When the light turns green at an intersection, do you put the pedal to the metal? Or do you ease through with caution? What if there's a pedestrian in the way, heavy traffic ahead or poor visibility? There are compelling reasons to treat each intersection differently. Risk management in the stock market is the same.
Just like road conditions will suggest different speeds, stock market conditions will dictate different levels of exposure. That is, how much of your money available to invest in stocks should actually be invested at that time. That's why we are making an improvement to our website homepage and The Big Picture, one of the most popular Investor's Business Daily features. In this subscriber-only daily column, we give a synopsis of the latest stock market action and analyze the current market condition.
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More Granular Levels Of Exposure
So what's changing? Our Market Pulse had highlighted a three-tiered current outlook: confirmed uptrend, uptrend under pressure, and market in correction. We often referred to these as our traffic signals for the market, with the tiers representing green, yellow and red lights.
But risk management in the stock market requires a little more granularity. When stocks are in a correction, we look for a follow-through day when a major index closes significantly higher in heavier volume. But some follow-through days are stronger than others. While some deliver many stocks to buy, others offer no emerging leaders. And not every emerging uptrend means you should invest heavily.
So to give more guidance and insight, our three-tiered system is expanding to five different levels centered on market exposure that equate to the percentage of your investing portfolio that's invested in stocks:
- 0%-20%: The most cautious level. Put very little, if any, of your investing capital at risk.
- 20%-40%: Remain cautious, with your portfolio tilted toward cash. But you might try out some of your stock ideas when the market starts to improve. If the market is pulling back from higher levels, this might suggest a correction is near and more defense is necessary.
- 40%-60%: The stock market is showing more signs of improvement, so you might put more of your portfolio to work in stocks. In a weakening market, a drop in exposure to this level means you should be raising cash and avoiding new stock buys.
- 60%-80%: The market shows more signs that an uptrend is gaining steam. In a weakening market, a drop in exposure to this level means you cut back on stock buys and take profits on at least some winners.
- 80%-100%: An uptrend is well in place. (But always remain on the lookout for signs of a change in direction.)
Here's an example (not necessarily the current exposure and market analysis) of what you'll see:
Click Here To See The Current Recommended Market Exposure Level
This new tool has more flexibility to communicate where we are on a sliding scale of exposure. Sticking with extremes of either 0% or 100% invested didn't tell the full story. Even our middle ground of 50% could be misunderstood. Was it caution due to weakness early in a rally that suggested a high failure rate? Or a mild pullback taking place in an otherwise strong rally? The five exposure levels allow IBD's markets team more flexibility. They can adapt to ever-changing market environments.
It's Not A One-Way Street
It's no surprise that exposure may go back and forth at different times. Early in a rally you may ramp up quickly. But if distribution piles up, market indexes break below moving average lines or get wildly extended, these are signals to potentially lighten up. So direction matters too. Is exposure in a trend of going higher or is it coming down from high levels to more cautious levels?
Here again, the greater granularity provides more flexibility. A market might start with a follow-through day and get up to exposure of 40% to 60% but then it gets into trouble. We could return to a more cautious 20% to 40% level and only start increasing exposure if the market rights itself. The highest exposure level is reserved for the strongest of markets.
A Model Of Risk Management In The Stock Market
This won't be a new concept for some of our subscribers. More than a decade ago, we launched a workshop titled "Market School." IBD's founder Bill O'Neil guided its development. In it, we introduced a multitiered and automated system for risk management in the stock market. It included buy and sell signals, introduced concepts like the power trend and codified stalling rules. The end result led to a more gradual increase and decrease of exposure levels.
With years of real-time application bolstered by historical back-testing, the gradual increase and decrease of exposure has proved useful and profitable for investors.
We are now applying that same concept to the Market Pulse found in The Big Picture, as well as the ETF Market Strategy and our Leaderboard and MarketSmith products. Subscribers also will find the recommended exposure on the Investors.com homepage.
The new Stock Market Exposure starts with the lowest exposure level of 0% to 20% invested. When a market is in a correction, the dangers of a downtrend are high enough that sitting mostly on the sidelines is preferable to aggressive buying. And remember, leading stocks usually correct 1.5 to 2.5 times the general market. That can make a big dent in your portfolio. Sure, there might be the exceptions of stocks that perform counter to the trend. But overall, applying risk management to the stock market can get you outperformance by keeping exposure low when risks are high and avoiding huge drawdowns.
How It Works In Practice
We'll continue to use follow-through days that inform our decision on when to raise the recommended stock market exposure. A follow-through day under the new system might dictate an exposure level at the 20% to 40% invested level. Or if only a few top-rated stocks appear to be setting up for potential gains, we may keep exposure at 0% to 20%.
Even under the old system, in The Big Picture we often mentioned the idea of carefully increasing exposure. But now it's easier for readers to decipher at a glance. An image will visually show the current level. Explanations will be found in The Big Picture.
After an increase in the exposure level, the feedback of the stock market will inform further moves. Indexes undercutting the follow-through day, a lack of stocks setting up or failed breakouts might be reasons to curtail further buying or even decrease exposure. This might lead to an adjustment in the exposure in a way that wouldn't have been possible under the old system.
On the flip side, we'll be mindful of signals that would suggest increasing exposure gradually. Should you see more days of accumulation in the indexes, lots of stocks to choose from and buyable stocks trending higher, that would suggest a move. Investors could go to higher tiers of 40% to 60% invested, 60% to 80% or the highest tier at 80% to 100%. The speed at which the Stock Market Exposure moves through those levels will depend on the strength of the stock market and the individual stocks leading it.
Greater Flexibility For Risk Management In The Stock Market
Context matters, and the daily price and volume action, support and resistance levels as well as the stage of the larger market cycle are all part of the equation.
When the stock market gets extended, exposure could be preemptively lowered to protect profits. After particularly damaging action, like a vertical violation, the exposure levels will require more proof before edging higher.
Indeed, while the new system is partly rules-based, the decades of experience within IBD's team of markets writers and editors will influence the exposure levels.
Under the new system, investors who follow IBD's ETF Market Strategy will have more flexibility with their buys and sells. A strong follow-through with lots of top-notch breakouts may warrant a 40% initial position. A dubious gain in below-average but higher volume may keep you at 0% to 20% exposure. You can take IBD's exposure range and shape it to your own risk management in the stock market. You might, for instance, find 5% to 10% to be the right exposure for you.
Ultimately, the Stock Market Exposure levels will give you greater insight into how to manage your portfolio in every stage of a bull or bear market.
Follow Nielsen on X, formerly known as Twitter, at @IBD_JNielsen for more stock market content and analysis.
