examples. From The Dallas Morning News:

    Are small cap stocks waving a warning flag? One of the key signs of a bull market about to roll over is when just a few big stocks are pushing the indexes higher as the riskier, more volatile small caps sell off. In the two years leading up to the 2001 bear market, 80 percent of the gains in the S&P 500 came from fewer than 20 percent of the stocks. If the S&P 500 is hitting new highs, the much broader Russell 2000 should also be hitting new highs. The Russell 2000 has moved in lockstep with both the S&P 500 and the Dow Jones Industrial Average through most of the current bull market.

    From CNBC:

    After the worst week in two years, stocks are vulnerable to a further selloff, technicians say. From European bank stocks to small caps and junk bonds, there are a variety of indicators that are flashing warning signs, including the S&P 500 itself, which last week fell through an area around 1,950, an important support level, they said.

    Small Caps: The Facts

    If someone tells you to be concerned about something, it is always wise to look at history and ask:

    How concerned should we be?

    The chart below tells us small cap underperformance is not necessarily a show-stopper for a bull market. The top of the chart below shows the performance of the S&P 500 (large caps) relative to the Russell 2000 Index (small caps). The bottom of the chart shows the S&P 500 in isolation. When the large-cap-to-small-cap ratio rises, it tells us large caps are outperforming small caps. From 1994 to late 1999, small caps significantly underperformed large caps. During the same period the S&P 500 moved from 443 to 1,419. Said another way, during a period of small cap underperformance, the S&P 500 increased by a factor of 3.2, which is a massive gain in the broader stock market.

    We have covered this topic in the past; thus if you want more evidence, Busting Small Cap/Stock Market Risk Myths is a good source.

    Investment Implications – The Weight Of The Evidence

    All things being equal we would prefer to see small caps outperform their more established and larger brothers. However, having small caps lag, taken in isolation, is not a reason to sprint for the nearest equity exit. Rather than focus on small caps alone, it is best to look at all the evidence from multiple markets, asset classes, and ratios, something we accomplish via our market model. The weight of the evidence was somewhat shaky as of the close on Friday, August 15. Somewhat shaky does not mean bearish; it means it was prudent to reduce equity exposure until the market provided us with a bit more clarity from a probability perspective. The odds began to improve on Monday, August 18, prompting us to increase our equity exposure to get back aligned with the hard evidence.

    Fed Remains A Concern

    When this article was penned, the market was still digesting Janet Yellen’s Jackson Hole address. There is no way to sugar coat the impact of rate hikes from central banks. All things being equal, markets prefer to see rate cuts rather than rate hikes. However, the market and evidence will begin to show some observable signs of deterioration if interest rate concerns begin to threaten the rally in equities. Therefore, our approach does not change. We will continue to monitor the evidence with a flexible, unbiased, and open mind.

    Freak out image from Karl-Ludwig Poggemann via Flickr creative commons.

    Are U.S. Stocks More Attractive Than Emerging Markets?

    August 21, 2014

    Strong Dollar Could Alter Capital Flows

    Once you invest outside the United States, the impact of currency fluctuations becomes more pronounced. All things being equal, emerging market economies would prefer to see a weak U.S. Dollar. From Reuters:

    Rising rates in the United States could prompt heavy flows of investment out of emerging markets where investors flocked in search of higher returns. A stronger dollar also erodes the appeal of holding emerging market currencies. Minutes from the Fed’s last meeting fueled speculation that interest rates could soon start rising and news also emerged that two Bank of England policymakers had voted for higher interest rates earlier this month.

    Why Be Different When Different Is Worse?

    The facts are since the second half of 2010, emerging markets (EEM) have significantly underperformed the S&P 500 (SPY). At some point, the odds and correlations tell us the trend will reverse in favor of emerging markets. However, trying to guess, forecast, or anticipate a reversal has been a painful process in recent years.

    Some Progress, But Hurdles Remain

    According to the graph from below, emerging markets and the S&P 500 have performed in a very similar manner YTD.

    Before we are willing to look at emerging markets more seriously from a longer-term investment perspective, we prefer to see the ratio of EEM to the S&P 500 break above the longer-term bearish trend channel shown in blue below.

    Pulling Back On The Reins

    At some point, professional investors begin to question, “Am I being compensated for investing in emerging markets relative to developed markets?” One of the biggest players on the investment stage seems to be having some doubts. From Bloomberg:

    Norway’s $880 billion sovereign wealth fund, the world’s largest, is slowing its expansion into emerging markets as it scales back a two-year mission to tap into the fastest growing markets. “We are gradually picking up some new markets but at a less rapid pace than we did at the beginning of the year,” Yngve Slyngstad, the fund’s chief executive officer, said yesterday in an interview after a press conference in Oslo.

    Guideposts To Monitor Progress

    The blue horizontal line in the chart below tells us there has been no advantage to owning emerging markets relative to the S&P 500 over the last year or so. We prefer to see evidence of an advantage before considering shifting capital out of the United States. If the EEM/SPY ratio can break above the orange box below that would be a good first step in a “prove it to me” campaign. Better yet, a break above the red box would represent a significant higher high.

    Investment Implications - The Weight Of The Evidence

    With the most important event of the week, Jackson Hole, still on tap, equities have a big hurdle to cross Friday. Our allocations of stocks (VTI) and leading sectors, such as technology (XLK), remain in line with the evidence we had in hand as of Thursday’s close. A positive reaction to Janet Yellen’s remarks could prompt another reduction in our cash holdings.

    Image of Washington, D.C. from Matthew Straubmuller’s Flickr.

    Have The Charts Been Helpful?

    August 20, 2014

    Fed Minutes Fail To Spook Bulls

    While it is next to impossible to discern what made stocks rally after the Fed minutes were released, we can offer a few plausible explanations:

    1. The market knows an interest rate hike is coming. Therefore, talk of rate hikes has a greatly diminished shock value at this point.
    2. The minutes were more concerned with the “how to” of rate hikes rather than the “when”.

    Observable Shifts In Risk Tolerance

    Why do traders and investment managers use charts? They provide a method to monitor the market’s risk-reward profile. For example, the colored moving averages in the chart below help us filter out day to day noise, allowing us to focus on the underlying trend. When the slopes of the moving average are up, it indicates a bullish and lower-risk trend (see green arrow below). When risk starts to increase, the slopes start to flatten out (orange arrow). When the slopes of the moving averages begin to roll over, it tells us the market’s risk-reward profile is deteriorating (red arrow).

    Higher Risk Period In 2010

    In the 2010 chart below, notice how changes start to take place before the “Flash Crash”. The slopes of both the blue and red moving averages have rolled over, and price is below the blue, red, and green moving averages. Did the moving averages predict the Flash Crash? No, they simply said “risks are higher now than they were about a week ago”.

    2014: Higher Risk Look Two Weeks Ago

    The chart below is as of the close on August 7, 2014. It told us “the probability of bad things happening is higher today than it was about eight trading days ago.” From a general risk-management perspective, if the probability of bad things happening is higher, it might be prudent to reduce risk until conditions improve. The key term here is probability. Probabilities speak to flexibility; they acknowledge that the outcome could be bullish or bearish.

    Even with the lower-probability look of the chart above, we noted on August 7 that possible support was close by and some patience might be in order to see how things played out.

    Improvements Noted In Recent Sessions

    Patience was rewarded as support did hold after the close on August 7. On August 18, we posted a chart showing the S&P 500 breaking above an area of potential resistance, which also spoke to improving probabilities for the sustainability of the rally attempt. The chart as of August 20 below looks much better than it did on August 7, telling us “the probability of bad things happening has decreased and the probability of good things happening has increased.”

    Investment Implications – The Weight Of The Evidence

    Are these moving averages the holy grail of investing? No, but they do add value and help illustrate the basic concepts of using observable evidence to manage portfolio risk. As noted Monday, our market model began increasing equity exposure as the market’s risk-reward profile improved.

    We added to our stock holdings on Monday, Tuesday, and again Wednesday, allowing us to get aligned with the evidence we had in hand as of Wednesday’s close. Thursday is a new day. Therefore, we will enter the session with a flexible, unbiased, and open mind, especially considering Jackson Hole remains on the weekly agenda.

    How About 1987 and 2008?

    If you are skeptical about using observable evidence to manage risk-and-reward, the links below illustrate the concepts during two of the more difficult periods for investors:

    1. 1987 - Was There A Way To Mitigate Risk?
    2. 2008 - Was There Anything Investors Could Have Done?

    Fed Minutes: Key Passages

    If you want to dig a little deeper into Wednesday’s minutes from the Federal Reserve Open Market Committee, some key passages are provided below:

    Meeting participants continued their discussion of issues associated with the eventual normalization of the stance and conduct of monetary policy, consistent with the Committee’s intention to provide additional information to the public later this year, well before most participants anticipate the first steps in reducing policy accommodation to become appropriate.

    Most participants supported reducing or ending re- investment sometime after the first increase in the target range for the federal funds rate. A few, however, believed that ceasing reinvestment before liftoff was a better approach because it would lead to an earlier reduction in the size of the portfolio.

    Participants agreed that the Committee should provide additional information to the public regarding the details of normalization well before most participants anticipate the first steps in reducing policy accommodation to become appropriate. They stressed the importance of communicating a clear plan while at the same time noting the importance of maintaining flexibility so that adjustments to the normalization approach could be made as the situation changed and in light of experience.

    Help image from Marc Falardeau. The image used in this post has been slightly altered.

    What Can We Expect From The Fed This Week?

    August 19, 2014

    Minutes Coming Wednesday

    With the Fed hinting at an interest rate increase sometime in 2015, the financial markets have tended to be jittery before any new Fed-related information comes to light. As noted by The Wall Street Journal, this week is more than Jackson Hole:

    Minutes of the Fed’s July meeting, to be released Wednesday, could provide fresh clues on how officials are thinking. One issue that warrants attention: Will the Fed in the future target a specific interest rate, as it did before 2008, or an interest rate range, as it does now? The strategy the Fed is developing strongly suggests it will be the latter at least for a few years.

    Handicapping Yellen

    On August 18, we hypothesized Janet Yellen may err on the dovish side at this Friday’s gathering in Jackson Hole. MarketWatch provided a similar outlook:

    Federal Reserve Chairwoman Janet Yellen will deliver a simple message from Jackson Hole this week: Don’t be fooled by the sharp drop in the unemployment rate. Economists expect Yellen to give a master-class explaining why she believes there is still a lot of slack in the job market…Economists don’t think Yellen will signal any shift in the easy stance of policy at the conference in western Wyoming. Fed officials remain comfortable with their guidance that the first rate hike will come sometime in the second half of next year, said Jan Hatzius, chief economist at Goldman Sachs, in an interview with MarketWatch.

    What Is The Fed Watching?

    The Fed has a dual mandate; keep prices stable while fostering an environment to achieve maximum employment. The chart below shows interest rates have been held at low levels in an attempt to jump-start hiring.

    While the impact of Fed policy on employment is a subject of constant debate, the figures published by Uncle Sam do show an improvement in the unemployment rate.

    Support Held Last Week

    Since showing the chart below on August 7, the S&P 500 has rallied sharply.

    Investment Implications – The Weight Of The Evidence

    Based on the improvement in the big picture risk-reward profile for equities, our market model called for an incremental bump to the growth side of our portfolios Monday. Tuesday’s improvement reached levels calling for another “add” to the equity side.

    The charts below provide a few examples of “observable improvement”. On August 14 (left below), the S&P 500 remained below several forms of possible resistance, including the 50-day moving average and downward-sloping trendline C. This week, the S&P 500 has successfully cleared both hurdles, telling us the probability of the current rally carrying further is higher today than it was on August 14.

    Are there hurdles above? Yes, there are always things to be concerned about both technically and fundamentally. The Fed minutes or something out of Jackson Hole could either propel the markets higher or spook them into a reversal. Therefore, we will enter Wednesday’s session with a flexible stance.

    Janet Yellen image from DonkeyHotey Flickr creative commons. The source image for the caricature of Janet Yellen is a photo in the public domain available via Wikimedia. The mimeograph is based on an image in the public domain from Wikimedia. The dollars are adapted from Nadya Peek’s Flickr photostream.