June 27, 2022
Good morning,
I promised elaboration for this morning’s note. A review of the construction of the taxable, liquid portions of client portfolios is overdue.
Like most professions, investment management is full of jargon. I attempt plain speak in my morning notes but am often reminded, especially by newer readers, that I come up short in that effort a lot. Investment management is not that complex, and it should be explained in a transparent, straightforward way. The application however is not easy, and it is humbling. The following is your humbled scribe’s explanation of how I use Technical/Quantitative (T/Q) Analysis to manage client portfolios:
Definitions – these are mine and only for the purpose of explanation, to cut through the jargon, some of which is inescapable because of the way market data is gathered and presented.
*Secular Bull and Secular Bear Markets – (in finance, secular is used to mean long term, normally measured in years)
A secular bull market is a period in which stock prices rise at an above-average rate for an extended period and suffer only relatively short intervening declines. A secular bear market is an extended period of flat or declining stock prices. Since 1900, there have been 5 secular bull markets and 4 secular bear markets.
*Cyclical Bull and Cyclical Bear Markets – (vs secular, cyclical denotes short term, measured in days but often lasting months and occasionally years)
The Wall Street Rule of Thumb defines cyclical moves as plus (bull) or minus (bear) >20% in the S&P 500 Index. Actual criteria for cyclical bull and bear markets in T/Q analysis combine time and price and are used in all historical analysis but the 20% gain/loss rule of thumb holds up well compared to actual data and is sufficient for explanatory purposes. Since 1900 there have been 38 cyclical bull markets and 37 cyclical bear markets as defined by T/QA rules.
*Strategic Asset Allocation
The long-term target allocations (target weights within the portfolio) of assets and sub-asset classes based on factors such as investor’s risk tolerance, objectives, investment time horizon, and the secular trend of the market.
*Tactical Asset Allocation
Modest short-term allocation deviations from the strategic allocation plan based on cyclical trends in the market.
*Recession
Another Rule of Thumb, but again it holds up well enough for explanation. Two consecutive quarters of economic contraction as measured by monthly negative GDP growth.
*Buying Weakness
Buying securities after a market decline. It is often a rebalancing exercise. A market decline should mathematically lower the weight of the declining asset in a portfolio. Absent a change in the tactical or strategic allocation target, rebalancing to target weight is synonymous with buying weakness.
*Selling Strength
During a market decline, tactical and although rare, even strategic, allocation changes are made. Periods of market decline are often accompanied by elevated volatility. If a target allocation change occurs during a market selloff, waiting for an oversold bounce rally within the selloff to rebalance down to the new target is called selling strength.
Within a family’s wealth plan, today’s note speaks to what is often the largest portion of their investable wealth. Money in taxable entities, invested in liquid public securities (stocks, bonds, cash). The investment of non-taxable entities and private investments will be reviewed on another day.
I believe it is crucial to long-term investment success for portfolios to be in tune with market trends in asset classes, geographies, sectors, market caps and styles. However, getting the asset class allocation in tune with the secular trends in equities and fixed income has an overwhelming influence on portfolio performance and is greater than the influence of the other four categories combined.
Secular bull or bear markets typically consist of multiple cyclical bull and bear markets. Historically, and this is key, cyclical moves within their same secular backdrops are exaggerated. In other words, cyclical bulls are much stronger within secular bulls. Cyclical bears have been the worst within secular bears. The contra is true as well; cyclical bulls are weaker inside secular bears and cyclical bears are weaker inside secular bulls. The numbers in the charts below bear this out more clearly than the written word.
Finally, from a methodology perspective, each family has their own strategic asset allocation target, customized to their circumstances, for each of the two secular backdrops. We label the sub-asset class strategic targets as market-weight targets. Each sub-asset class has a cyclical overweight and underweight target band around its market-weight strategic target.
Today and since 2009, we have been investing inside a secular bull market. Last Tuesday, I reported that the probability of a recession had risen considerably based on the synthesis of May’s economic data into NDR’s (Ned Davis Research) Economic Timing Model (ETM). Historically cyclical bear markets when accompanied by a recession are worse than cyclical bears without a recession. Since the likelihood of a recession had risen, a portfolio asset target shift down to underweight for equities within a secular bull seemed called for. However, the move to the lower target should ideally occur on an oversold rally like the one’s in March (+11% on S&P) and May (+7%) oversold rallies. This is commonly called selling strength.
I also mentioned the possibility of a secular change ahead in last Tuesday’s note. However, only that the probability had risen and that for the first time in over a decade it was a non-zero number. It’s not a prediction and I’ll elaborate on the possibilities of a secular change and its implications to portfolios later this week.
Recall the beginning of the year when the base case for equities was a correction or even possibly a cyclical bear market (in our secular bull) without a recession. The average decline for that market set up has been about -20%. We have had that already and the possibility of a recession has turned to probable where the average cyclical decline is over -30%. Hence the call for selling strength.
I hope this helps clarify portfolio positioning and near-term intent, which I muddled in last week’s note.
Be well,
Mike