By: Jeff Yastine — July 16, 2021
How to Brace Your Portfolio for a Market Correction
It’s the doldrums of summer. The market moves inexorably higher. The talking heads on CNBC tell us “C’mon on in, the water’s fine.”
But in our hearts and minds, we know there’s something wrong.
For instance, with our US Industry Bell Curve -- available to premium subscribers of Sector Prophets Pro -- we’re seeing lots more sectors turning red.
(Click any image to enlarge)
We have 38 red bearish sectors, meaning they’re in an “O-column” on their respective Bullish Percent Index (BPI) charts…
… and just seven blue sectors that are in an “X-column” on their BPI charts.
We’re also back to an unhealthy “winner-take-all” market environment driven solely by gains in just a handful of the biggest stocks.
Perhaps the biggest case for a bearish climate is that the granddaddy of all indicators, the NYSE Bullish Percentage Index (BPI), just switched to a column of O’s after four months (March 16) in X’s.
This means the NYSE BPI is now on a Bear confirmed status, as the chart is on a Sell signal and below the 70% overbought level.
This is a big deal because a column switch from X’s to O’s requires a 6% (or "three box") move. In another words, a net 6% of NYSE stock have to go on point-and-figure Sell signals on their own price charts.
It takes a lot of selling by the big institutions for that to happen. So more and more stocks are participating in the bearish trend.
Be sure to read, Here’s the Sector to Look at While the Market’s in Turmoil, from Costas Bocelli, and Technical Tuesday - Declines to Come and Strength to Follow, by Chris Rowe for more on the bearish outlook.
Of course, the climate could change for the better if -- like last fall -- we see a strong fund rotation out of large-cap stocks and into small- and medium-sized companies in preparation for the next advance.
But last year’s rotation still took all the indexes down 10% -- a painful correction for the unprepared.
You can’t control the market, but you can take two actions to help yourselves whether or not the broader market sees a correction.
Portfolio Bracing Move #1 - Use Position Sizing to Manage Your Risk
I don’t know a single trader (myself included) who hasn’t wrecked their own portfolio at least once -- because they bought too many shares of stock (or became too concentrated in a group of stocks like Technology), and then watched them fall in unison 20%... 30%... or more.
Position-sizing is sort of like remembering to drive at a slower speed when it’s raining. You may not avoid an accident completely, but it could mean the difference between a fender-bender, or a damaging crash.
If you still want to buy stocks, you can make sure you’re not taking on too much risk by using our Position Size Calculator, (a tool available to Sector Prophets Pro subscribers).
The Position Size Tool measures risk when we buy a stock, based on five key variables. It calculates the number of shares you should buy based on those variables.
And the most important variable is the percentage loss you’re willing to accept from your total portfolio’s value (“maximum allowable risk”) before crying “uncle” and hitting the sell button.
Portfolio Bracing Move #2 - Raise Cash
The second thing you can do to prepare for a potential correction is to cull your stocks a bit and raise cash levels in your portfolio.
It’s hard to do when the indices making headlines continue to edge higher day after day.
But when a correction comes, if we know we have a chunk of cash to draw from, we’ll have a lot more confidence to buy when stocks reach a bottom.
The alternative is to be stuck holding what you own (potentially at a bigger loss than anticipated) while you wait for those positions to come back. Not all of them might.
Or you could be forced to add funds to your trading account from a bank account, or borrow on margin, or sell existing positions (again, possibly at a big loss) in order to take advantage of new post-correction bargains.
Yes, I know in the world of professional portfolio management, holding more than a few percentage points of cash at any time is considered verboten.
But pro fund managers have a steady supply of fresh cash coming in every two weeks from customers’ 401k and IRA retirement programs. Even in a rough bear market, they’ll always have “new cash” to put to work.
For the rest of us, there’s no one to bail us out when our portfolios take a dive.
Guest Editor, True Market Insiders