Thursday, May 27, 2010

Bulls and Bears Need a Plan

If there is anything certain about what direction the market has moved since late April, it is that it is unpredictable and moving fast. In that environment, we need to be comfortable about our allocations measured against the market risk we are comfortable carrying. The quickness and degree of change we are seeing makes it clear that the time to move on strategic allocation decisions is whenever you can, on any positive bounce. John Hussman has a great way of describing his view of portfolio management that addresses the concept of risk management and evaluating your plan. His article is titled "Don't Mess With Aunt Minnie".

As you'll read, he is not making a bull or bear declaration. Instead, he is pointing out a big technical warning signal (see the graph below) to be aware of, and suggesting there is still elevated risk of fast downside moves from day to day for the unquantified near term. Here is a bit of his article...
   Finally, as longer-term readers of these comments know, I have a lot of respect for Richard Russell, who publishes Dow Theory Letters and is as close as one can get to having William Peter Hamilton - who wrote for the Wall Street Journal in the early part of the 20th century - still writing. While our views certainly don't always agree, you won't find a more informative, if colorful, observer of market action than Russell. At present, Dick suggests "If I read the stock market correctly, it's telling me that there is a surprise ahead, and that surprise will be a reversal to the downside for the economy, plus a collection of other troubles." Speaking in reference to one of his key measures of market internals, he observes "In 50 years, this is the most decisive top I can ever remember... the damage and cost of this reversal will run into the trillions." 

We can't rule out a recovery in market internals that would allow a further extension of market gains, but the historical record provides little basis for that expectation. Take risk seriously here. That is not advice to abandon all exposure to risk, but it is important to accept only the risks you can actually tolerate in the event that further problems materialize. 

In his article he points to a technical observation, the number of NYSE issues making new highs compared to new lows. I wanted to create a graph of this for myself and see what he sees. This is as close to the data as I can find in the world of free and reprintable charts. I am using the S&P instead of the smaller NYSE list. Remember, Hussman published his article on May 24.

Click on Chart to update

Obviously, the number of decliners is much greater now than any other period observed in this six month view, and by a substantial margin. I could not create a longer looking period. This is a trend I'll enjoy watching because it is a clear message, all by itself, that even a fundamental approach will appreciate. A little more balance in the ratio will be welcomed. Who enjoys frequent big moves anyway? And for any reader that does not approach market risk with a risk management approach, or use a plan that is not based around risk management, defense and offense, its not too late yet. In this market, the right amount of defense with the right amount of offense will keep values from dramatic reversals that do not have to happen. It's what I do and although I cannot claim to be beating any indexes, I am keeping values from being reversed at any moment. I use a plan and I'm sticking to it. Scanner