To those who have not been investing for a long time, the prospect of the Dow Jones Industrial Average falling 5,700 points in one day may seem ridiculous. But is it?
On Black Monday, 31 years from last Friday, the Dow Jones Industrial Average
DJIA, -0.22%
fell about 23%. If the same percentage drop were to happen today, it would be about 5,700 points. I lost millions that day, and so did many others. Of course, today is not 1987.
Some of the most dangerous words in investing are “this time it’s different.” Basic human emotions of greed and fear that drive the markets do not change. Let’s explore this issue with two charts.
Two charts
Please click here for six differences between now and 1987.
Please click here for six similarities between now and 1987.
Here are the biggest dangers to the stock market that can precipitate a quick, big decline.
• The popularity of passive investing. Broad-based ETFs such as S&P 500 ETF
SPY, -0.18%
Nasdaq 100 ETF
QQQ, +0.69%
and small-cap ETF
IWM, +0.37%
are popular. There is unshakable faith among many that the long-term buy-and-hold approach cannot lose. They cite 100 years’ worth of data. But much of the same data was available in 1987. Do you really know that the next 50 years will be similar to the last 50 years?
• A Federal Reserve policy mistake.
• Over-ownership of stocks such as Apple
AAPL, +1.30%
Facebook
FB, +1.36%
Amazon
AMZN, +1.50%
and other large-cap tech stocks.
• Geopolitics.
Ask Arora: Nigam Arora answers your questions about investing in stocks, ETFs, bonds, gold and silver, oil and currencies. Have a question? Send it to Nigam Arora.
Arora’s Second Law of Investing
Investors ought to pay attention to Arora’s Second Law of Investing: “No one knows with certainty what is going to happen next.” The best thing investors can do is rely on probabilities. To figure out the probabilities, at The Arora Report we rely on the ZYX Global Multi Asset Allocation Model with 10 inputs. Please click here for detail of the 10 inputs. The model has a proven track record in both bull and bear markets. In 2008, when most portfolios lost one-half of their value, The Arora Report produced a 45.9% return. This was accomplished through inverse ETFs, hedges and cash.
Right now the model gives a low probability of a crash. Nonetheless, some defensive measures are warranted while holding good positions because the bull market is long in the tooth, valuations are high, interest rates are rising and earnings growth is slowing.
Here’s what to do now
There are several steps you can take now.
• Hold a fair amount of cash. To Arora Report subscribers, we recommend precise levels of cash, Treasury bills or very short-term bonds to hold. Markets are dynamic and this amount is constantly adjusted.
• Hold some hedges. We recommend, monitor and change hedges levels on a continuous basis.
• Reduce beta in your portfolios. In plain English, beta simply means how much a stock or ETF moves relative to the market. Popular stocks such as Nvidia
NVDA, +1.70%
AMD
AMD, +6.47%
and Micron Technology
MU, -1.83%
are high-beta stocks.
• In addition to traditional diversification by asset classes, sectors, number of positions and geographies, diversify by time frames. If things do not work out in one time frame, they often work out in other time frames.
• Have ready access to credible resources of real-time analysis with proven track records. Become familiar with them in advance.
• Focus on special situations.
• Be always in the mode of booking some profits while still holding good positions. Unrealized profits can quickly disappear.
• Use a proven model such as the ZYX Global Multi Asset Allocation Model.
• Use techniques that increase returns and lower risks. I have often written about and given examples of one such technique — trade-around positions.
• Become more sophisticated about stops. Walk away from the simple method of putting all stops at a fixed percentage.
• Learn to short-sell. In short-selling, money is made when stocks fall.
• Become familiar with inverse ETFs.
For the sake of readability, the foregoing has been simplified. Markets are complex and there are many nuances that investors need to understand to be successful if the environment changes from the bullish trend. It is a natural human tendency to suffer from recency bias, the idea that a person most easily remembers something that has happened recently. Recency bias will lead to losses if the market environment changes.
Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. Nigam Arora is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.
Source : MTV
