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

Updated April 01, 2022

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 2007-2009 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.

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 through 2022. 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?).

Approaches To Asset Allocation

Strategic Asset Allocation

A typical Strategic Asset Allocation portfolio employs a buy-and-hold strategy constructed to include multiple asset classes with emphasis on equities and fixed income. A fixed target allocation for each asset class is then selected. A very simplified example would be 60% stocks and 40% bonds, referred to as a 60/40 portfolio. This allocation is maintained throughout all market conditions with rebalancing as necessary to maintain the target allocations.

Tactical Asset Allocation

Tactical Asset Allocation is an active management strategy that dynamically adjusts a portfolio’s asset allocation to current market conditions with the objectives of minimizing the potential for large losses and maximizing opportunities to improve returns. Tactical Asset Allocation employs a mechanical approach to selection of funds within a basket of low cost index funds.

Asset Allocation Compared: Tactical versus Strategic

We are going to compare Tactical Asset Allocation driven by TAAStrategies Market Conditions Model to 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.

While Open End mutual funds provide greater depth of history; we prefer to use Exchange Traded Funds (ETFs) wherever possible. We will use two Vanguard ETFs with infill from their similarly indexed Open End Funds (OEF) for depth of history.

• VTI (inception 2001) & VTSMX: the Vanguard Total Stock Market Index Fund includes US large, small, and mid cap stocks. Its holdings are nearly identical to those of the equity portion of the Vanguard Balanced Fund. Its OEF equivalent is VTSMX with history back to 1992.
• BND (inception 2007)& VBMFX: the Vanguard Total Bond Market Index Fund, invests in US government  and corporate investment grade bonds.  Its holdings are nearly identical to those of the fixed income portion of the Vanguard Balanced Fund. Its OEF equivalent is VBMFX with history back to 1987.

Comparison Methodology

Our comparison consists of two setups

• Strategic Asset Allocation is represented by holding the Vanguard Balanced Index Fund
• Tactical Asset Allocation is represented by Fund switching using TAAStrategies own Market Conditions Model.

We use the Market Conditions Model to drive our Tactical Asset Allocation 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

Scoring The Results

The Tactical Model is run through four market cycles from 2000 - 2023 to calculate Compound Annual Growth Rate (CAGR), Maximum Monthly and Daily Drawdown, and a number of other performance metrics.

The Tactical Asset Allocation with Market Conditions Model scores impressive returns for the entire 23+ years and for each of the Market Conditions. And the low drawdowns are exceptional. These are the kind of results which can both enhance your lifestyle and allow you to sleep soundly at night.

Once a drawdown has been incurred, the drawdown must be fully recovered before portfolio growth can resume. Big drawdowns require long recoveries. Much of the Tactical outperformance is attributable to drawdowns which are significantly lower than the Strategic. Not only are drawdowns reduced by 46%, but the total gain of the Tactical strategy is 48%+ higher than the Strategic.

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 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

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.