At Paragon we follow the mantra of the three “P’s” – Private, Proactive, and Protective. These guiding principles direct our unique approach to investment and wealth management. I thought this would be a good time to focus specifically on the Protective side of our investment approach – what we do to monitor and benefit from market movements.
In one of my newsletters, I wrote about how a consistent investment program can minimize the negative effects of inevitable market downturns. Unlike many advisors who talk about accepting what the market gives, we embrace the challenge of getting the best the market has to offer while avoiding the worst. Our portfolios are designed to maintain and/or accentuate the positive movements of the markets while limiting the negative movements. A pretty tall order, right? Well, what else do you hire an investment manager for?
We are often asked about the criteria we use to choose investments for maximum investor benefit. The protective aspect of our investment philosophy leads us to perform quantitative analysis that considers many market indicators to help determine market risk. What is quantitative analysis? I’m glad you asked. Investopedia defines quantitative analysis as “a business or financial analysis technique that seeks to understand behavior by using complex mathematical and statistical modeling, measurement and research.” In other words, it’s a way to objectively measure things.
In the investing world, quantitative analysts are usually stereotyped as pure numbers people who disregard the qualitative aspects (management expertise, industry cycles, labor relations, etc.) of companies or markets. Many investment managers will often adhere to one type of analysis (fundamental vs. technical) while eschewing all others. This is usually a result of their training, education and experience. We find this to be a narrow and incomplete point of view. We don’t believe that any one style of analysis can give a full picture of market behavior by itself. They all have advantages and disadvantages, and we feel it most effective to use the best elements of each style.
At Paragon, we employ a type of quantitative analysis that incorporates fundamental, technical, behavioral and qualitative factors. These quantitative indicators give us a feel for the market at the present time. They help us determine where the strength of the market is, the degree of the strength and any changes in strength that appear to be occurring. We use them to find out what other market participants are actually doing and what they think about both the current market and where it might be headed.
One of the primary models we use is based upon a composition of monetary, economic, valuation and sentiment indicators. This model attempts to identify periods of outperformance and underperformance of the stock market by gauging the external environment of the market while staying in harmony with the primary trend.
Another one of our favorite models is a sentiment model that uses a variety of indicators to measure investor psychology and the changes in attitude as they occur. This model indicates what percentage of all investors can be classified as bullish on the stock market at any given time. This allows us to anticipate reversals in investor psychology, and thus the market. Our policy is to mirror the general sentiment until it reaches an extreme, at which point we take a contrary position. High bullish sentiment has frequently coincided with intermediate-term peaks in stock prices. Conversely, when sentiment has fallen to low levels (meaning investors are bearish), markets have typically been near a bottom. By understanding sentiment we can take advantage of these market movements by anticipating them before they occur.
Another type of sentiment indicator we rely on uses the CBOE Equity Put/Call ratio. When sentiment gets extreme we can use this information to anticipate market movements that are contrary to the general expectations. Put/call ratios track the activity of highly speculative options traders, who are notorious for being wrong when taking extreme action. In practical terms, this means that the S&P 500 tends to perform poorly when an extreme in optimism has been reached. Conversely, extreme pessimism is often accompanied by high market performance. By keeping our eye on put/call ratios we can identify the extreme sentiment levels that tend to precede reversals in the market and move our investments accordingly.
Other models that we use measure items such as earnings yields, Treasury bill yields, price/dividend ratios, median price/earnings ratios and the number of stocks hitting 52 week new highs or lows. By watching each of these indicators we can get a well-rounded picture of the current state of the market as well make good educated guesses about what will happen next.
Our general policy is to stay invested in the market, using these models to assess overall market risk. When our indicators signal an increase in risk, we reduce our exposure to the market by degrees while keeping the majority of the portfolio invested. Only rarely do they signal for us to be entirely out of the market.
While these models do measure a great many financial indicators, they can’t eliminate risk altogether. Many market events are simply unpredictable. The markets, like life, are full of the unexpected, and the only way to succeed is to stay in the game, keep your head up and be as informed as possible.