Understanding the Market Environment
Traditional asset allocation fails investors when they need it most – in major declines when correlations between asset classes increase and values decline in tandem. We have seen this happen over and over again in every bear market. Prudent asset management requires that we add a new parameter to our investment decisions – an understanding of the current market environment. We need to know when to be on the offense and when to be on the defense.
Among the tools that I subscribe to is a Market Environment Indicator (MEI), a broad based indicator that signals what we expect to be intermediate term moves. This signal is used because it meets key success parameters:
- It should be right more than it is wrong.
- But more importantly, the ‘wins’ when right should be bigger than the ‘losses’ when wrong. When the signal is correct, it has led to either participating in large advances (2009-2011) or avoiding large declines (like 2007-2009). When wrong, the losses or missed buying opportunities are small and short.
Naturally, past performance is never a guarantee of future returns. Every investment strategy has the potential for loss as well as gain. With that caution, the MEI measures the trend and momentum of +100 sub industry groups, similar to the ones that make up the S&P/MSCI Global Industry Classification System. Each sub industry group’s price is equal-weighted, eliminating the distortions large capitalization stocks have on many indexes.
Trend indicators are based on moving averages, mathematical measurements. Momentum is a measurement of the rate of change of the sub industry’s price index. These are combined with shorter term bullish and bearish signals. The goal of the MEI is to aligned client portfolios with the direction of the broad market. “Don’t fight the tape” is a long-time Wall Street adage that holds true today. If the market is down, assets should be positioned to avoid the decline. If the market is up, we want to be participating. This is the core of active
management.
Implementing Active Investment Management
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