"Those who have knowledge, don't predict. Those who predict, don't have knowledge." ~ Lau-tzu
When Lau-tzu shared this wisdom approximately 2500 years ago, he probably did not envision financial markets in the 21st century; however, I am confident that, if he were living today, he would agree that selecting a position (bull or bear) based upon the likelihood of a future occurrence (stock market movements, economic conditions) is foolish...
As I stated in a previous post, "Bull vs Bear vs Right," the prudent investor will not choose a "bullish" side or a "bearish" side but will choose the "right" side, which is a position based only upon the investor's tolerance and capacity for risk and the controllable determinants of investing, which includes asset allocation, investment selection, investment time horizon, investment location, and savings rate.
With that said, however, I've consistently supported Mark Twain's notion that "history does not repeat itself but it does rhyme" and that investing is largely an undertaking in risk management. Even without the consideration of recent market volatility, the "rhyme of history" suggests that prudent risk management would give deference to the downside risks before upside potential. Put simply, risk management is about the pursuit of "above average" returns while assuming "below-average" market risk...
In light of last week's 10% "correction" followed by the biggest two-day rally in five years and, in the interest of risk management, I would like to share some recent "rhyme of history" information I have found that is quite compelling:
Based on analyses of 116 previous "corrections," or a 10% retreat in the Dow Jones Industrial Average, since 1900, Ned Davis Research... found that once the market falls 10%, there is a 50-50 chance it is heading for a 15% drop from its recent high.
Then, if the 15% mark is breached, there is a 54% chance of a "bear market," defined as a 20% decline.
Stock market volatility -- as measured by the 100-day moving average of changes in the Standard & Poor's 500 stock index -- recently hit its highest level since 2002. Such spikes in volatility generally foreshadow a bear market.
Based upon long-term averages, the S&P 500 is about 13% above its normal price-earnings ratio.
From The Wall Street Journal, Be Ready to Buy On the Word 'Recession'
A few other "rhymes of history" that I have noted are undeniable signs that the stock market momentum is shifting negative: Large company growth stocks are out-performing large-value stocks; November was one of the worst months in four years for small-cap stocks; the current bull market is the second-oldest in history and getting older every day; and presidential elections years do not favor stocks.
What is an investor to do? Outside of the ever-wise "passive" investing route, some classic downside risk management techniques include, allocating more assets to large-company stocks, high-quality bonds, and defensive areas such as health care, while shifting assets away from the riskier assets such as small-cap stocks, emerging markets stocks, and high-yield bonds.
Of course, you may always peruse through my "Where to Invest 2008" series of posts (beginning with this one) for model allocations and further guidance.
In summary, if wisdom is "knowing what we don't know" then an absolute "Bull or Bear" position is not wise because that would assume we know what the future holds. In the spirit of risk management, we strive to achieve "above-average" returns while taking "below average" risk. Winning "the race" is more often a result of "losing less" than it is a result of "winning more."
TFPAuthor, Kent N. Thune, QPFC, is the President and founder of Atlantic Capital Investments, LLC (ACI), a 'fee-only' Registered Investment Advisory firm located in Mount Pleasant, SC.
Comments