Gauging When to Add Risk, or Proceed with Caution

Marc Zabicki (00:00):

When managing a tactical portfolio, understanding investor sentiment can provide a powerful edge when it comes to applying added doses of risk management. In this latest edition of LPL Street View, we'll examine the key data series that helps us, LPL Research, gauge when to perhaps tactically add more risk to portfolios and when to pull back on the reins. As a matter of process, we apply this information to tactical portions of the hundred billion dollars of model assets we manage on behalf of LPL advisors and their clients. So what type of data are we talking about here? In our view, institutional and retail equity positioning data that can help show relative demand for U.S. equities is key engaging when investors are in or out of the market, and is an important factor in determining when markets may be tactically overbought or tactically oversold. Take a look at this chart.

Marc Zabicki (01:06):

Here, we show the Z-score of U.S. equity marketing positioning data to determine how far overall equity buying is deviating from the mean or the average. This chart paints the picture of exactly what we mean. When equity positioning is bullish and it exceeds the positive 1.5 line of demarcation, shown here by the red line, we believe markets can be called overbought, indicating a higher probability of a market drawdown, which means investor sentiment may be at an extreme. The opposite is true when markets get oversold and sentiment dissipates, or when the Z-score falls below the negative 1.5 line in the chart, shown here by the green line. In this case, we believe the data indicates few buyers are coming into the market and thus points to the potential for a near term reversal and market buying activity. What is important to note is that we do not believe these equity positioning Z-scores serve as optimal entry and exit tools or trading indicators, as markets can stay either overbought or oversold for extended periods.

Marc Zabicki (02:23):

However, we use the Z-scores to gauge the probabilities of a turn higher or lower in the market, and we may tactically adjust portfolio risk accordingly. Said another way, the data helps inform us as to when the market may be getting a bit frothy or one sentiment has seemed to bottom out. We use this information to perhaps tactically add risk to portfolios or to reduce risk. We don't necessarily use the data as an indication of when to buy or when to sell. In our view, this Z-score, or any other data point, should not be used in isolation, but as part of a broader investment process we believe it can significantly improve risk adjusted decision making. What does this all mean? Well, by systematically incorporating sentiment extremes in a tactical investment process, we believe you can manage a portfolio that is proactive relative to market conditions rather than reactive. Thanks for listening and as always, allocate wisely.