There are a number of different schools of thought on positioning your portfolio for momentum crashes caused by the herding effects of overcrowded trades. Historically speaking, it rarely makes sense for investors to move to 100% cash to try and avoid a large S&P 500 SPX, -1.11% drawdown. No one over a market cycle can generate alpha by calling market tops and bottoms.

Although that doesn't mean investors can't tactically hedge or better yet raise cash levels when markets become overbought on a technical basis. For our purpose, we measure overbought markets measured by technical metrics on an intermediate-term basis (90 to 250 days).

In our April column, “Is the S&P 500 about to correct,” we discussed using the iVIEWMarkets sentiment indicator to reduce equity exposure at a 60 reading. The reading maxed out at 64.90 on June 10. As a reminder, this is not an indicator to attempt to call market tops or bottoms, we are strictly looking at market momentum exhaustion points to increase or reduce equity risk.

In my opinion, investors are increasingly more at risk of momentum crashes as factor-based and quant funds grow in popularity and raise more assets causing crowded trade behavior. Many of these strategies encompass momentum-related factors.

As this investor class grows in assets, the markets will experience more and more momentum crashes from a result of herding effects. Typically, these funds use the same momentum factor by buying the strongest stocks on either a six- or 12-month relative strength time frame, also known as relative strength. While relative strength is an excellent strategy for achieving above-market returns, it is not prone to nasty momentum crashes. While there is absolutely no good way to forecast volatility effectively or foresee momentum crashes, we want to mitigate them as much as possible.

As we saw in the selloffs of August of 2015 and January 2016, long-only investors ran for the exits first, selling the biggest gainers which were the 12-month greatest returns. We are seeing a similar pattern once again with recent momentum within utilities, REITS and higher-yielding names as the 10-year yield remains suppressed.

So how can investors mitigate the impact of a momentum crash?

1. Use a top-down approach utilizing the iVIEWMarkets S&P 500 sentiment index. Look to reduce equity exposure once the index reaches the upper bands. You can use it for free found here.

Look to reduce equities with heightened short-term volatility if their respective ATR significantly expands.

Reduce your highest six-month beta positions, typically above 1.40 works well. Beta longer than six months will not be as effective as it smooths out the volatility too much.

Also, look to reduce stocks with the greatest 12-month returns within your portfolio at peak S&P 500 exhaustion levels in the index.

Look for countertrend weakness. You can use the RSI Index for those positions that have a decreasing RSI greater than 80. While RSI is not the best tool for countertrend reversals because it's not smooth, it's a good start.

2. This process also can work well for mean reversion for oversold S&P 500 rallies for potential “V”-shape recoveries.

Look for the iVIEWMarkets sentiment Index to rebound off lower levels of -50 or less for the most substantial rallies.

Look to allocate to the highest six-month beta stocks within the S&P 500.

Look to allocate to equities the greatest 12-month returns.

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