Risk Management in Financial Markets

Legitimate Fear of Investing Cash Near A Top

On January 16, we presented the chart below, which shows the possible negative impact of holding too much cash during the latter stages of a bull market. Is it rational to keep a big stash of cash on the sidelines after witnessing stock market declines of over 50% in both the 2000-2002 and 2007-2009 bear markets? Yes, it is very rational. However, the Bob-Sally-Dave chart below tells us being too conservative has costs as well. In today’s post, we will cover some specific examples of risk-management techniques to balance upside investment potential with downside bear market risks.

Recent Earnings Highlight Need For Risk Management

What eventually kills a bull market? Typically, bear markets begin when earnings begin to drop as the economy begins to contract (a.k.a. a recession). Investors have been reminded recently that stocks need more than the Fed. Friday brought additional reasons for concern. From Bloomberg:

UPS dropped 2 percent as it projected earnings that trailed estimates. Intel Corp. fell 3.4 percent as its revenue forecast raised concern the personal-computer market is struggling to grow. General Electric lost 2.5 percent as margins at its manufacturing units fell short of guidance.

When The Market Does This…

How could have underinvested Sally and Dave captured additional gains between 1997 and 2000 in the graph above? They could have used charts such as the one below, which asks some simple questions about Bollinger Bands. From a probability perspective, the odds of “good things happening” in the stock market are higher when (a) the S&P 500 is above the dotted line, and (b) when the slope of the dotted line is positive. Between 1997 and the peak in 2000, the answers to both questions were “yes” or bullish. From a probability perspective, the “odds of bad things happening” in the stock market increase when the answers to both (a) and (b) are “no”, which was the case during the vast majority of the net-worth destroying bear market following the demise of the technology bubble.

In January 2014, the chart above sides with stock market bulls, which aligns with the majority of the hard, binary, and observable evidence.