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. 

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