Today, I thought I’d write a bit about risk control. I believe it is one of the better ways to outperform stock market indices over time.
At ValueTrend, our mandate is risk control before all else. I know from 33 years of managing money that few managers control risk in a bear market better than ValueTrend. In a bull market, most money managers try to beat or keep up with the indices. Sometimes we, like other managers, will outperform the market with superior stock picking. Sometimes not. Truth be told: Research shows that its pretty hard to consistently beat a bull market through good stock picking.
But in bear markets, like 2008 and 2022, ValueTrend has a history of outperformance. We win…by not losing as much as the market. We raise cash and lower beta (see my Online Course) to reduce our downside.
If you control the downside, you need far less time to recover. You will also have cash to invest when markets bottom and begin to recover. This strategy affords superior long termed performance, even if you aren’t the best stock picker.
Which brings up 2 points
Buy & hold isn’t working now, and may not for a while.
Most world indices peaked in early 2022. They have yet to recover. Craig and I have done a fair amount of research on the potential of a sideways market (note: post a comment requesting it below and I will send you a copy of a research report written by Craig and I in early 2022). There’s no sure thing, but we do ponder on the possibility that markets may be entering another one of the long sideways consolidations we’ve witnessed many times over the past 140 years. Well, we didn’t actually witness them all!
You may be interested in knowing that I did predict the 2001-2013 sideways period before it happened. See the chart below. I made that prediction in an article I wrote in January 2001 for Canadian MoneySaver. So, here I go again, predicting a sideways market. Right or wrong – this time with added research from Craig.
If the market is entrenched in a sideways consolidation pattern, this means that truly active, systematic money managers like us, or do-it-yourself investors like you who study my techniques, will outperform. Not necessarily by picking the best stocks, although that can help. More on that in a minute. Instead, you have better odds of beating the market by not losing money in the downswings! Study the chart below and take note of those big swings in the multi-year consolidation periods marked by horizontal red arrows. Buy & hold didn’t work during those long consolidation patterns.
This years winner is next years loser
I noted above that ValueTrend’s primary job is to protect capital – bull or bear markets. We do this by selling when our signals go bearish. Few managers trade like this. That is why most managers failed to protect capital in 2022, or 2008, 2001, etc, etc.
This is not a unique problem.
Most investors & money managers follow a more or less buy/hold mandate. They do well in bull markets, and lose money in the bear phases. They believe rotating stocks, sectors or regions – rather than going to cash- is the answer to a bear market. Don’t get me wrong, you need to become defensive with your stocks you hold in a bear market. But cash is king. And few managers raise enough of it to make a difference. They are protected when markets are generally trending up because their losses in a short bear move are recovered quickly when the market rallies. But in sideways periods…..
If the market enters another of its historic sideways phases…
Per the long termed Dow chart above – sideways markets demand a different strategy. What happens if this market is in fact entering such a period? In the current case, if the market tops at 4800 and declines – this might suggest a sideways period is upon us. Our system will force us to reduce stocks. Just as it did in 2022, 2008, etc. In fact, we even reduced stocks on a minor sell signal this summer. You know that, you read my blogs. Other managers do not do this consistently.
Of note: If the market goes through 4800 with conviction, we stay long the market. A breakout would offer some proof that the market has not entered a sideways swing period per the top chart. We have to play it with an open mind to ANY possibility at ALL times! No flat assertions allowed.
Win by not losing
It’s not about momentarily “winning” the game by picking stocks. The better strategy, in my experience, is to control risk. Case in point: the vast majority of “stock pickers” (Portfolio Managers AND individual investors) underperform indices over the long run. This years market beating performance is next years loser…
”It’s a mistake to assume that active managers’ recent success will persist. The evidence is overwhelming that the longer they play the game, the more likely they are to lose.”- VettaFi
Most investors don’t outperform markets consistently.
The basic principle here is linear regression. In plain English, this means that all outsized movements from a trend will correct themselves to equal the trend over the long run. An investor having a couple of killer outperforming years will typically experience a couple of lousy underperforming years to bring it back to the average. At the end of the day, that average rate of return typically ends up being close to the market return. Give or take a bit.
Below is the SPX showing how regression works (Raff regression channel applied). The middle line is the median return/trend. The outer lines contain the outlying moves. Note that the outside moves regress to the mean and equalize the return/trend over time. You can apply regression analysis to markets, to your own portfolio performance, and to a money manager’s performance. Stockcharts.com has such a tool.
The bottom line
OK, so lets assume that you agree that the odds are against you if you want to beat the market by good stock picking alone. Does this mean that you should just buy & hold an index ETF, or a few good stocks? Well, given the long drawn out sideways consolidations noted on the above chart, I don’t think that’s the best thing to do. Would you want to buy and hold during one of those periods? I’d think not!
In other words, “win by not losing” is a better/ more valid strategy in a consolidating sideways market. My system teaches you to hold during the least risky phase of a market move, then reduce your equity exposure during the most risky phase. Of course, Craig and I always try to add alpha through sector rotation and good stock picking. But it is our market risk control & timing process that is the more important strategy.
At ValueTrend we don’t claim we can beat a bull market exclusively through stock picking. Sure, we are pretty good sector and stock pickers. We’ve had some big outperforming years during bulls. But we’ve also had some underperforming years during bull runs. It happens. In the stock picking game, you are only as good as your last decisions, whether you are a professional or an individual investor.
So–we don’t know if we will beat the market by buying the best stocks or sectors. But here’s the thing: We do know that we can effectively reduce risk in bear markets through our systematic Technical Analysis based rules. We have the track record to prove that claim. We find that controlling the downside in bear markets to be a more reliable way of realizing superior long termed performance. And you sleep better!
History suggests that we are getting closer to the point of seeing another multi-year sideways market. I don’t know if it’s already begun, or if it happens in a few more years. Sideways markets are where more passive investors will not do so well, net-net. You must be prepared to change your strategy as the game rules change.
I hope that my work has helped you become more prepared to prosper in this, or any market!
Don’t forget to tell your friends about my upcoming Technical Analysis 101 webinar. Suitable for all levels of investors. Even you old dogs!