Friday, March 25, 2016

The Current Market Environment and Implications for Tactical Asset Allocation Part III

As I write this the market has gone through what looks like another V shaped correction.  After a few of these types of moves in succession we can no longer call it a fluke, it may not be the new normal but we have to expect that these types of moves will be more common in the future.  Buy and hold and asset allocation don't handle these types of moves well.  They experience all the downside and then ride the market back up, ultimately not going anywhere but having a wild roller coaster ride with all of the emotional minefields that causes.   Asset allocation strategies also have asset classes that move down more than US stocks, magnifying losses.  Traditional tactical strategies don't offer much of a solution to these types of environments.  They can lower the losses on the downside, and if a correction turns into a bear market they come out like heroes.  But, if the correction quickly reverses tactical strategies will take a while to get back in and experience the gains.  These types of strategies look to latch onto trends that last weeks or months, but in this new environment trends are now lasting hours to a couple of days.  By the time a traditional tactical strategy reacts the trend has already changed.  

Investing in the market involves risk and reward.  A good investment strategy has the proper balance between the two---the less risk and more reward the better.  To improve an investment strategy you can increase reward while keeping risk constant, lower risk while keeping reward constant, or any combination that increases the ratio.  Buy and hold and asset allocation will always have a terrible risk reward ratio, there are large potential rewards but the risk is huge.  Traditional tactical strategies have much better risk/reward ratios but if this choppy market environment persists and we don't see a bear market soon it will be difficult for investors to see that.  Similar to this concept is the idea that every investment strategy has its Achilles Heal, the market environment that it just won't perform well in.  Another key then to improving an investment strategy is to make its Achilles Heal as insignificant as possible.  This is impossible in buy and hold and asset allocation as these types of strategies will always ride a market down, reducing the Achilles Heal would involve turning these into tactical strategies.  Traditional tactical will not perform well in choppy markets, this is not significant if markets are trending most of the time, but in this environment all we have seen are choppy markets for two years, making the Achilles Heal much more significant.  The key to improving tactical strategies is in reducing this Achilles Heal and making it much less significant.  The key to this is understanding that time frames have changed and tactical strategies have to be even more responsive to market shifts than ever before.

In the past, running a tactical strategy could be simple, you could just apply a 200 day moving average to the S&P 500 on a monthly basis and rotate in and out at the end of the month.  You would never get out at the top or in at the bottom but trend changes gave enough warning that you didn't need to.  Today, trend changes can happen in an instant, giving no warning at all.  There is still a place for looking at multi month momentum but it can no longer be the centerpiece of an investment strategy.  Markets are too choppy month to month.  There is one place however where momentum still exists, that is intraday.  In this new environment, what happens day to day is much more important than ever, the market can go up or down massive amounts in the space of a couple of days and the shift can happen intraday.   The key to improving the performance of a tactical strategy in choppy markets then is to combine strategies that have much shorter holding periods, from a couple of hours to a couple of days, with traditional longer term strategies.  These strategies can take advantage of the momentum that is still present during a trading day or overnight, without experiencing the gut wrenching ups and downs of a longer term approach.  A market that ultimately goes nowhere has enough of these short term movements that a tactical strategy using short term strategies can make money regardless of how choppy the market is.  Applied appropriately these types of strategies can shift the Achilles Heal of a tactical strategy from a choppy market that lasts over a couple of weeks or months to a choppy market that lasts for a day.  So instead of having problems navigating a market that can move up or down 10% or more over a couple of weeks, which is easy to navigate using short term strategies, the problem shifts to choppy markets intraday that might move up and down 1-2%.  This makes the Achilles Heal of a tactical strategy much smaller while at the same time reducing risk and increasing potential returns. 

Tuesday, March 8, 2016

An Example of Forward Looking Due Diligence in System Development

When most investors do due diligence they look at past returns and expect them to persist into the future.  Unfortunately, they rarely do.  Forward looking due diligence takes past returns with a grain of salt, the goal is to determine where the returns came from and how likely they are to persist.  Forward looking due diligence can be done on money managers, investment strategies, and tactical methodologies.

We recently developed a model for the SPDR S&P 500 ETF (SPY).  The model can either be long SPY, short SPY, or in cash.  From 3/7/2011 to 3/7/2016 it makes $142.6 on one share of SPY, not including any dividends.  For comparison to buy and hold SPY opened at $132.86 on March 7, 2011 and closed at $200.59 on March 7, 2016, so buy and hold would have only made $67.73.  So far so good, our strategy  more than doubles buy and hold over this period.  If we look at the annual returns of our strategy it would have also made money ever year with a low of $3.75 in 2014 and a high of $55.28 in 2015.  Still so far so good.  However, over the past 12 months the strategy made $81.14 and it made $28.24 in February, $14.18 in December, and $14.66 in September.  Those are the best, third best, and fourth best months for the strategy over 5 years, and they all happened within the last 12 months.  On the one hand this tells me that the strategy will do its best in a troubled market.  One the other hand I am worried about whether returns like this can persist.

Backward looking due diligence would place a lot of money into this strategy expecting these recent returns to persist.  In fact our optimization program wants to allocate 50% or more to this model.  Forward looking due diligence is much more cautious.  Yes the strategy has done exceptionally lately, and yes we are likely to stay in a market environment that is conducive to this strategy.  However, the strategy has done so well that the returns actually border on ridiculous, they could persist but they could also revert back to the mean.  Looking at the monthly returns the strategy is up 6 months in a row (March is currently down).  It has only done that once before.  This could be the best model we have ever developed but we have decided to limit exposure to 12.5% until we have a bad month or any type of drawdown. 

Monday, February 29, 2016

Using Intra-Day Models to Improve Tactical Asset Allocation

Just about any form of tactical asset allocation (TAA) will work extremely well in a straight up market and a straight down market.  However, many methodologies will struggle in a choppy market that either has no real trend or that moves so quickly that a TAA strategy just doesn't have time to adjust.  In the past I have written about a number of different ways to improve the way TAA strategies navigate choppy markets, this post will talk about adding intra day models. 

The main reason that TAA works so well is that markets are not random.  For the random walk theory to be valid the day to day movements in the stock market would have to be like a coin flip, where what the market does today has no bearing on what it will do tomorrow.  Markets don't work that way.  They move back and forth between trend following environments, where an increase today is likely to be followed by an increase tomorrow, or mean reverting environments, where an increase today is likely to be followed by an increase tomorrow.  However, in a choppy market the day to day movements do start to become more random in nature and each day becomes less motivated by what happened previously.  At the same time choppy markets tend to be more volatile and the spread between the open price of the market and the close tends to widen out. 

Just like markets tend to trend over longer term time frames, they also tend to trend during the day.  Ghao, Han, Li, and Zhou wrote an interesting paper in 2015 showing that the first half an hour return in the market tend to predict that last half an hour return.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2552752

This means that a momentum model can be constructed for intra day trading just like a momentum model can be constructed for longer time periods.  This offers a number of important advantages:

1. In a choppy market there is no real momentum over longer time periods but this should not impact momentum intra day.

2. In a choppy market the risk of holding positions overnight increases, intra day models close out all positions at the end of the day and start fresh the next day.

3. In a choppy market most TAA models would be out of stocks entirely and would not be able to participate in gains on up days.  Intra day models can participate in up days.

Intra day models can substantially improve TAA strategies by allowing them to do better in choppy markets and participate in intra day gains when  they normally would not be positioned in stocks.

Thursday, February 4, 2016

Why We Use Counter Trend Models

Counter trend models seek to buy into market weakness and sell into market strength.  They expect that markets overreact and will be mean reverting in nature.  When the market rallies they expect that the market will go to far and that some of that rally will eventually be retraced.  When markets decline they expect that market will overreact and some of the decline will eventually be retraced.   Because these models go counter to the trend I sometimes get questions from clients who wonder why we are buying when the market is going down and why we are selling when the market is going up. 

Counter trend models shouldn't be looked at in a vacuum, they are part of a diversified tactical portfolio.  Imagine a world where traditional asset allocation actually worked like it was supposed to and you had a diversified portfolio of all different kinds of stocks and bonds.  Lets assume you also had an allocation to an alternative asset class like managed futures.  In 2008 your stocks would have declined, your bonds probably would have held steady, and your managed futures would have gone up a lot.  You may not have understood why managed futures went up, typically these strategies are a black box, but you wouldn't have questioned it.  Then in 2009 your stocks would have gone up and your managed futures might have gone down.  Now you would start to question why you have an allocation to managed futures, conveniently forgetting that they saved your butt in 2008.  Of course this isn't the right way to think, you can't take one asset class out of a diversified portfolio and look at it under a microscope, you need to look at it as part of an overall portfolio and as a diversifier. 

So why do people sometimes have trouble wrapping their head around a counter trend methodology?  I believe that in our minds we are all trend followers, we believe the most recent past will equal the future.  So if the market is up big one day we think it will continue to go up, and if it is down big one day we think it will continue to go down.  We then have trouble understanding why you would sell into a rally and buy into a decline.  However, the data supports the fact that markets really are mean reverting.  CSS Analytics did an interesting study on the frequency of daily runs by decade:

https://cssanalytics.wordpress.com/2009/09/20/runs-by-decade/

They basically looked at each decade from 1950 to 2009 to see how long market runs were.  What they found was that in the 50's one day market runs, meaning the market went up or down and then reversed the next day, happened only 40% of the time.  Meaning that if the market went up or down today it had a 60% chance that the next day would be in the same direction.  Fast forward to the 2000's and one day market runs happened 53% of the time, meaning if the market went up or down today you have a 53% chance the next day will reverse. 

I found similar study on the woodshedder blog.  They tested a daily follow through strategy vs. a daily mean reversion strategy.  The daily follow through strategy would buy when the market was up and sell short when the market was down.  The daily mean reversion strategy would do the opposite.  what they found was the daily follow through strategy was only profitable 34% of the time and would have lost money.  The daily mean reversion strategy was profitable 64% of the time and would have made money.  The results are below:

http://ibankcoin.com/woodshedderblog/2010/07/11/daily-follow-through-mean-reversion-and-a-secret-ingredient-part-2/

http://ibankcoin.com/woodshedderblog/2010/07/17/daily-follow-through-mean-reversion-and-a-secret-ingredient-part-3/

So the disconnect is simple, in our minds we are trend followers and in reality markets are mean reverting.  When counter trend methodologies are doing well there is no problem but when we hit a period where counter trend methodologies struggle then we get the disconnect. 

In a tactical portfolio counter trend methodologies are a powerful diversifier to trend following methodologies.  They tend to do best in market periods when trend following methodologies do their worst and they can profit in bear markets without having to go short.  Where they struggle is in market corrections where weakness continues for a long period without enough strength to sell into.  There are a number of things you can do to minimize the impact of this in the overall portfolio..

Thursday, January 28, 2016

Forward Looking Due Diligence

One important skill we try to teach financial advisors is how to do forward looking due diligence on money managers and investment strategies.  Backward looking due diligence looks at what a manager or strategy did in the past and assumes, usually wrongly, that past performance will persist.  It is the path of least resistance as it is easy to just look at a stream of returns.  Forward looking due diligence tries to figure out whether past performance will actually persist into the future. 

Forward looking due diligence involves answering a couple of key questions:

1. How was the past performance achieved?
2. Why will it persist into the future?
3. And, in the case of a money manager, how will you change your strategy when market dynamics change?

As an example, lets say we are going to do due diligence on a large cap growth money manager and it is March 1, 2000.  If we do backwards looking due diligence all we would do is look at past returns and call it a day.  The manager would have had stellar returns from 1995-2000 and we would make the assumption that they would persist.  Of course we would have been horribly wrong as the manager would have tanked from 2000-2002.  Forward looking due diligence would have sniffed this out by answering the key questions:

1. How was the performance achieved?  You don't need to know the intricacies of the manager's strategy or how they pick stocks.  The answer to this question is simple, large cap growth stocks went up like a rocket ship in the late 1990's.  Since this manager owned large cap growth stocks they rode the market up. 

2. Why will this persist into the future?  Here is the problem.  Growth stocks earned about 30%/year for five years.  That's great but long term returns on stocks are closer to 10%.  Since we know markets mean revert it is safe to assume that not only can't the manager return 30% a year, they also need some losses to get back to more normal average returns.

3. If market dynamics change how will this manager's strategy change?  Here is another problem.  If market mean revert it is safe to assume that at some point we would need to see a bear market.  Since this is a buy and hold money manager they ride the market up, and they ride the market down.

Forward looking due diligence would have failed this money manager on two out of the three questions and it wouldn't take any advanced financial knowledge to figure this out.

Now lets say we are looking at a tactical manager who uses a simple strategy of buying the S&P 500 when it is above its 200 day moving average and selling below.  This strategy would have a very strong backtest most likely showing returns equal to buy and hold with less volatility.  The answers to the three questions would be as follows:

1. How was the performance achieved?  It was achieved because over the intermediate term markets trend.  This is based on psychology and the fact that once the smart money has started to buy or sell something it takes the dumb money a long time to join in.

2. Why will this persist?  Again since this is based on psychology the performance will persist, but we have a small problem here.  Since the manager uses only one methodology there will be times when it cycles in and out of favor, and when it cycles out of favor it can cycle way out of favor.  The performance will persist but it might not be ideal.

3. If market dynamics change how will this manager's strategy change?  This is the make or break question here.  Since we know the strategy will cycle in and out of favor and market dynamics could change to the point were it cycles out of favor more than it cycles in, it is very important to know if the manager is willing to improve their strategy if need be.  If the answer is no then it is time to move on.

Most of the biggest investment mistakes are made because investors only use backward looking due diligence to evaluate opportunities.  Forward looking due diligence can avoid many of these mistakes.

Tactical Diversification

In traditional asset allocation the goal is not to find the "best" asset class, it is to find the best combination of asset classes that gives the client the best chance of achieving the desired result.  Each asset class, be it large cap growth, value, small cap, etc, goes through periods where it appears to be the best.  Imagine you were doing due diligence on a large cap growth manager in March 2000 and looking at how they had done over the past five years.  It would be easy to fool yourself into believing you found the Holy Grail.  The same would go for any asset class, that is why you are better off combining asset classes than you are trying to be in just one. 

The same logic works in Tactical Asset Allocation .  There are a number of tactical methodologies (sets of tactical rules) that work over time.  Things like buying the S&P 500 when it is above the 200 day moving average and selling below or using a 2 period RSI to determine overbought and oversold points will have periods where they will do extremely well.  It is also not a rare occurrence to do a backtest on a set of rules and find that it does extremely well over the entire backtest period.  Tactical methodologies be even more misleading than asset classes as they can go through much longer periods where they are doing well than an asset class can.  However, just like there is no one best asset class, there is no one best tactical methodology.  Every methodology will fall on its face at some point.  Instead of expending effort to find the one methodology that does well in every market, the goal should be to have a mix of different methodologies and expend effort finding the combination that produces the desired results.

Wednesday, January 20, 2016

A Shorter Bear Market?

Nobody can predict the markets but it is useful to look at a number of different possible scenarios to make sure you are prepared when/if it happens.  This recent decline in the market has brought about a possible scenario involving an abbreviated bear market.  We have had three bear markets in history that haven't really lasted that long:

1. 1957 3 Months -20.7%
2. 1962 6 Months -28%
3. 1966 8 Months -22.2%

The sharp decline the market has had since December 2 increases the possibility that we are in another short term bear market.  If this is the case then the lower price target on the S&P 500 would be around 1630-1730 (1737 is the February 2014 low which would be the next major support area if we break the October 2014 lows).  If this scenario actually plays out the market could actually reach new highs by year end.  The Fed will have a lot to say about this, they are probably one and done for now until things stabilize, but things get really interesting if they reverse the December rate hike. 

Another possibility if this is a short term bear market is that we don't reach new highs but we bop around between the new lows and old highs.  For anyone who likes turbulence on a plane this scenario would be lots of fun.

There is still the disaster scenario if the oil continues to decline and China implodes.