This simple investment strategy could protect you if the US stock market cracks
By Thomas H. Kee Jr.
How do you control risk in the stock market when central banks flood the financial system with fabricated dollars?
The US Federal Reserve and the European Central Bank (ECB) have artificially pushed down interest rates and prompted demand for equities, as bond yields in recent years sunk to record lows. The Dow Jones Industrial Average DJIA, +0.02%the S&P 500 Index SPX, +0.03% and the Nasdaq Composite Index COMP, -0.29% are all at record highs. On Wednesday, the Dow closed at a record high for the 51st time this year.
The first thing you need to know is that you can control risk better than any billion-dollar mutual fund, money manager or hedge fund could ever hope to. We as individual investors have a competitive advantage: We can be nimble where they aren't. But we also must embrace that competitive advantage for it to work.
There's a three-step process to controlling risk in the stock market, given the environment we are in today:
1. Recognize and respect the risks. I outlined these in this article. The long and short of it is that the ECB is about to wind down its stimulus, which will drain money from the financial system. As the Fed has already ended its bond-buying program, the ECB's actions will come as a double whammy.
2. Evaluate your portfolio and raise cash when and where possible.
3. Find strategies that can be managed within your time schedule, and allocate between a mix of conservative and aggressive, proven risk-control strategies.
I will describe each of these briefly in this short article, but everyone has different risk tolerances.
After respecting the risks, you need to evaluate your portfolio and determine if there is anything that is overvalued. If so, sell it immediately and don't look back.
I offer valuation reports for 1,300 stocks through Stock Traders Daily. Given IBM'sIBM, +0.86% report this week, here's a valuation analysis for IBM.
In my opinion, any stock that moves in the same direction as the Dow, S&P 500, Nasdaq 100 NDX, -0.36% or Russell 2000 RUT, -0.21% should be sold or neutralized. (I'll explain what neutralized means when I discuss the CORE Portfolio Strategy, below).
In addition, if there is anything you bought for a short-term gain, and that position is relatively new, you need to set a tight stop-loss immediately.
For any stocks left in your portfolio, conduct a valuation analysis and get rid of anything you don't really like.
And finally, for whatever's left, ask yourself if you would care if that stock fell by 40%. If your answer is 'yes,' sell that too.
Importantly, if you have large capital-gain consequences that you want to avoid, you can protect assets without selling the position using our CORE Strategy. So, do not rush to sell anything before evaluating tax implications.
After recognizing risks and generating cash, we need a plan for a deconstructed portfolio. If the directions above are followed, you will be left with stocks you either cannot sell due to tax implications, stocks you plan on holding forever and, of course, cash.
The next step is to separate assets between conservative and aggressive. This is based on your personal risk tolerance. For clients, I usually start the discussion with 50% in our CORE Strategy (conservative) and two aggressive strategies with the balance. All have embedded risk controls.
I constructed CORE for this exact market environment.
Before I continue, my definition of conservative is not traditional, and I do not mean you should allocate money to conservative stocks. The influence of stimulus has propelled almost all asset classes and sectors higher, and the five-year rally has been broad-based in equities, suggesting that a reversal, should one come, could be equally as broad.
I still have a July 2008 clip from USA Today that shows almost every asset class down big, including conservative large-cap stocks. They may not have fallen as much as small-caps, but they fell hard nonetheless. The same thing happened between 2000-2002.
I constructed the CORE Portfolio Strategy to be a conservative option that can work no matter what happens, while controlling risk along the way. It is very simple, and simplicity is required. The more complex things get, the more difficult it is to control risk. Keep it simple, stupid.
Shooting for 7%-8% returns
The objective of the CORE Portfolio Strategy is to make 7%-8% a year in any market environment while being neutralized against market conditions most of the time. The average has been about a 70% neutralization rate, meaning we have been exposed to the market only about 30% of the time. The strategy has been achieving its objective.
Neutralized against the market means that if the market declines, it won't hurt the portfolio. That doesn't matter in bull markets, but it does when the market falls. Word on the street is that the market will never fall again, but we know better.
Instead of being exposed to stocks that are determined to be conservative, but that are in reality still able to decline massively when the going gets tough, CORE is completely neutralized against decline most of the time, and only exposed opportunistically.
Here's how CORE works:
CORE can be even easier to use within an IRA account, but it is simple to use in taxable accounts, and it is scalable enough to be used by pension plans too. The example below is for a taxable account.
CORE buys a position in the SPDR S&P 500 ETF Trust SPY, +0.03% regardless of price. Assume the allocation to CORE was $200,000; that would all go into SPY.
When neutralization is required, CORE uses margin to buy ProShares UltraShort S&P500 SDS, -0.09% with 50% of the portfolio, or $100,000 given the example. That neutralizes the SPY position from market risk. SDS is two times short the S&P 500, and SPY is one times long.
That's right; CORE uses margin and a leveraged exchange traded fund to neutralize. If you ask Schwab or Fidelity brokers about leveraged ETFs and margin, you will see that they have been trained to express the high degrees of added risk of those, but the way we use them actually reduces risk considerably.
When conditions are better, CORE sells SDS and SPY is left to work. We can even buy more SPY with SDS proceeds when we have them.
Neutralized or not, dividends accrue during this process.
Simplicity is key
CORE is simple to use. It requires a little work, but not an overwhelming amount, and the risk-reward is significant. Also, for accounts with large tax consequences, SPY can be replaced by those stocks in context, but the portfolio would also need to be evaluated for relative correlation. For example, if the stocks tracked the Nasdaq 100, ProShares UltraShort QQQ QID, +0.88% would be used to neutralize. And ProShares UltraShort Dow30 DXD, -0.30% for the Dow, and ProShares UltraShort Russell2000 TWM, +0.22% for the Russell 2000.
CORE empowers our competitive advantages, and we can neutralize our portfolio within seconds if needed. The big boys can't do that, but we as individual investors can. It is up to us to embrace that competitive advantage. Details are available on Stock Traders Daily.( marketwatch)
Thomas H. Kee Jr. is a former Morgan Stanley broker and founder of Stock Traders Daily. Kee managed the fourth-best-performing strategy in the world in 2016, according to HedgeCo.
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