Investing in a Volatile Market

The S&P 500 again respected primary support at 2550. Twiggs Volatility Index is retreating but a trough that forms above 1.0% would warn that market risk remains elevated.

S&P 500

I explained recently to my clients that the odds are at least 2 to 1 that the S&P 500 will recover and go on to make new highs later in the year.

But there is still a significant risk (one-third to one quarter) that tensions will continue to escalate and the S&P 500 breaks primary support to commence a primary down-trend.

If you are risk-averse, as my clients tend to be, it makes sense to adjust your portfolio allocation to cope with either scenario. What I call “having one foot each side of the fence” or “having a bet each way” in racing parlance.

Typical Portfolio Allocation

Gen Stocks are what I call “generational stocks” such as Apple (AAPL), Google (GOOGL), Amazon (AMZN), etc. ASX Income are stocks that yield strong dividends and franking credits.

If you have 50% of your investment portfolio in cash and short-to-medium-term interest-bearing securities (I collectively refer to this as “cash investments”) and 50% in equities, you are well-positioned to take advantage of either scenario.

If the market does fall — the less-likely scenario — you are well-positioned to convert some of your cash investments to take advantage of lower prices when the dust has settled after the crash. If the market rises, as expected, then you have enough exposure to benefit from the continued bull market. In that case, your only downside is the difference in yields between cash and equities.

Bear in mind that:

  1. This only addresses clients’ equity portfolios and does not take account of their other assets;
  2. The allocation is generic and does not take account of your personal circumstances; and
  3. The allocation is addressed at Australian investors.

Although the equity allocation is split equally between Australian and International (mainly US) stocks this does not infer that I rate them as equal market risk. Australian equities includes an allocation to Cyclicals which, in the present situation, could best be described as “counter-cyclical” as this largely consists of gold stocks which tend to rise as the market falls. My “Trump Insurance as I called it in an earlier newsletter.

J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to your sleeping point.”

~ Burton Malkiel

Robert Shiller: CAPE should not be used for market timing

From an interview with Robert Shiller in January 2013:

Blodget: ….one frustration a lot of people have with the cyclically adjusted P/E and others is that it’s not particularly helpful for the timing mechanism, do you think it’s good to use as a sort of projected 10-year return, where when P/Es are high the return tends to be low, and vice versa?

Shiller: John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you — and I had the same mistake in my mind, to some extent — Wait until it goes all the way down to a P/E of 7, or something.

Blodget: Right, perfectly safe, so then you can buy.

Shiller: But actually, the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it’s not super high. I think it looks like stocks should be a substantial part of a portfolio.

Read more at Robert Shiller On Stocks – Business Insider.