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Analyzing Market Risk

Market Risk: Market risk is the challenge of the overall market and unpredictable price swings. I can select good companies and still have them pulled down with a market correction or crash. The Stock market is on the short-term emotional and inefficient. Stocks fluctuate on news stories everyday and this is what creates buying and selling opportunities.Managing these risks it can help you avoid problems and make gains.

I manage this type of risk by following the U.S. stock market value in relationship to their Gross Domestic Product-GDP. I watch the U.S. market because we (Canada) often follow the states. If they crash we usually go with them.

An example is when the banking system in the states had the sub prime crisis which resulted in a recession and a market crash. In Canada our banks were properly capitalized and should not have fallen but still they were hammered along with the American Banks. Below is a graph I showed before on the website, it illustrates the emotional aspect of the market. The green line represents the Gross Domestic Product-GDP of the United States (the value of their products and services produced).

The value of the stock market in theory should increase at the same rate as the economy is growing represented here by the GDP. The blue line is the stock market valuations of all the businesses in the United States. The graph shows the market cap overshot both above and below the GDP line.

This is the emotion of the market. People getting excited and overbuying causing the market to exceed the value of the underlying businesses and people panicking selling the market off to levels that undervalue the businesses.  This is why Warren Buffet says “be fearful when others are greedy and be greedy when others are fearful”. Looking at the blue line for market cap, when it is under the green line is when people are panicked and selling and if I bought in those times you would find my best gains and on the other hand when it is over the green line it is a time to sell or develop a more defensive allocation.

This is a rather simple point of view but it does reflect how I manage my portfolio. When the blue line is below the green line, I can find a lot of businesses selling for less than they are worth which will be covered in the business risk section. This decreases my risk and increases my opportunity for gains. As a result I will hold only a little cash and have most of my resources invested in equities to take advantage of the situation.

On the other hand when the market prices, the blue line, exceeds the green line it is a time when I will sell some of my equities to give me a larger holding of cash. I put some of the cash in treasury ETF’s, which tend to be a flight to safety area in a crash and Preferred shares ETF’s to get some income while I wait for the market to correct. I do not know when it will correct but I now when the market cap value is over the GDP then the risk is higher and the risk that the market will correct is higher.

The first peak, in the graph above, was the dotcom bubble at the end of the 90s and the second peak was the great recession. Both ended up in a crash of the market. Currently we are in what I consider another risk area with the market cap significantly over the GDP so I have 40-50% of my portfolio in treasuries, cash and preferred investments.

I use another version of the chart above which relates the market valuation to the GDP as a percentage. Below is a graph of the Market Cap to GDP as a percentage and below it is the approximate allocations I do in my portfolio to reduce the risk because of the overall valuation.

I allocate my Cash/fixed income in the approximate percentages below based on the above percentages in the graph:

  • market cap to GDP is < 80% =        0-5% fixed/cash
  • market cap to GDP is > 80% =        5-15% fixed/cash
  • market cap to GDP is > 90% =      15-25% fixed/cash
  • market cap to GDP is > 100% =    25-35% fixed/cash
  • market cap to GDP is > 110% =    35-45% fixed/cash
  • market cap to GDP is >  120% =   45-50% fixed/cash
  • market cap to GDP is >  130% =   50-55% fixed/cash
  • market cap to GDP is >  140% =   consider short on market

Fixed refers to treasuries and preferred ETF’s. After 140% I would look at purchasing an ETF that shorts the market which means it increases if the market goes down.

After figuring out my approximate portfolio allocations between equities and cash/fixed income then I screen and analyse businesses.

Next Business Risk and Analysis


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