Stocks Have Been Great. What Now? Buckle up or Buckle Down?

Predictions of stock market volatility have been shrill since Donald J. Trump won the presidency. While the ballots were still wet with Putin’s ink, many pundits predicted, as did Paul Krugman, that the stock market would suffer an apocalyptic meltdown, and would never, ever, recover for as long as the Orange Administration was in office.

Nothing could have been further from the truth. Since the November 2016 elections the stock market has surged nearly 40%. That’s less than a year. Indeed, the equity markets have been a great place to be.

Nonetheless, the stock market has continued to advance on increasingly lower volume, thus stock holdings may well warrant a modicum of defensive measure. Don’t misunderstand: the appropriate long-term outlook recognizes that positions held today will hold greater value two years from now and likely one year from now. But as stock markets rally, there are simply fewer and fewer players willing to trade at those lofty levels, which thins out market breadth and liquidity, thereby setting the possibility for some pullbacks…. and, yes, volatility. (By the way, “volatility” in the press is a euphemism for investment declines: virtually no one complains about ‘upside’ volatility!)

Bank of America (NYSE:BAC) warned the week of October 16, 2017 that corporate profits could weaken the S&P 500 Index by 10 percent or more by Q1 2018. Of course, BofA has made these dire predictions almost yearly without any particular consequence (Google it) but even for the Blithe Bulls, there are steps one might take today to mitigate portfolio risk, while staying market long, or ‘long’ volatility.

The Shotgun Risk Weighting

Volatility is at a ten-year low right now (INDEXCBOE:VIX) as the equity run continues. That probably means that when volatility does kick up again, the market will experience internal rotation: in a market decline, the highest performers will lose more than the low-beta stocks or market laggards. The latter often substantially appreciate as capital flees to stability. Under that circumstance, the equity indices may move very little in level, but the component individual stocks within the indices may move quite a bit, as the year’s winners and losers converge.

The professional managers have all manner of fancy Value-at-Risk models to optimize and re-jigger their portfolios for downside protection. But there are some simple techniques to approximate the same principles without spending a bunch of money or buying the latest technology. Old school still works.

Instead of using a subjective assessment of risk, use a specific, mathematical calculation. Optimize the portfolio based upon the incremental risk of each position in the portfolio. Past performance, we learned long ago from Long Term Capital Management, does not always predict future performance, but relative risk performance is an historical measure that has some legs. And it is an immanently available risk measure approximated by a stock’s ‘Beta,’ which measures a stock’s tendency to move with the market. Beta of 1 means the stock and the market move in tandem. Beta of 2 means the stock is likely to move twice as rapidly in the same direction as the market. A Beta of -1 suggests the stock moves proportionally opposite the market and represents a potential hedge. A Beta of -1 >< +1 means the stock is relatively uncorrelated with the market. And so on. For this exercise, lookup the historical Beta for each stock in the target portfolio, which one may obtain easily from an online broker software or google finance for that matter.

The simplest way is to allocate capital in inverse proportion to the beta (or annualised volatility if the acceptable risk is lower than the equity market). The result is that it allocates more to the dependable, unsexy, individual winners and lesser amounts to the securities that have shown spectacular gains over the past year.

Here is what a portfolio of the Dow Jones Industrial 30 would adjust to, ignoring for the moment the starting position percentage of each member of the portfolio:

Dow Jones Industrial (INDEXDJX:.DJI)
Data as of market close: October 20, 2017

One can use the same scheme for any portfolio of stocks using Excel or docs.google.com to create the spreadsheet. Take the reciprocal of each volatility number and that represents the relative weight adjustment in the portfolio. This simple scheme works directly upon an equal-weight, or capitalization-weighted portfolio, but can also normalise to any portfolio based upon the target capital position of the portfolio post-trade.

For example, if the 1-year beta is 1.9x adjust the current position to 53% of the current holding. If the Beta is 0.8, increase it by 25%. Caveat: this assumes that current portfolio membership is fine, as the names in the portfolio do not change, only their relative proportion. Second Caveat: This does not take tax consequences into consideration. Last caveat: None of the beta-weight ‘recommendations’ is hard-and-fast, one should use judgment. OK, absolutely final caveat: for the illuminati, beta-weighting a portfolio can also be well-accomplished, with less turnover, through stock options.

Either way it is a straightforward ‘reality check’ if one is feeling the cold chill of future volatility creeping over the near horizon.

By: Wayne P. Weddington III,

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