RIsk Management: Jumping Off a Cliff with a Bungee Chord

As mentioned before, we may enter a second leg of the sell down of equities.

Psychologically, the first leg catches most investors by surprise. It happened too fast for them to sell. Value investors, those who missed the rally will then buy on the support lines, usually 150 and 200 days moving averages. The more people look at the averages, the more the support will hold. It usually pushes the index up to the mid point of the correction, before sellers come back again, pushing down to the last low. Thereafter, value investors will usually come in again at the 150 or 200 days moving averages to buy. What happens next depends on a mixture of fundamentals, valuations, and liquidity. It depends on whether economic growth is going to be positive, valuations are not expensive and whether enough money is on the sidelines to push the demand / supply dynamics in the bulls’ favor. I must say of the three factors, liquidity is the biggest factor.

There is a high probability that the support of 150 and 200 days will hold, OR even if the indices breaks below, it will rebound shortly. 

1.       Valuations in the US are on the expensive side, 17x PE and 27x CAPE. But dividend yields are higher than bond yields and money has to find a place to park. As long as bond yields are lower, retail investors, pension fund managers need to put it in either equities or high yield bonds to get the yields.

2.       Valuations of developed Europe like Germany are on the high side, 18x PE, but in peripheral Europe like Spain, Russia, Turkey, Poland they are between 8x in the case of Russia to 12x for Spain. UK is on the cheap side and from memory is at 15x.

3.       Most of Asia have cheap valuations vs historical. Shanghai Composite A is at 13x vs historical average of 17x.

https://www.youtube.com/watch?v=mq_E_0L1CrM

Lastly, this is probaby the most important lesson you will ever learn.

What If We Are Wrong and You Are Already In the Stock Markets?

There are two ways of buying risk assets. Buy when the trend continues to the upside, meaning using MACD weekly charts to gauge if the worst is over. The cons of this is that you will miss the first 5 to 10% of the rebound. 50 - 75% of the returns of a wave usually come from the first few weeks of the bounce.

The second way is to buy in stages at the support levels of 150 and 200 days moving averages. The cons is it could keep falling and you end up catching a falling knife.

This is where risk management comes in. If you are long the stock markets, whichever method you choose, you need a "hard" or "soft" stop loss at around 5 to 10%. Meaning whatever you do, you limit your losses to just 5 to 10% of each position. As long as your take profit strategy is at least double of the stop loss, meaning you take profit at between 15 and 20%, even if your accuracy rate is 50%, you will eventually make money. This is a mathematical truth.

Risk management plays a huge part in returns over time.

In any case, after such a sharp sell down, I expect to see the stock markets rebound back towards the 150 days moving averages. The question is whether the markets will resume the uptrend or fall to a new low. The trend is still on the up as of now. But now we know what to do if the trend changes.

I shall talk about using inverse ETFs to hedge in my next few posts.