Market Conditions Model Lowers Risks, Improves Returns

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 58 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. The much shallower drawdown from the Market Conditions Model accounts for a good deal of the out-performance in Compound Annual Growth Rate."

What Is The Market Conditions Model?

The Market Conditions Model is a multi-factor model that tracks price momentum, credit risk, market valuation and analyzes the interrelationships of these factors to identify periods of high and low directional probability. The Model identifies three market conditions:

  • 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 extended market Correction (10%+) and Bear Market (20%+) declines and large equity drawdowns.

Tactical Asset Allocation Strategies Market Conditions Model

This illustration shows how the Market Conditions Model categorizes conditions. The black line shows the trajectory of the SPDR S&P 500 ETF (“the market”) from early 2000 through June 2017. 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?).

Tactical Market Conditions and Strategic Asset Allocation Compared

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

Rather than "buy and hold" the fixed 60/40 allocation, we are going to use the Market Conditions Model to drive our investment strategy. There are the 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 the Market Conditions based strategy 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 "The Market" and Vanguard Balanced.

Careful scrutiny of the chart shows much shallower drawdowns which are roughly half of the Vanguard Balanced and roughly a third of the Standard & Poor's 500. Not only are drawdowns reduced, but returns are more than double those of the Standard & Poor's 500 (remember to subtract the starting $100,000 from the ending value to calculate the net change increase in value).

While Vanguard Balanced held a constant equity/fixed income allocation for 19 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 19 years, the Market Conditions Model did a far better job of adapting to market conditions even as the average equity/fixed income allocation 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 Strategy. This strategy employs a very large basket of global funds across equity, fixed income, commodity, and precious metals classes.

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 emphasizes domestic and international equities supplemented with real estate, commodities and fixed income.
  • Balanced Condition: The fund basket includes a mix of larger domestic and international equity funds together with a complement of high quality fixed income.
  • Hostile Condition: The fund basket emphasizes a broad spectrum of government fixed income together with a limited selection of large cap equity funds and commodities.

The first table shows the performance of these highly diversified funds across a full market cycle (see What Is A Full Market Cycle And Why Should I Care?) without the benefit of signals from the Market Conditions Model (note that most investors would be quite happy with this level of return and maximum drawdown):

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):

The final set of three tables shows how each of the fund baskets contributes to the performance of the Adaptive Global Strategy as market conditions change from month to month across a full market cycle:

 

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.

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I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

The primary benefit of minor changes to Adaptive Global is reduction in both Standard Deviation of Monthly Returns and the Ulcer Index:.

  • Fund basket and condition eligibility: no change was made to fund baskets or condition eligibility
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Volatility Weighting was replaced with Limited Portfolio Volatility Weighting which is employed to cap the expected total portfolio volatility when high volatility funds (especially equities and commodities) are used. This slightly reduces both risk and return.
  • Position Optimization: Upgraded which slightly improves holding periods and performance.
  • Full cycle: CAGR decreased slightly from 14.9% to 14.5%;  Max Monthly Drawdown declined from 8.7% to 7.9%; and the Up/Down Ratio decreased fractionally from 226.4% to 226.1%. The Ulcer Index declined from 3.7% to 3.6% and Standard Deviation of Monthly Returns declined from 9.5% to 9.1% reflecting improved consistency of returns.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

The primary benefit of changes to Adaptive Income is a broadening of the fund basket and reduction in both Standard Deviation of Monthly Returns and the Ulcer Index:

  • Fund basket and condition eligibility: the number of fixed income ETFs was increased from 5 to 6 to broaden the basket to include an investment grade ETF.
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Adaptive Income used a single selection with a 100% weighting to the best performing fund. Limited Portfolio Volatility Weighting is now employed to cap the expected total portfolio volatility when higher volatility funds (especially high yield) are used. This forces the allocation across a second, lower volatility fund when the cap is exceeded.
  • Position Optimization: Upgraded which slightly improves holding periods and performance.
  • Full Cycle: CAGR increased slightly from 10.5% to 10.9%; Max Monthly Drawdown increased from 2.9% to 3.8% however Max Daily Drawdown remains unchanged at 7.1%; and the Up/Down Ratio rose from 503.0% to 555.7% (a huge jump in efficiency). The Ulcer Index declined from 1.3% to 1.2% and Standard Deviation of Monthly Returns declined from 5.5% to 5.0%.
  • Note: the increase in Max Monthly Drawdown is directly attributable to the addition of the investment grade ETF. Because the Max Monthly Drawdown remains exceptionally low, this appears to be a reasonable trade-off given the size of other improvements.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

This upgrade to Adaptive Innovation improves performance while significantly reducing volatility.

  • Fund basket and condition eligibility: The existing long duration Treasury ETF was added to the eligible funds for Balanced conditions. This allows strongly performing Treasuries to complete effectively with the Innovation equities for selection. A short duration Treasury ETF was added to provide a higher yielding alternative to cash.
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Volatility Weighting was replaced with Limited Portfolio Volatility Weighting which is employed to cap the expected total portfolio volatility when the higher volatility Innovation funds are used. While Adaptive Innovation typically employs 2 fund selections, this can force the allocation to a third fund when the volatility of the primary fund(s) exceeds the cap.
  • Position Optimization: Upgraded which made no change in holding periods and performance.
  • Partial cycle: CAGR increased slightly from 25.5% to 27.6%,  Max Monthly Drawdown and Maximum Daily Drawdown remained unchanged at 12.2% and 19.2% respectively; and the Up/Down Ratio increased from 277.3% to 329.8% (another big increase in efficiency). The Ulcer Index declined from 5.7% to 5.1% and Standard Deviation of Monthly Returns declined from 15.6% to 14.8%.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.