Guideposts Can Assist With Risk Management In Uncertain Market [Dow Jones Industrial Average, ProShares Short S&P500 (ETF)]

bearbullChris Ciovacco: Schizophrenic Market Still With Us.

In a May 14 article, we discussed ways to reduce personal bias and increase investment flexibility. Since the present day market is continuing a pattern of schizophrenic behavior, we will discuss the use of guideposts as a portfolio risk management tool. Thursday, the news from Europe had a potentially mixed message; economically negative, but it could move the European Central Bank closer to taking some stimulative action. From The Wall Street Journal:

The euro-zone economy grew only slightly last quarter, suggesting that its convalescence from crisis remains troubled and putting added pressure on the European Central Bank to enact fresh stimulus measures. Economic activity in the 18-country currency zone rose by 0.8%, in annualized terms, in the first three months of 2014 compared with the previous quarter—well below economists’ expectations.

Imagine If You Used Guideposts In 2008

We could have picked any number of charts, ratios, or indicators to use a guidepost implementation example. We chose the chart of the S&P 500 relative to being short the S&P 500 (NYSEARCA:SH). If we are to experience a sharp correction or enter a new bear market, it will begin to show up on the long vs. short chart. A simple visual inspection of the charts below tells us 2014 still looks better than ugly periods in 2008 and 2010. We will be watching the chart closely Friday, especially if the bears begin to roam again.

As we covered in detail in October 2013, a guidepost can be paired with an IF-THEN type approach to risk management:

If the 2014 chart above takes on a 2008 or 2010 look, then I will reduce my exposure to stocks by X%.

Is the long-short guidepost a foolproof way to help manage portfolio risk? No, but it can help us improve our odds of investment success. Since no indicator or guidepost is perfect, using numerous inputs to create “guidepost redundancy” is prudent, which is exactly what our market model does.

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