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Avoiding Portfolio Panic During A Sell-Off

Summary Stocks took a hard dive in a very short period of time, and now everyone is scrambling to forecast the future or come up with a game plan. It has been vicious on the downside, and no matter how well prepared you are for it, there is now a sense of foreboding about what the future holds. Keeping a level-headed approach to the market will allow you to make changes in the face of adversity with far greater success than a fear-driven impulse will. By now you have likely realized something is up in the stock market. If you are like me, you have probably consumed a tremendous amount of reading material this weekend that has framed and/or extrapolated this recent pullback in a number of different scenarios. The end result is that stocks took a hard dive in a very short period of time, and now, everyone is scrambling to forecast the future or come up with a game plan in the midst of the chaos. One of my favorite metaphors for the stock market is that it “takes the stairs (or escalator) on the way up and the elevator on the way down”. The elevator analogy most aptly describes this current drop. It has been vicious on the downside, and no matter how well prepared you are for it, there is now a sense of foreboding about what the future holds. Let’s look at a sample of the major world markets through Friday’s close. @MichaelBatnick posted this chart showing some of the drawdowns from the 52-week highs. The 7.51% drop in the S&P 500 index translates into a total return of -4.27% year to date. Certainly not the optimistic spot I thought we would be in at this point in the year, but not a catastrophe either. Percent from 52-week high (closing basis). pic.twitter.com/Ps8Dp6fg6y – Irrelevant Investor (@michaelbatnick) August 23, 2015 For a more balanced perspective, the iShares Growth Allocation ETF (NYSEARCA: AOR ) is down -2.08% this year. This index represents a 60/40 mix of stocks and bonds that is more in line with a typical investor portfolio. Now, there are a million technical indicators that you can point to as evidence that the market “has to” or “should” bounce from here. Conversely, the bears are enthusiastic that the fundamental backdrop of equity valuations are now being re-priced closer to historical norms and are salivating to press their short bets. Keep in mind that the market doesn’t have to do anything. It can stay oversold for far longer than you thought possible, or it could reverse to new highs for seemingly no reason at all. I have no idea what the next move will be, but at this stage, I am more inclined to take advantage of the sell-off than hoard more guns, canned goods, and gold. If you are worried about what the remainder of 2015 may bring, take a step back and evaluate your positions from an objective standpoint. These three concepts may help you along the way. Avoid becoming overly pessimistic or reading too far into things. It’s easy to feed into the hype and extrapolate that the next two weeks may bring about the same ferocious selling that we have experienced over the last two weeks. I’m not trying to make light of the situation, but sell-offs of 5-10% occur in every type of market with astonishing regularity. So far, this is a very orderly and typical event. If you find yourself leaning too hard on the risk side of the ledger, look for opportunistic exit points (such as a short-term rally) to reduce exposure or transition to lower-volatility positions . Watch out for the “I told you so” crowd. Anyone that is overly excited about this sell-off likely has an ulterior motive, were lucky to sell near the highs, or have been wrong for quite some time . Taking victory laps as the market tanks doesn’t help anyone’s confidence or emotional capital. Rather, it’s important to focus on your investment process to ensure you have an appropriate asset allocation to meet your goals and risk tolerance. Make sure you identify the difference between a short-term trader that moves to cash quickly and a more strategic investment process that focuses on longer time frames or trends. Have a clear game plan for multiple scenarios. We could be at the brink of the next bear market or simply hitting a short-term speed bump. From a technical perspective, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) has come right down to its January lows, which is a likely area of support. Nevertheless, a break below those levels could draw in more sellers looking to avoid the next significant drop to the October 2014 lows. Remember that if you do end up reducing your equity exposure, that swift rallies may lead to performance chasing on the way back up. It’s important to weigh the benefits and risks of changes to your asset allocation in the context of your investment plan rather than short-term emotional pressures. The Bottom Line Keeping a level-headed approach to the market will allow you to make changes in the face of adversity with far greater success than a fear-driven impulse. There have been several opportunities this year to take advantage of new trends or step up your risk management plan as needed. The key is to stay as objective as possible when making changes, to ensure that they align with your long-term goals. Disclosure: I am/we are long AOR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.

Counting The Down Days For Favorable Odds

SPY closed lower for the fourth consecutive day on Friday. Historical data analysis shows that the probability of another day in red is below 40%. Expected return for the next trading session is +0.3%. S&P 500 and its tracker SPDR S&P 500 ETF (NYSEARCA: SPY ) finished this trading week crashing like there is no tomorrow. It was a move not seen for a while that got market participants panicking. This was also the fourth consecutive trading session when the market went down. With a bit of simplistic historical data analysis I would like to explain why this presents a favorable setup for short term traders. SPY began trading on January 29, 1993, which gives us 5,683 trading days of data. Out of all those days, SPY closed lower on 2,580 occasions. This means that over the last 22 years the probability of a down day was 45.4%. If we investigate at what happens after a down day, we will see that on 1,141 occasions, or 44.2% of time, SPY went lower again. After two consecutive days down, the probability of another close lower decreases to 42.3% (483 instances). Extending this type of analysis to more days, we get the following table: One will immediately spot that thus far SPY has never gone down 9 trading sessions in a row . There was also only one instance when it closed lower for 8 consecutive trading sessions (any guesses when that happened?). More importantly, it is clear that the probability of a down day decreases gradually with each trading session in red. The probability spikes up at the 7th day but the sample in that category is already too small for statistical inference. One caveat about the table above is that some runs will be included in the data multiple times. For example, the recent four day decline will generate one instance (Friday) in the 4 days down bucket, 2 instances (Thursday and Friday) for 3 days down and so on. To account for that, we also take a look at the setups with exact number of down days preceded by a trading session with a nonnegative return: The interpretation of the figures above is as follows: after a nonnegative day, SPY went down 46.4% of times. After exactly one day down, SPY went lower on 45.7% of occasions and so on. Despite a slightly different methodology, the drift remains the same – the probability of a down day decreases gradually as the market slump persists. So with SPY having closed lower for the fourth time in a row on Friday, this gives us a pretty nice setup where the chance of another decline in the next trading session appears to be below 40% . Obviously, the probability in isolation is not enough and we need to complement it with expected return. The next table compares average and median return after exact number of down days: The returns tell even a more persuasive story. It turns out that not only the probability of a decline decreases with each down day but at the same time the expected return rises steadily. History tells us that with the current SPY streak of 4 down days, the expected return for the next trading session is 0.30% . Not a bad profit for a single day, which would compound to over 110% return annualized. This is not to say than one should trade such a setup without taking other factors into consideration. Proper risk management and exit strategies are required. They could also be complemented with trend indicators, seasonality metrics, fundamental ratios, etc. But at the very minimum it is a good starting point. I went long SPY at the close on Friday. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Scrutinizing International REIT ETFs

Correlations with S&P 500 have declined to around 0.70 in the last year. International REIT ETFs appear to be more correlated to S&P 500 than their counterparts investing solely in the U.S. Largest international REIT ETFs share almost identical risk profile. In a separate article last week I took a look at how U.S. real estate investment trust (“REIT”) ETFs affect the overall portfolio risk and tried to assess the extent of the diversification benefit they offer. This time I would like to extend the analysis to international REIT ETFs and scrutinize them from the risk perspective. For the purpose of this article the focus will be on the four largest and most established global REIT ETFs: the SPDR Dow Jones International Real Estate ETF (NYSEARCA: RWX ), the Vanguard Global ex-U.S. Real Estate ETF (NASDAQ: VNQI ), the SPDR DJ Wilshire Global Real Estate ETF (NYSEARCA: RWO ), and the iShares International Developed Real Estate ETF (NASDAQ: IFGL ). All of these funds manage at least $950m of assets and have been around for a while, giving us enough historical data for meaningful analysis (the most junior one is VNQI launched in November 2010). To begin with, I inspect the correlation matrix of these ETFs including the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as a proxy for the broader equity market. The calculations were carried out on InvestSpy using almost 5 years of historical data (truncated to VNQI’s inception date): The table above shows that global REIT ETFs are fairly highly correlated between each other with coefficients ranging from 0.88 to 0.96. Not surprisingly, the least correlated with others is RWO, which is the only one offering exposure to the U.S. market with a substantial 58% country weighting. Perhaps more unexpected observation is that international REIT ETFs have higher correlations with SPY than their U.S. counterparts. As outlined in my previous article , global REIT ETFs had correlation coefficients with SPY below 0.80 over the same period. To verify if the findings above hold true in a more recent period, I checked correlation coefficients for the last 12 months: RWX, VNQI and IFGL remained highly correlated between each other (coefficients of 0.94-0.97), however RWO drifted away significantly, highlighting diverging performances of international and U.S. REITs. Furthermore, correlations with S&P 500 weakened across the board in the last year although the effect was yet again not as pronounced as in local U.S. REITs. The fact that international REITs are more correlated with S&P 500 than REITs investing in the U.S. only looks a bit like a mystery as intuitively one would expected exactly the opposite to be true. I can only speculate about potential drivers of this effect. The first thought that springs to my mind is that currency movement could be accountable for this. Indeed, simplistic factor analysis reveals that a basket of currency ETFs could have explained about 40% of movement in RWX. However, this is a fairly average number for an internationally diversified fund and thus does not imply anything unusual. Alternative explanations could be more of fundamental nature: e.g. U.S. investors understand the local real estate market better and see it more like a standalone asset class, whilst international real estate is put in the same bucket with stocks. Correlations aside, the table below depicts further risk metrics of the global REIT ETFs utilizing last 12 months data: (click to enlarge) Annualized volatility, beta and maximum drawdown readings are comparable for RWX, VNQI and IFGL. Meanwhile, RWO realized considerably lower beta and annualized volatility, once again presenting itself as a middle option between international and U.S. REIT ETFs. Summing up, international REIT ETFs appear to be more correlated to S&P 500 than their counterparts investing solely in the U.S. Somewhat surprisingly, this means that global REIT ETFs offer lower diversification benefit to a U.S. investor. Furthermore, three of the largest international REIT ETFs (RWX, VNQI and IFGL) share almost identical risk profile, thus an investor needs to look more closely at other ETF features such as expense ratio and bid-ask spread. RWO sits somewhere in the middle between international and local REITs and may be a good choice for someone who wants a bit of worlds. Last but not least, correlations do change over time and a smart investor will monitor them periodically to achieve the intended outcome. Disclosure: I am/we are long VNQI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.