Sunday, March 11, 2018

Will diversified portfolios be doomed in the next recession?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Neutral*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.

Will Treasuries continue to be diversifiers?
Bloomberg recently reported that Sanford Bernstein declared the 60/40 portfolio to be doomed, because the prices of different asset classes, which were believed to be diversifying, are moving together.

This brings up an interesting point, will bonds do their part to diversify portfolio returns and cushion equity downside risk in the next bear market? In the last crisis, fixed income investments proved to be a poor diversifier as credit spreads blew out, and only Treasuries rallied. In the next bear market, will Treasuries be able to fulfill their role as diversifying investments?

In the wake of widespread worries over the Republicans' latest fiscal experiment with tax cuts during the late phase of an expansion, a number of strategists have voiced concerns about the downward pressure that exploding fiscal deficits would put on the US Dollar. Macquarie pointed out that priming the fiscal pump during a period of low unemployment is highly unusual.

If history is any guide, then the USD is likely to face significant downward pressure in the future as deficits explode upwards.

The FT reported that Vasileiocs Gkionakis of UniCredit came to a similar conclusion.

That got me thinking. A falling USD implies that the market is losing confidence in the value of USD assets. If the greenback is going to be under such pressure, what happens in the next recession?

In the past, USD assets, and Treasury securities in particular, have been the safe haven asset of choice during periods of economic stress. If the USD and USTs lose their safe status, what happens to diversified portfolio returns? Will the decline in their asset values accelerate because bonds, and especially USTs, fall in value along with the price of other risky assets like stocks?

The full post can be found at our new site here.

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