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October 17, 2017

In the last commentary I discussed a major market loss like that of the early 2000’s or 2008, as the single biggest risk for most investors. And today I’d like to discuss that risk from an investment strategy perspective.

In the interest of readability, this will just be a cursory look, but I’m hopeful that it may help investors feel a bit more grounded in an environment (like that of the late 90’s) that is leading some to extremes.

Let’s start with the S&P 500 index, and using an index is important because the method I’m about to discuss doesn’t work with individual stocks – an index or quantitative based approach is required.

Next, let’s look at the 200-day moving average (MA) of the S&P 500 index. The 200-day MA is simply the average price of the index over the past 200-days.

From a buy / sell perspective when the current price of the index is higher than the 200-day MA the trend is positive so an investor may consider that a buy – and if the price is below the 200-day MA the trend is negative and may be considered a sell.

Historically the use of this simple trend-following approach has helped reduce losses in significant market selloffs dating back to the great depression.

In fact, in January 2008, the 200-day MA of the S&P 500 turned negative and remained that way until June 2009.

In other words, an investor that was solely focused on the signal avoided the financial crisis almost in its entirety.

Clearly this isn’t rocket science, but it’s also not as easy as it may look at first glance. That’s because faulty signals are possible, and have historically reduced performance in up markets. September 2011 is a good example of a faulty signal. An investor solely focused on the 200-day MA was triggered to sell and then the market quickly rallied (whipsawed) back up.

So how do you reduce the whipsaws and maximize the great signals like 2008? There’s no perfect answer to it, but when other factors are added the hope is that an investor can minimize whipsaw events.

For example: If you overlay recession odds the accuracy of the signal may be enhanced. What that means is that if the 200-day MA signal turns negative but your recession factors do not, then you might choose to ignore the MA signal in totality or in part.

In our investment application of the strategy we use multiple trend factors, as well as recession factors, volatility factors, and long-term fundamentals. It’s also very common for us to ”gradually scale” out of or into positions within a global asset allocation.

The Big Picture

Decades of research and real world application shows that trend-following has historically reduced portfolio drawdowns and improved risk-adjusted returns over a strategic buy and hold approach.

And in my experience, the positive investor behavioral impact of reducing volatility extremes is likely the single most important key to investors weathering the most difficult stages of the market cycle.

Consider for moment, that in the financial crisis, after experiencing extreme market volatility more than a third of all investors fled to cash, and then stayed there for years. In the process, they realized substantial losses in both the present and future value of their financial and retirement plans.

So why highlight this now? Because in my opinion, we appear to be in or at least approaching the latter-stage of the market cycle. And as we’ve seen over the decades, late-stage market cycles are where many investors (especially buy and hold investors) set themselves up for future volatility extremes that go beyond their comfort level.

Rather than stretching risk exposures, it’s precisely at the latter-stage of the market cycle where risk management reaches its pinnacle of importance. And the more late-stage (or extreme) the cycle gets the more applicable and impactful ”downside” risk management likely becomes.

The business cycle in a few months will be the second longest in history, we also have the second or third longest bull market depending on your measurement choice, and market valuation is tied for the second highest in history. Combine that with the Fed trying to change course, and numerous other fundamental headwinds and our present cycle is textbook late-stage.

It’s not often that investors find themselves in an environment marked by the factors noted above, but it’s very important to keep in mind that that doesn’t mean this cycle will come to a quick end. For example, the market extremes in 1998 were similar to todays, yet the US market rose 28% that year and was followed by a 21% gain in 1999.

The present cycle could indeed extend to a record length and/ or valuation for any number of reasons - private sector stimulus, Central Bank activity, healthy earnings growth, etc.. And the demise of the cycle may not be a bear market (as is often the case) it could instead be an extended period of low returns.

So what’s an investor to do?

I think the best advice for investors today is to try to temper strong opinions, stay within your long-term risk tolerance, and invest in ways that provide an opportunity for upside with a clear strategic emphasis on downside risk management.

For now – from a technical trend perspective equities remain positive, and as such I’m encouraging our investors to stay invested at the moderate level of their personal risk tolerance.

As for bonds, trend factors are mostly neutral to negative, given this we remain positioned in the 3 to 9-year range.

In closing, and just a sidebar note, in 2002 I stated that by 2010 ETFs would reshape the investment world. I was early on that call, but today ETFs are clearly reshaping the investment world, and since that’s the case I’d like to make another prediction:

ETFs have made the above strategy easier and less expensive than ever. So the next logical step is that it will (in various forms) likely soon become the wealth management industries dominant core strategy for high net worth investor portfolios.

 

*Past performance does not guarantee future performance.

**There is no such thing as a perfect investment strategy, and investing always involves the risk of loss.