What Is A Market Conditions Model? How Does It Lower Risk?

Updated July 13, 2020

We may be forgiven for chuckling at the Grand Old Duke of York’s obvious exercise in futility, when he marched his men to the top of the hill and marched them down again. However, the perils that made His Grace relinquish that elevated perch are similar to those faced by all investors. Many have seen their portfolios climb to satisfying levels only to witness them fall precipitously thereafter.

Losses are painful, both financially and psychologically and while small losses may be inevitable, large ones can destroy portfolios, and lives. If a portfolio suffers a 20% loss, it must rise 25% to regain its original value. As losses go up, it becomes harder to recover. The 55% loss in the S&P 500 during the last Bear Market required a recovery of more than 100% over a period of 67 months.

Such dismal potential scenarios have prompted another grand figure, Warren Buffett, to formulate two investing rules:

Rule 1. "Don’t lose money"
Rule 2. "Don’t forget Rule 1"

The Market Conditions Model is a way of observing those rules, as far as is possible, in a perilous world.

"Once a drawdown has been incurred, the drawdown must be fully recovered before portfolio growth can resume. Big drawdowns require long recoveries."

Market Condition Defined

Market Condition is a ranking mechanism for risk and reward based on probability:

  • Favorable: A strongly trending market with little risk of major decline. Unexpected declines are likely to be temporary and relatively short-lived.
  • Balanced: Risks of market decline and opportunity for advance are roughly equal; however conditions are supportive of increased volatility and uncertainty.
  • Hostile: High risk of sudden declines, extended market corrections (10%+), bear market (20%+) declines, and large equity drawdowns.

What Is The Market Conditions Model?

The Market Conditions Model is a multi-factor model that tracks price momentum, credit markets, and valuation; then analyzes the interrelationships of these factors to identify periods of high and low directional probability.

Market Conditions 2000 - 2020

This illustration shows how the Market Conditions Model categorizes conditions. The black line shows the trajectory of the SPDR S&P 500 ETF from early 2000 into mid-2020. The colored areas indicate market risk conditions: dark green for Favorable, light green for Balanced and red for Hostile.

The Market Conditions Model measures market conditions in a probabilistic way. For example, it may signal Favorable conditions if there is a high probability of a market rise with low risk. However, a signal of Favorable conditions is not a guarantee of a Bull Market nor does a signal of Hostile conditions presage, with certainty, a Bear Market. However, the three conditions, when coupled with the appropriate fund baskets, work incredibly well in lowering risk and improving returns across full market cycles (see What Is A Full Market Cycle And Why Should I Care?).

Comparison: Market Conditions versus Strategic Asset Allocation (aka Buy and Hold)

Strategic Asset Allocation

We begin with the Vanguard Balanced Index Fund (VBINX), the poster child for Strategic Asset Allocation which is widely considered a suitable core portfolio holding for all investors. Vanguard Balanced applies a fixed 60% allocation to equities and 40% allocation to fixed income.

Vanguard has two index funds which can be used to replicate the equity and fixed income allocations:

  • VTSMX: the Vanguard Total Stock Market Index Fund includes US large, small, and mid cap stocks
  • VBMFX: the Vanguard’s Total Bond Market Index Fund, which includes US government  and corporate bonds

Market Conditions Model

We use the Market Conditions Model to drive our investment strategy. There are three simple rules:

  • Favorable Market: Buy and Hold the Vanguard Total Stock Fund
  • Balanced Market: Buy and Hold 50% Vanguard Total Stock Fund and 50% Vanguard Total Bond Fund
  • Hostile Market: Buy and Hold the Vanguard Total Bond Fund

We run strategies for two full bull and bear market cycles starting with the Bull Market top in March of 2000. The chart shows that this very simple strategy handily outperforms both the Vanguard Balanced Index Fund and the S&P 500.

The Market Condition Model driven strategy delivers a 61% higher Compound Annual Growth Rate and nearly halves the Maximum Monthly Drawdown. (When comparing ending values, remember to subtract the starting $100,000 from the ending value to calculate the net increase in value).

While Vanguard Balanced held a constant equity/fixed income allocation for 20 years (60% equities and 40% fixed income), the Market Conditions Model had a choice of being 100% equity, 100% fixed income or 50% equity and 50% fixed income during any one month. Over the course of 20 years, the Market Conditions Model did a far better job of adapting to market conditions. Interestingly, the average equity/fixed income allocation using the Market Conditions Model very closely approximated the same 60%/40% as the Vanguard Balanced.

Once a drawdown has been incurred, the drawdown must be fully recovered before portfolio growth can resume. Big drawdowns require long recoveries. The Market Condition Model's much shallower drawdown accounts for a good deal of the out-performance.

Lower Risk, Improved Returns

Our Market Conditions Model, which is tightly integrated with our Tactical Model, makes a major contribution to reducing risk and improving returns for our Tactical Adaptive Global and Tactical Adaptive Innovation strategies. (The Market Conditions Model is not used in our Tactical Adaptive Income strategy.)

The Market Conditions Model provides a market condition signal to the Tactical Model at the end of each month. The Tactical Model then uses the condition to select one of three fund baskets to be used for the next portfolio rebalance:

  • Favorable Condition: The fund basket prioritizes investment in risk assets
  • Balanced Condition: The fund basket includes a mix of risk and fixed income assets.
  • Hostile Condition: The fund basket emphasizes risk-off assets

The first table shows the performance of Tactical Adaptive Global across two full market cycles (see What Is A Full Market Cycle And Why Should I Care?) without the benefit of signals from the Market Conditions Model. Most investors would be quite happy with this level of return and maximum drawdown.

Illustrative Performance Table For The Tactical Adaptive Global Strategy Without Use Of Market Conditions Model

The second table shows the results of using the Market Conditions Model to select the appropriate fund basket coupled with the Tactical Model's fund selections. Note the exceptionally high Compound Annual Growth coupled with the exceptionally low Maximum Monthly Drawdown):

Conclusion

There are two kinds of risk ... risk of loss and risk of lost opportunity. Successful investors seek to balance both types of risk in a manner which delivers portfolio growth while managing risk of loss to acceptable levels. The Market Conditions Model is an effective tool for identifying Favorable, Balanced, and Hostile market conditions. Coupling this information with investment strategies which are targeted to these market conditions significantly lowers risk and improves returns. With both equity and fixed income markets at extreme levels of valuations; investors would do well to incorporate Market Conditions modeling into their investment strategy.