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Risk Management in the Portfolio Business

S&P 500 with PMODouble Click Image for a Full Sized View

Given the damage done to the markets over the past five or six weeks, I wanted to share with you a risk management discussion.

I’ve talked to you about the fact that we raised cash in client accounts earlier this year when we saw that the market was weakening.  The graph above is one of the primary tools I use to help guide my decisions about when to be aggressive and when to be conservative.

This is a 20 year graph of the S&P 500 Index (the top 1/2 of the graph) along with one of the most reliable indicators I use, the Price Momentum Oscillator (PMO).  The PMO is best used on long-term charts, like the 20-year graph above, and provides an indication of the underlying strength of the market action since it measures the momentum of the market at the current price.  In essence, if the market is being driven higher by fewer and fewer companies, then the momentum is losing steam and the oscillator cross down over its red indicator line much like you see happened earlier this year.  The stock market did not go down immediately as the market vacillated up and down within a narrow range, but we finally got to a point where the buyers took a step back and the market dropped.

You can see that I’ve circled five instances over the past 20 years when the indicator flashed a signal that a change in direction of the market was coming.  In each of those instances, we either got more conservative by raising cash or we got more aggressive by moving to a fully invested equity position.  If you follow the circles on the PMO to the circles on the S&P 500 Index above it, you will see that shortly after the PMO gave its signal, the market change direction.  This is the kind of reliable indicator that you want to follow if you are a portfolio manager because it allows you to manage your risk appropriately.

Now that the S&P 500 is down on the year, lets take a look at our fair value calculation to see where today’s price level for the market is compared to its fair value based on historic mean valuations.

The value of the S&P 500 as I write this is 1892.38

Below I will outline five valuations, four based upon historic means and one a weighted average of the other four:

Price to Earnings Ratio Valuation

     Historic Mean P/E Ratio = 15.55

     S&P 500 Earnings Estimate for 2015:  $129.45

     Fair Value = 15.55 X 129.45 = 2012.95

Shiller P/E Ratio Valuation

     Historic Mean Shiller P/E Ratio = 16.63

     S&P 500 Earnings Estimate for 2015:  $129.45

     Fair Value = 16.63 X 129.45 = 2152.75

Price to Book Value Ratio Valuation

     Historic Mean P/B Ratio = 2.74

     S&P 500 Book Value per share:  $729.29

     Fair Value = 2.74 X 729.29 = 1998.26

Price to Sales Ratio Valuation

     Historic Mean P/S Ratio:  1.4

     S&P 500 Current Sales per share:  1156.54

     Fair Value = 1.4 X 1156.54 = 1619.16

Weighted Average Valuation

     P/E:       2012.95 X 25% weight

+   Shiller:  2152.75 X 25% weight

+   P/B:       1998.26 X 25% weight

+   P/S:        1619.16 X 25% weight

=   Weighted Average Fair Value = 1945.78

S&P 500 Index currently Undervalued by 2.82%

This is obviously not an exact science – you can arbitrarily choose whatever weighting you want to calculate the weighted average.

The point of it is to give us a feel for where the stock market is based upon historic valuation criteria to know from a risk management stand point whether right now represents a decent value to which to commit capital.

In the case above, three of the four valuation methodologies show the market at today’s prices very undervalued with only one showing the market overvalued.   From that perspective, now is a pretty good time to be a buyer, clearly a lot better time than when the S&P 500 Index was at 2100 instead of today’s 1892.

We will continue to invest some of the cash we have on hand as bargains present themselves – however its not likely we will be fully invested in equities until we see the PMO start to reverse itself.

We will also likely use the volatility in the market to book profits where we see fit and to add or eliminate positions as fundamentals dictate.

We will continue on this wild ride in the market and see it through to the end using sound risk management practices, fundamental and technical analysis.  In the end, by managing the process, our clients’ portfolios will be better for it.