With the recent revelation from the ECB, and the predictable reaction of market participants, is it time to amplify your risk taking? Quite possibly. On the other hand, there are at least two reasons to exercise some restraint. First, extreme stock valuations challenge the notion that you should always follow the central banks (e.g., Federal Reserve, European Central Bank, Bank of Japan, Bank of England, etc.). Warren Buffett’s favorite measure of stock valuation, total-market-cap-to-GDP, sits at 117.7%. That is the second highest in history and it is higher than the 2007 peak of 110.7%. Market-cap-to-GDP fell to 62.2% at the 2009 March bottom.

In addition to clear concerns regarding fundamental valuation, the most widely regarded technical indicator still points to a long-term downtrend. The S&P 500 has yet to reclaim its 200-day moving average since falling below the level in mid-August. (Note: That might change by the time this article hits the Internet!)

S&P 500 200 Day

 

Prior to the start of the mid-August correction, our tactical asset allocation moved moderate clients from a 65%-70% equity stake (e.g., domestic, foreign, large, small, etc.) to a 50%-55% equity stake (mostly large-cap domestic). Similarly, we shifted the 30%-35% income allocation (e.g., short, long, investment grade, higher yielding, etc.) to something akin to 20%-25% income (mostly investment grade). The aim? Reduce exposure to riskier assets and raise cash equivalents to roughly 25% for a future move back into risk assets.

Granted, valuations represent a significant concern over the longer-term. This bull market in stocks is unlikely to carry on indefinitely regardless of central bank rate manipulation and monetary stimulus. That said, trendlines and other market internals give us the best indication of near-term risk preferences. It follows that a break above 200-day trendline resistance coupled by continued improvement in credit spreads and advance-decline lines would be a reason to put some capital back to work.

Where might I add some risk? At present, our equity holdings include funds like iShares USA Minimum Volatility (USMV), Vanguard Mid-Cap Value (VOE) and Vanguard High Dividend Yield (VYM). Certain sector funds that have already reestablished respective uptrends – SPDR Select Sector Technology (XLK), SPDR Select Sector Consumer Staples (XLP) and Vanguard REIT (VNQ) – are funds on my radar screen.

XLK 200 Day

By the same token, investors may wish to hedge against a longer-term bearish turn of events. The ECB’s comments this morning did not just create demand for “risk-on” assets; that is, “risk-off” assets are holding their own. German bunds catapulted higher on Draghi’s comments. The U.S. dollar via PowerShares DB Dollar Bullish (UUP) skyrocketed. And risk-off treasuries at the long-end of the curve also gained ground.

In fact, a second-half-of-the-year comparison between the FTSE Multi-Asset Stock Hedge Index (a.k.a. “MASH”) and the S&P 500 shows the value of multi-asset stock hedging. Components of “MASH” include zero-coupons, TIPS, munis, long-dated treasury bonds, gold, German bunds, Japanese government bonds, the yen, the dollar and the Swiss franc.

MASH_v_SPX_3

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Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.