Written by Lance Roberts, Clarity Financial
As noted by Sentiment Trader this past week, the CNN Fear/Greed Proxy has turned down recently from very high readings. While this does NOT suggest stocks will crash, it does indicate over the next few weeks returns will likely be more muted with increased volatility.
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With this in mind we can update our risk/reward ranges for next week.
As noted last week:
“The rally reversed much of the short-term oversold condition. While the bulls are in control of the market currently, the upside is somewhat limited. However, the downside risks are reduced with the improvement in the technical underpinnings. Such puts the risk/reward dynamics to a more equally balanced, than opportunistic, positioning. As such, risk controls and hedges should remain for now.”
That advice played out well this past week, given daily swings in the market. While the market was up for the week, it has not reclaimed the June highs. As such, the consolidation continues with risk/reward remaining primarily “neutral” with a “negative” bias.
- -2.6% to breakout level vs. +1.1% previous rally peak. (Neutral)
- -4.5 to 5.4% to 50 & 200 dma support vs. +4.0% to January peak (Neutral)
- -7.9% to previous consolidation peak vs. +5.5% to all-time highs. (Negative)
- -14.2% to previous consolidation lows vs. +5.5% to all-time highs. (Negative)
Reason To Focus On Risk
It seems appropriate to restate something I wrote the last time we saw these types of divergences.
“Our job as investors is to navigate the waters within which we currently sail, not the waters we think we will sail in later. Higher returns come from the management of ‘risks’ rather than the attempt to create returns by chasing markets. Robert Rubin, former Secretary of the Treasury, defined this philosophy when he stated;
‘As I think back over the years, I have been guided by four principles for decision making. The only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty, we must decide and we must act. And lastly, we need to judge decisions not only on the results but also on how we made them.
Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecasted. Such keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.'”
An Honest Assessment
It should be evident that an honest assessment of uncertainty leads to better decisions. Still, the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk, while denial increases it. Another benefit of acknowledged uncertainty is it keeps you honest.
“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”
– Robert Rubin
We must be able to recognize and be responsive to changes in underlying market dynamics. If they change for the worse, we must be aware of the inherent risks in portfolio allocation models. The reality is that we can’t control outcomes. The most we can do is influence the probability of specific outcomes. Such is why we manage risk by investing on probabilities rather than possibilities.
Such is essential not only to capital preservation but to investment success over time.
