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"There's Always a
Bull Market Somewhere"
That may be a cliché, but like most clichés there is also more than a grain of truth in it. For generations, investors have been implored to diversify in order to participate in that bull market, wherever it happens to be. Diversification was considered the closest thing to a "free lunch" that the markets could offer you. By allocating your portfolio among various asset classes (i.e., stocks, bonds, real estate, etc.), investors wouldn't get killed when one sector collapsed - hopefully another sector would be rising. And for generations this advice predominately worked: don't put all your eggs in one basket.
The chart below shows how various assets performed over the last 13 years. In any given year, different asset categories would rise to the top or sink to the bottom. A diversified portfolio made up of equal weights of all assets (the dark green), was never at the top or bottom, but over 13 years it was the third best performing asset, and did so with less risk.
DIVERSIFICATION - The Only "Free Lunch" in Finance has been Eaten
But what happened in 2008? Look again at the chart above and the returns for 2008. The dark green Diversified Portfolio was down -25.67%! While not as bad as the S&P 500, which was down -37%, or emerging market stocks, which were down by -53%, a -25% loss in your defensive diversified portfolio is still a pretty tough pill to swallow.
What happened is Systemic Risk, risk that impacts entire markets, not just individual asset categories. The uncomfortable fact is that we now live in a world that is predominately driven by systemic events. Events that have nothing to do with capitalism or fundamentals, such as;
- Crony-capitalism that misallocates resources and keeps some favored corporations alive long past their "Best-by Date" (i.e. TBTF Banks, auto companies, solar companies, etc).
- The precarious balance between massively over-leveraged governments that can't begin to live up to their promises, and the growing restlessness of citizens faced with generations of lower living standards.
- Central Banks setting rates at zero and buying their own government's bonds, while engaging in a race of competitive currency devaluations.
The investment world is not oblivious to these changes. If anything, the investment world is highly adaptive. The market continually evolves, and the most recent evolution has led to a bifurcation of assets into Risk-On and (a scarce few) Risk-Off havens. Risk-On assets include equities, commodities, REITs, emerging market bonds and currencies, and high-yield credit. Risk-Off is limited to a few sovereign bond markets deemed "safe" for the time being like the US, Germany, and Switzerland, and gold.
The graphs below show how the correlations between developed market equities (DM) and emerging market equities (EM) have increased in the last several years, as well as the increasing correlations between different sectors and even individual stocks.
Global markets used to be divided, where risks in one part of the world would not affect others. Today, valuations are driven by coordinated monetary policy decisions, globalization of supply chains, and capital and labor flows, while investors use algorithmic trading to instantaneously move between Risk-On and Risk-Off. Markets resemble a game of musical chairs played by sumo-wrestlers using fragile chairs.
Here is JP Morgan's view on rising correlation:
This [correlation] trend has been caused by the globalization of economies and financial markets. We believe this globalization, and hence the high cross-regional correlation trend, is not reversible. While region-specific events such as the recent earthquake in Japan may soften cross-regional correlations, markets are not likely to revert to the levels observed in the mid-1990s, when the average correlation between EM benchmarks was close to zero and EM/DM correlation was only ~25%.
This trend of rising cross-regional correlation significantly diminished the once-important diversification benefit of investing across emerging and developed markets. It appears that in the case of cross-regional investing, 'the only free lunch in finance' (a common reference to diversification) has been eaten.
The recent increase of equity correlation has largely been driven by the increased macro volatility since 2007. However, other structural reasons contributed to increased levels of equity correlation. The widespread use of index products (e.g., futures) and high-frequency trading strategies, such as statistical arbitrage and index arbitrage, are likely contributing to increased levels of correlation.
We Don't Make The Rules - But We Play The Game
So this is the New Normal: a world where assets are more correlated, more volatile, and more prone to systemic risks. The investing world is always changing and always evolving, and it is not our job to question whether it is right or wrong; it is our job to figure out a way to adapt and survive. As Charles Darwin said, "It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change."
For me, the best way to be a successful investor is to constantly adapt, and the best way to adapt is to follow the money. Money will always flow to where it is treated the best, and one of the most proven investment strategies is following that money via relative strength. Relative strength or trend following has been around for hundreds of years, and a multitude of academics and researchers have proven that it simply works. Relative strength is price following: when prices of assets increase, that means that money is flowing into them; when prices fall, that means money is flowing out.
Relative strength investing will not get you out at the top or in at the bottom. There is no strategy or guru that can consistently call market tops or bottoms. None. But as asset classes start to deteriorate, a relative strength strategy will rotate your portfolio away from those areas and into something showing strength. This is active asset allocation, also known as Global Tactical Asset Allocation.
Another way to look at relative strength investing is with the old adage that there's always a bull market somewhere. A relative strength strategy seeks to help us identify and allocate assets into those bull markets. Simply shifting assets from areas of weakness into areas of strength greatly enhances returns.
Rockhaven's Focused Tactical Asset Allocation Process (FTAA)
In today's investment world, static diversification simply does not work. Investors need to think of assets in their Risk-On/Risk-Off states, and actively allocate into those areas that are working. Investors also have to be aware of the fact that major systemic shocks (Black Swans) can and will happen, and during those periods the best strategy is often to simply step away from the table (go to cash).
At Rockhaven, we've broken the investing world into the following Risk-On/Risk-Off categories using measures of correlation, volatility, and liquidity:
Risk-On:
US Equities
International Equities
US REITs
International REITs
Commodities
Emerging Market Debt
High-Yield Debt
Risk-Off:
US Government Bonds
Gold
Cash
Once we've divided the investing world into its Risk-On/Risk-Off segments, we then rank each security by its respective relative strength. We then buy the top ranked securities and eliminate the lower ranked securities. If a security's relative strength is lower than the relative strength for cash, we simply own cash. In a period of systemic shock like 2008, we went to 100% cash for 10 months.
The performance of this model has been outstanding. Here are the return numbers since 2008:
The table below shows some Risk/Reward statistics for the period of 2008 through July 2012. While the raw performance numbers are very impressive, what is most impressive is where that performance came from...namely downside protection. The maximum drawdown is the worst trade that you could make over the time period, buying at the high and selling at the low. For the FTAA model, the max. drawdown was only -9.6% versus a max. drawdown of -31.7% for a buy & hold balanced portfolio. Also, the worst one-month return was only -4.55% versus a -11.45% return for the balanced portfolio. But this portfolio is not just about defense; it also performed very well in the strong up markets of 2009 and 2010.
Buy & Hold & Hope is a quaint notion that served us well decades ago, but in today's world of macro risks and manipulation you are exposing yourself to massive drawdowns. Asset allocation is still an appropriate way to manage risk in your portfolios, as long as it is active asset allocation, and as long as you are willing to step to the sidelines during periods of systemic shock. Obviously, none of us know what the future may bring, but at least with relative strength driving our decisions we have the opportunity of finding that bull market wherever it may be.
Be careful out there, and keep the lights on,
Chris Wiles, CFA
President & Portfolio Manager
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For a FREE Investment Consultation with Chris Wiles,
click here or call 412-260-7917
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