What to Make of This Week's Sell Down

Investing in equities is like living near a volcano. The carbon-rich soil is fertile, suitable for growing crops. When the volcano is dormant, all is good, the farmer gets abundant harvest, lifestocks expand bountifully. Once in a while smoke erupts from the volcano. Sometimes the ground trembles. These moments cause the farmer to worry whether this is the BIG eruption that will wipe out not only his wealth, but his family as well. If the farmer is extremely cautious and shifts his home everytime the volcano blows smoke, it will be very disruptive to his family and he may end up bankrupt because other lands may have less fertile soil. If he lives "too near the edge", i.e. ignore the warnings too often, or only pays attention to the more extreme tremours, he may leave it too late to save himself.

Investing is like that. You can buy-and-hold, ride out the peaks and troughs, earning that 15 - 20% per annum, but experiencing volatility of being 100% up in a bull year and -70% down in a bear year. You can try to trade more often and exit at the slightest sign of distress, which means that you will probably avoid the volatility of -70% down. But you also miss out on the upside as well. Plus your trading costs will skyrocket. The 3rd way is to trade less, maintain a balance across asset classes and exit equities only on the major bears.

For those who use methods 2 and 3, you'll be concerned whenever we face violent corrections such as the one we experienced this week. Stock markets worldwide fell by around 4 - 6% this week. You'll probably wonder if this is the BIG one; the one that will wipe out your family.

My take is that this is a mild one. There are many indicators suggesting this. Non Investment Grade index has not shot up. 3mth LIBOR - OIS spread is falling. Only the VIX is up to 25. Valuations are still below average, at around 14x. 10y bond yields are still at record low levels. Earnings yield premium is around 4 - 5%. 4 out of 5 ain't bad.

But we should be close to another major correction. I've spoken to some of you to take profit already. Sell in stages, take profit if you have, maintain an asset allocation of around 60 - 70% equities.

I will write more to explain my position later.