Will It Take Another Fall?

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My 96-year-old mother broke her neck.

Over the summer my mother slipped and fell during the night and broke her neck. She’s doing well now, although she still wears a soft neck collar. Fortunately, there was no dislocation or damage to the spinal cord. After a month of hospitalization and rehabilitation, she returned home. Thank God!

For years we have urged Mom to use a walker or a cane when walking. She had gotten increasingly wobbly as she made her daily walk around the grounds of the senior living complex she calls home.

But Mom is independently minded. She resisted all of the family’s efforts to get her to make a relatively minor change to her routine. And I think she thought it wasn’t “cool” to walk with assistance.

The fall changed her thinking, and a month of rehabilitation reinforced the message that assistance was necessary for her safety. They worked twice a day at getting her to use the walker. Since her return home, the walker has been by her bedside—a constant companion.

This has been a change for the better. Even Mom admits it. She now walks more steadily and confidently through the halls and on the sidewalks of her senior village. And the family breathes a little easier.

But it took a life-threatening fall. It took breaking her neck to bring about a needed change that was so obvious to most everyone else.

This same scenario seems to be playing out among investors.

Life has been pretty easy for investors for some time. Year to date, the greatest maximum loss (daily) has amounted to just 2.8%.

The rally that began after the 2007–2008 financial bloodletting, with 5% down days and 50%-plus total losses, is now 8½ years old. It has become the second-longest rally in history!

Investors fall victim to recency bias, which is just what it sounds like. You are more likely to remember something if you just heard it. That sounds reasonable, doesn’t it? But it’s not just a matter of memory capacity.

What you most recently see, hear, or feel becomes, by virtue of its current part of your history, the norm. This is especially true if you experience the same thing over and over again.

The potential problem with this is that recency is associated with probability. We see something frequently in the short term and think it is more probable in the long term than it really is.

This can be very dangerous when dealing with risk and reward in the financial world. You need to have a reasonable estimate of the true probabilities to have a reasonable chance of success.

Recency bias is ubiquitous. If you are a sports, movie, or music fan, then you have seen the lists compiled by many of the “greatest” games, movies, or songs. If you think about the items on most lists, you will realize that a high percentage of the chosen few are of rather recent vintage.

Sirius XM Satellite Radio’s Beatles channel played what its listeners chose as their top 100 Beatles hits. I was surprised how much the top of the list was dominated by their later hits as opposed to the songs that came early in their careers that made them famous. The top five came out, on average, in 1966, while the bottom five came out, on average, in 1964. (See what statistics-oriented people do with their free time? It’s a sickness.)

In investments, recent experience can cause you to favor stocks in the news instead of the quiet plodders, and to solely pick growth stocks over value. You’re just more likely to hear about them.

Similarly, when the market is in a long-term rally mode, we focus on current returns. Like in a high-scoring football game, the offense gets all of the discussion, and the defense is rarely part of the dialogue.

But as I often say, “risk is always with us,” and the only way you can deal with that fact is to continuously have your portfolio positioned to help you survive the market crash that is always lurking in the wings.

You can’t just wait for a crash to do something about it. Risk management has to be part of your portfolio, regardless of the market environment.

How do you do that? Conventional finance theory will tell you to diversify your portfolio. In practice that’s really hard to do because you want your investments to realize the returns of “hot” sectors, not the returns of the laggards.

Diversification among asset classes, some that are soaring and others that are diving and going nowhere, seems boring. It isn’t where the action is and by design yields mediocre returns. Also, during the last stock market meltdown, many asset classes retained for their diversification potential acted just like stocks and joined in the losses.

I believe a better solution is the use of alternative strategies instead of just asset classes. Each strategy should be dynamically risk managed to deal with the unexpected. Each should have a low beta to the stock market and little correlation with the other assets and strategies in your portfolio.

The end product of this filtering should be a portfolio that is robust. It should be capable of mitigating the losses in the next crash.

We know that another market crash is coming. But no one knows when it will occur. Yet, it should not take the actual occurrence of another crash before investors once again realize the need for risk management in their portfolios. We shouldn’t need another fall.

Market update

Last week’s stock market action certainly did not make the case for the beginning of a crash. Four out of five days saw not only gains but also new market all-time highs.

In addition, the current post-2008 stock market rally was extended by each of the new highs and now stands at 3,110 calendar days, the second-longest rally in the history of the S&P 500. However, as the following chart illustrates, this bull market, while long in the tooth, has not packed the punch of many past rallies, delivering an average gain of 16% per year, a level surpassed by many other bullish regimes.

One of the big stories last week was the increase recorded by the Consumer Price Index. The inflation measure went higher and did so more than was expected. While the Producer Price Index did not exceed expectations, it too moved higher.

This increase in inflation tanked the bond market and made a Federal Reserve rate hike sometime in the future more likely. Still, most observers do not think this month’s meeting of the Fed will be the time for the announcement. An announcement of a commencement date for beginning to liquidate its massive bond inventory is more likely, which, of course, is also bearish for bonds.

The increase in rates was not bearish for stocks; however, economic reports in general for the week were not supportive of stocks. They basically split in number between the outperforming and underperforming. One positive highlight, though, was the Empire State Manufacturing Survey, which jumped more than expected. Its New Orders component grew at its fastest rate in eight years.

There is some negativity for stocks in seasonality. Historically, the third week in September is the year’s worst week. In addition, individual investors turned suddenly bullish last week, normally a negative factor on a contrarian basis.

All in all, there is little to suggest that a crash is imminent. But investors shouldn’t need another fall to be prepared.

Weekly Edge: Fed Takes the Leap to Reduce Its Balance Sheet

The Federal Reserve has decided to run-off $3.7 trillion bonds and mortgage securities that it gathered during the financial crisis. According to MarketWatch, the Federal Reserve will reduce its balance sheet in October. Such a step will affect how the Fed will carry the future’s monetary policy. As of now, the economy is strong enough to cope with a tight policy position.

But what does a small balance sheet mean? It allows the Fed to revert back to its practice of targeting the federal funds rate. Small adjustments in reserves made from the central bank would fine-tune the federal funds rate. A large funds rate would mean the Federal Reserve would need to accept cash from banks and money-market funds overnight for a security to set a floor for rates.

At this week’s Fed meeting, Yellen emphasized that normalizing the balance sheet will be gradual to avoid disrupting the market. Bonds and currency markets will go through the most volatility if there are Fed revelations. This week’s meeting will also give the Fed the opportunity to have their say on the state of inflation in the world.

Sectors: As the market recovered from hurricane fallout, the leading Sector Benchmark ETFs exhibited mostly positive shifts over the past week. Telecom, Energy, and Materials rose, and Utilities fell significantly. Momentum scores of most sectors increased for the week. The only exceptions were Health Care and Utilities. Energy shot up incredibly, coming out of the red. The spread between the highest and lowest decreased from 49 to 28. In terms of ranking organization, there appears to be no general trend between cyclicals and defensive sectors, continuing last week’s trend. Technology, which stayed the same, sat above Utilities. Energy improved significantly from last week, jumping from -1 to 16. An overall increase in momentum for most sectors suggests the potential for a market increase.

Factors: The leading Factor Benchmark ETFs had mostly positive results for the week. Momentum and Growth remain in the lead, though Momentum slightly edged out Growth. Value and Dividend Growth sit at the bottom. Risk-off factors such as Quality, Yield, and Low Volatility were dispersed. Quality was toward the top, Yield was at the center, and Low Volatility was at the bottom. Overall momentum for all factors increased once more last week, with the average momentum score changing from 10.6 to 15.5. The spread increased from 15 to 17.

Global: Rankings in the leading Global Benchmark ETFs were mixed last week. Latin America and China remain at the top of the rankings, with China having a slight lead. Most momentum scores have risen slightly for the week. Developed and developing countries both climbed, with USA increasing from 12 to 15 and China increasing from 46 to 52. Emerging Markets increased slightly, from 31 to 32. The average momentum score globally increased from 25.1 to 25.8. USA and Japan were at the bottom in terms of absolute rank. Developed markets have mostly risen for the week: the UK jumped from 1 to 17 and Japan increased from 13 to 14.

Two Week Edge Chart

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