A Simple 3-Step Method To Protect Your Portfolio In Q4


I have 37 years of experience forecasting global financial markets. Opinions expressed by Forbes Contributors are their own.


The U.S. Stock market has been a steamroller lately.  On October 11th, the PHLX Semiconductor (SOX) Index met the 1214 target first mentioned in my September 7 Forbes article,  titled, The Key To Avoiding A Fall Stock Market Correction, a 10% advance in just over a month.  Meanwhile, the major US indexes have all risen to new all time highs while the benchmark S&P 500 has risen by a whopping 24% since November 2016.  Any seasoned investor knows that, despite the great market performance during the past 12 months, nothing goes up forever.  Moreover, the higher the market goes, the more likely it is that a correction will occur because of financial asset prices’ tendency to revert back to the mean.  So, while the financial media leads the cheers for even more strength during the 4th Quarter, here are three easy steps that can help protect your portfolio from an unexpected, and potentially nasty, decline between now and the New Year.

There is a plethora of quantitative and technical metrics that investors can use to “take the market’s temperature” at any time, to determine whether conditions are favorable for more strength or if asset prices are vulnerable to a decline.  I actually built a quantitative model years ago, which my firm Asbury Research calls the Correction Protection Model (CPM), to monitor these metrics on a daily basis for our clients.  For the purpose of this article, however, I have chosen three simple tools that, if monitored accurately and consistently, should greatly help the average investor understand when the market is in a “risk on” (playing offense) or “risk off” (playing defense) environment.

Step 1: Track Investor Urgency

I closely monitor trading volume to determine investor urgency to either buy or sell.  There are number of different ways to do this.  One such metric is called On Balance Volume (OBV) and was developed in the 1960s by legendary financial market analyst Joe Granville.  Granville effectively turned volume into a momentum indicator by simply adding the current day’s volume to the previous day’s cumulative total when the stock or index closed higher that day, and subtracting that day’s volume from the previous day’s if the asset closed lower.  In this way, increasing volume shows urgency to buy and decreasing volume shows urgency to sell.

Chart 1 below plots the S&P 500 daily since January in the upper panel, with the index’s On Balance Volume in the lower panel.  I overlaid a 21-day moving average on top of OBV to identify the monthly trend, which is Asbury Research’s tactical time frame.

Copyright 2017 Asbury Research LLC

Chart 1

The red highlights between both panels identify the two instances this year when OBV was in monthly decline (below its 21-day moving average).  A quick look at the chart shows that these were really the only two instances this year when the S&P 500 was declining.  Also note how early in a minor market decline OBV identified that the trend was changing.  The chart also shows that once OBV got back above its 21-day moving average, the S&P 500 regained its footing and the broad market resumed its advance.

Step 2: Track Investor Conviction

Like investor urgency, there are also a number of different ways to track investor conviction.  One of  my favorites is via ETF asset flows data, which is derived by multiplying daily Net Asset Value (NAV) by Shares Outstanding to compute total net assets.  Unlike volume, which measures intraday trading activity and thus can just as easily expand or contract on either price advances or declines, Total net assets measure the bullish conviction necessary to buy an asset and accept the market risk of holding it overnight.

The blue line in the lower panel of Chart 2 below plots the daily total net assets invested since July in the iShares Russell 2000 Index ETF (IWM), which tracks the Russell 2000 small cap index, along with its red 21-day moving average to identify a trend of monthly expansion or contraction.

Copyright 2017 Asbury Research LLC

Chart 2

The green highlights show that these assets shifted to a trend of monthly expansion on August 24th, which is four business days after IWM (upper panel) bottomed on August 18th.  This monthly expansion of assets indicates near term bullish conviction, and fueled IWM’s strong 10% rise since then.  As long as this trend of monthly expansion remains intact, the bullish investor conviction component of this simple three step process will remain valid.

Step 3: Know Your Time Frame

The third and perhaps most important component of this three step process is to know what your particular investment time frame is.  This means knowing your investment time horizon and how to define it.  This knowledge is imperative to your remaining calm during market declines, as well as your ability to define market risk from market opportunity.

Chart 3 below plots the S&P 500 daily since January along with its 50-day (blue) and 200-day (orange) moving averages, plus some key underlying support levels.  Many investors, myself included, view the 50-day moving average as a minor trend proxy and the 200-day as a major trend proxy.  These simple tools, especially when combined with the actual support levels on the chart, help to define and identify a minor correction, and a potential new buying opportunity, from a bearish trend change.

Copyright 2017 Asbury Research LLC

Chart 3

In this case, S&P 500 2491 represents a 3% decline from the index’s all-time high, and the convergence of the 50-day moving average and August 8th benchmark high.  This tells us that the minor trend, as defined by the 50-day moving average, will remain positive above this level, and may even provide an opportunity to put some new money to work — provided that the urgency and conviction metrics as shown in Charts 1 and 2 support it.

A sustained decline below 2491, however, with confirmation from our urgency and conviction metrics, would indicate that the S&P 500 has entered into a minor corrective phase, and thus is vulnerable to a deeper decline to the next underlying support levels 5% and 6% below the market at 2438 and 2401.  The latter, 2401, represents major support at the convergence of the 200-day moving average (major trend proxy) and March 1st benchmark high.  This simply means that, above 2401, the major trend is still up.  Moreover, if this major support level was tested and the index turned upward again, amid increasing urgency and conviction per Charts 1 and 2, it would indicate that the major uptrend had resumed — and would identify a place to potentially put some new money to work.

Finally, a sustained decline below 2401, accompanied by weakening urgency and conviction metrics, would indicate a major bearish trend change, which I would view as a signal to protect investor assets.  This can be done in a number of ways including paring down position size, buying a put, buying an inverse ETF, or selling the futures contract.

I have talked to way too many people who worked hard all their lives to save money for retirement, only to lose most of it during the 2008 Financial Crisis simply because they didn’t understand what was happening in the market — and they froze.  It’s easy to do, especially when you’re terrified.  Although I use a much more comprehensive and robust model to manage investment risk for my clients, combining and diligently tracking the three simple little tools shown above can be a very effective method to consistently keep you aware of the condition of the stock market — and give you the ability to make logical, fact-based decisions while others are letting their emotions sabotage their investment strategy and objectives.

This market analysis is being provided for information purposes only and is not a solicitation to buy or sell any financial asset or security. Past performance is not indicative of future results, and no inferences or guarantees of profitability are being stated by the author.

John Kosar, CMT, is Chief Market Strategist at Asbury Research LLC, a provider of technical and quantitative financial market research, and other investor services, to institutional money managers and high-net worth investors.

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