The TAAS Risk Model signaled a shift to “Hostile” market conditions at the end of November, 2014 with the S&P 500 Index at 2068. During the intervening 17 months, we’ve seen the S&P 500 run 3% higher to 2135, drop 13% to 1867, rally 13% to 2116, drop 14% to 1810, and rally 14% to 2065 where it closed on April 30. The jury remains out on whether the market has topped and is working its way down or has a bit more upside.
Adding up the Volatility
The cumulative effect is an astounding move of 1,145 points or 55% of its starting value of 2068 all for a net change of -3 points. No wonder investors are on edge! We all want to know what the Washing Machine Market is telling us and what comes next?
During this period, the returns from buy and hold have trumped the returns from Tactical Asset Allocation. The S&P 500 with dividends included produced a Compound Annual Growth Rate (CAGR) of 2.24% and the Vanguard Balanced Index Fund (VBINX) with dividends included produced a CAGR of 2.12%. By comparison, the TAAS Core Strategy turned in a CAGR of just 0.22%.
So, it’s time to ditch Tactical Asset Allocation?
The answer is that “it depends”. If your goal is to match or beat the market every year regardless of drawdowns, then you probably should not be using Tactical Asset Allocation to manage your portfolio. On the other hand, if your goals are to minimize portfolio drawdowns, participate in positive market trends, and employ a mechanical rather than discretionary methodology you’ll want to stick with TAA.
Let’s revisit the three strategies to measure Maximum Daily Drawdown (Max DD). The S&P 500 with dividends incurred a Max DD of 13.0% during the past 17 months. The Vanguard Balanced Index Fund (VBINX) incurred a Max DD of 8.5%. The TAAS Core incurred a Max DD of 3.5%. So TAAS Core has done exceptionally well in minimizing portfolio drawdowns.
But why do the returns lag?
Tactical Asset Allocation strategies use momentum to identify trends which are used to shift portfolio holdings into the best performing funds. The major issue is that we’ve had no trend! Equities start to go down, then reverse course. Bonds start to go down, then reverse course. Much of the volatility can be laid at the feet of Fed officials who have, for two years now, been alternating threats of tighter monetary policy while expressing fear of economic weakness. The result is that we are frequently shifting into funds which subsequently reverse course.
Better results from Strategic Asset Allocation?
Ignoring the 13.0% drawdown, the S&P 500 provided a CAGR of 2.24% and the Vanguard Balanced Index Fund (VBINX) a CAGR of 2.14% during the past 17 months … far more attractive than the 0.22% CAGR from the TAAS Core Strategy.
But we should not ignore the 13.0% drawdown! This is the same S&P 500 which incurred a 55% Max DD and VBINX which incurred a 36.0% Max DD during the last Bear Market of 2007-2008. When markets are going against us, we need a strategy which gets “The Hell Out Of Dodge” and Strategic Asset Allocation does not do that.
There is no “perfect” strategy which will never lose money and will always match or beat the market. So why not just switch to Strategic Asset Allocation during trendless markets and Tactical Asset Allocation during trending markets? Let’s assume we adopt two new rules: 1) we shift from TAA to SAA if the market remains relatively unchanged after 6 months and 2) shift from SAA to TAA if the market is up or down by 10% after 6 months. That will protect us from the chop but SAA drawdowns will bury us if the market decides to trend down rather than up.
We simply don’t have a crystal ball which will tell us when drawdowns are about to happen so we stick with what works best over longer periods. Since the start of the last Bear Market in September 2007, the TAAS Core Strategy has provided a 10.47% CAGR with a Max DD of 7.5%.
Why I worry about Max DD in a Washing Machine Market
The huge up and down moves we are seeing arise from uncertainty and instability of which there are two types:
- Sudden bouts of volatility in strongly trending markets. These are often quickly resolved in favor of continuing the underlying trend.
- Prolonged volatility in markets at extreme valuation levels. This is where we often see reversals leading to strong new trends and where I believe we are now situated.
The Historical Valuations paint a picture of valuations which are more likely to be at extreme highs than extreme lows. My concern for Max DD arises from the fact that conditions appear propitious for a new trend to the downside. Under current conditions, I want to be invested in a strategy which places first priority on protection of capital. The TAAS Core Strategy is that strategy because it can shift into Treasuries and cash when other assets are generating negative returns.
Light at the end of the tunnel
The best thing about major declines is that they are followed by major rallies. That’s where the second leg of the TAAS Core+Satellite Strategies comes into play: “participate in positive market trends”. First the Core Strategy shifts investments toward equity funds and then, when the Risk Model signals “Favorable” market conditions, investment can be further shifted into higher returning funds.
In other news
- I have returned to active research with the TAA Model and some fresh strategy ideas. I completed some refinements to the Satellite portfolios which improve on both CAGR and Max DD. The backtest charts and tables have been updated on the website and both Satellite Strategies are ready for use when market conditions turn Favorable.
- I am also in advanced stages of evaluating some minor improvements to the Risk Model.
- I am doing some research on a new Global version of the Core Strategy which would increase both global and commodity exposure without raising Max DD. That’s a tall order so it will be done very carefully, if at all.
- Finally, the website launch special of 15 months for the price of 12 will come to an end on May 31.
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