Volatile Times

Month of May: Sell and Go Away, or Hang in There? (Sonders)


Tuesday, May 15th, 2012

 

May 14, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

  • We believe the stock market’s correction is likely to be less severe this year relative to 2010 or 2011.
  • Be aware of the possible perils of following a “sell in May” trading strategy.
  • For now, macro concerns—including Europe and the looming “fiscal cliff”—are trumping better micro news.

The stock market is in correction mode and investors are on edge. There are likely several reasons for the weakness, including what we pointed out in our early-April report on elevated optimistic sentiment. Since sentiment tends to work a contrarian magic on the market, we were anticipating a period of consolidation after the stellar six-month, 30% run off the early October 2011 low—and we’re getting it.

Of course, we’re also yet again dealing with the eurozone debt crisis, but also choppier economic indicators in the United States recently, a volatile election season and concerns about the so-called “fiscal cliff” heading into the end of this year. But one of the questions I’ve gotten most often recently has been about the seasonal phenomenon called “sell in May and go away,” and whether the market’s in store for another summer swoon like we’ve had the past two years.

Macro trumping micro

I’ll start with “sell in May,” but before I do, I want to address an important general observation. As we’ve noted many times recently in reports and media appearances; and as detailed in a terrific recent report by Wall Street research firm Wolfe Trahan, macro is trumping micro. One of the reasons for this is the decline in guidance investors are receiving from company managements.

In the past, guidance was often an anchor of reason in volatile times. Events like European elections or spiking eurozone sovereign bond yields might not have been such big market-moving events when we could rest on US companies’ guidance as to the future. Add to that rapid-fire trading, shortened time horizons, greatly increased access to information, greatly increased speed of news’ dissemination, and much more globalized economic and financial systems, and you have a recipe for increased volatility around macro events.

Sell in May?

Much is made every year of the “sell in May” phenomenon. Its basis is rooted in the fact that the best performance for the market has generally come in the November through April period, while the worst has come between May and October.

There is some truth to the adage. According to data compiled by Ned Davis Research (NDR), through the beginning of May this year the average performance for the period from May 1 through October 31 each year since 1950 was 1.2%. The average performance for the period from November 1 through April 30 each year since 1950 was 7.0%.

As compelling as those numbers may seem, there are many things to consider, especially if it’s your inclination to develop a trading strategy around those seasonal patterns. First, the calendar months individually tend to fall into either the “hot” or “cold” columns for performance, as you can see in the table below. Three of the six months that fall into the “all out” period spanning from May through October are actually historically strong months, while three of the six months that fall into the “all in” period spanning from November through April are actually historically weak months.

Sell in May?

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of 1928-April 30, 2012.

As you can see, all of the seasons seem to be adequately represented in both columns. And what we know for a fact is that time horizons have become much shorter over the recent years, and the reaction function gets triggered more often. It’s likely that many investors may find their patience tested when experiencing either a great month (or two) during the May-October “all out” period and/or a poor month (or two) during the November-April “all in” period. Of course, the seasonal trading strategy must consider transaction costs and tax implications.

Sector performance May-October

For investors who like to take a tactical approach to the seasonal tendencies, a sector bias strategy may be worth considering. Before I get to the details, let me remind our clients that we moved toward a more sector-neutral strategy back in early April when we became more cautious about the market in the short term. Presently the only outperform rating we have is on the information technology sector, while the only underperform rating we have is on the utilities sector.

As you can see in the table below, courtesy of The Leuthold Group, cyclical groups have tended to outperform during the market’s traditionally strong November-April period, while defensive sectors have been the relative winners during the customarily weaker May-October period. In fact, the size and persistence of these effects have been impressive (at least since 1989, the span of the analysis).

S&P 500 Sector Seasonality

S&P 500 Sector Seasonality

Source: The Leuthold Group, October, 1989-April, 2012. Defensive sectors: consumer staples, health care and utilities. Cyclical sectors: consumer discretionary, industrials and materials.

Buy in May in election years?

There’s also the rub of this being an election year, during which sitting out the May through October period has historically not worked well. Using the Dow Jones Industrial Average because of its longer history, the market has been up 4.5% during election years in the May-October span versus 2.6% for all years (including election years). And for what it’s worth, according to NDR, the market has bucked seasonal weakness even more when the incumbent president has won, with a median gain of 7.6% versus 0.5% when the incumbent president has lost.

NDR provides a clue as to why this is the case: A correction has occurred during the second quarter of election years, on average (sound familiar?). But the correction has tended to be concentrated in the second quarter, setting the stage for a summer rally.

2012′s positive offsets to present weakness

I actually think the scenario noted above is more likely than not this year. Muscle memory has many investors fretting a repeat of 2011 and 2010, when economic weakness in the spring led to brutal corrections each year, to the tune of -19% and -16%, respectively. But there’s a long list of positive offsets this year relative to the past two years:

  • Inflation is coming down, especially among commodity prices.
  • Credit growth is quite strong, especially for consumers.
  • Housing has improved markedly.
  • The US manufacturing sector is humming.
  • NFIB’s small business survey made recent upside breakout.
  • Job growth is much better.
  • Consumer confidence is improving.
  • Private-sector leverage ratios are much improved (debt servicing costs are extremely low).
  • Recovery in state/local government spending.
  • The US economy somewhat decoupling from rest of world; at least Europe.
  • US bank capital/health is much better than Europe’s.
  • The European Central Bank’s Long-Term Refinancing Operations have reduced likelihood of global financial contagion.
  • Germany appears more willing to accept higher inflation, opening the door to easier monetary policy for the eurozone.
  • Valuations are quite cheap, especially on forward earnings.
  • Investor sentiment has improved sharply with the correction to-date (meaning pessimism has kicked back in).

 

I don’t think the present correction is over, but do believe it could be kept to within the normal 5-10% range. Since the current bull market began in March 2009, the S&P 500 has had 15 corrections of more than 5% that were preceded by at least a 5% rally (consistent with this year’s pattern). The table below highlights their duration and ultimate percentage drop.

S&P 500 5% Corrections
S&P 500 5% Corrections

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of May 11, 2012.

Wall of worry being rebuilt

Tempering my short-term concern has been the aforementioned improvement in sentiment conditions. That said, I think there’s likely a bit more pessimism needed to establish a short-term bottom for the market. As you can see, the well-watched NDR Crowd Sentiment Poll (CSP) has moved decisively lower, but not yet to the extreme pessimism zone:

Bye-Bye Optimism
Bye-Bye Optimism

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as May 8, 2012.

NDR noted in a recent report several key reasons to expect the correction to be within the normal 5-10% range:

  • Initial reversals in CSP extremes are consistent with median declines of about 8% within six months.
  • The first half of election years have shown median declines of just less than 10%.
  • Once “pre-waterfall” highs have been exceeded, as occurred in February of this year, median market declines have ranged between -3% and -7% within six months.

Saving the worst for last

I think investors and the media may be underestimating the impact the coming “fiscal cliff” is having on market and business psychology. The fiscal cliff refers to the near-simultaneous January 2013 expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester (automatic spending cuts) established in last summer’s debt-limit agreement.

The range of estimates for its ultimate impact are, unfortunately, quite wide. The lowest estimate I’ve seen comes from NDR, using Congressional Budget Office assumptions, with the impact at a relatively “low” 2.4% of US gross domestic product (GDP). Most estimates tend to cluster around 3.5% of GDP.

It’s impossible to know what’s right because different assumptions are being used. But the consensus is closing in on a worst-case scenario of about 4% of GDP. ISI recently put the numbers into three distinct buckets, each with about $200 billion of impact:

  1. Provisions likely to create a fiscal drag (approximately (≈) $221 billion or 1.4% of GDP):
    • Cuts to discretionary spending (≈$84 billion)
    • Tax increases on upper-income Americans included in the Affordable Care Act (≈$21 billion)
    • Payroll tax cut (≈$116 billion)
  2. Bush tax cuts (≈$200 billion or 1.3% of GDP, although likely impact would be spread over several years)
  3. Items unlikely to be allowed to take affect and thus aren’t likely to create a fiscal drag (≈$179 billion or 1.1% of GDP):
    • Huge increase in number of Americans paying the alternative minimum tax (≈$94 billion)
    • Sequester cuts (~$85 billion)

There are three additional items that don’t fall neatly into ISI’s three buckets, including tax extenders, extended unemployment insurance benefits and the “doc fix,” which would together total about $75 billion. These items are not expected to create a significant fiscal drag.

I actually think this is having a larger impact on psychology than many believe, especially on the confidence of corporate leaders and their ability to plan (and guide Wall Street’s analysts) for the future.

Muscle memory may fail us this year

In sum, there’s much to fret about, and volatility is likely to remain elevated until this correction has run its course. But a lot has changed in the past two years—much for the better—particularly for domestically oriented US companies. There’s at least a little bit of decoupling underway, certainly between the United States and Europe, and that’s likely to assist in keeping the correction from mirroring the ones in 2010 and 2011.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tags: , , , , , , , , , , , , , , , , , , ,
Posted in Markets | Comments Off

Andrew Lo: Navigating Volatile Markets (Video+Transcript)


Sunday, March 4th, 2012

 

MIT’s Andrew Lo, “Financial Thought Leader,” and the dean of Adaptive Market Hypothesis, discusses managing your portfolio’s risk in volatile times with Connie Mack.
Here is the full transcript of the interview, courtesy of Wealthtrack.com:

Consuelo Mack WealthTrack – February 24, 2012

CONSUELO MACK: This week on WealthTrack, keep your seatbelts fastened and prepare for turbulence! Financial Thought Leader, alternative investment manager and MIT Professor Andrew Lo says ongoing market volatility requires skillful maneuvers. He’ll tell us which ones to follow next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Investors are dealing with some really difficult choices. The Federal Reserve has kept short term interest rates near zero for three years and has told us it is committed to another three, until late 2014. That means savers are getting zilch- actually less than zilch when you subtract the affects of two percent inflation. So called negative yields don’t pay the mortgage, put food on the table or compound over time because there is nothing to reinvest. The result is that savers and retirees are being forced into riskier investments, that, to paraphrase Mark Twain, don’t guarantee either a return “on” or a return “of” your money.

As you know, many recent WealthTrack guests have been advocating investors return to the stock market and specifically to high quality, dividend paying stocks for capital appreciation and income. Companies are taking note. According to Standard and Poor’s, dividend increases reached $50.2 billion last year. That’s an 89% rise over the $26.5 billion in dividend increases announced in 2010. S&P predicts companies will set a new record for dividend payments this year. Among the reasons: dividend payout rates remain near historically low levels of around 30% of earnings- historically they average 52%, and companies still have robust cash reserves and cash flows. In addition, that much dreaded market volatility of the past four years seems to be abating. The CBOE Market Volatility Index, or VIX, a measure tracking price movements of the S&P 500, has fallen dramatically in recent months. But for how long?

This week’s WealthTrack guest is skeptical of the markets recent docility and believes investors need to be wary, vigilant and more proactive. He is Andrew Lo, a noted Financial Thought Leader, economist, Professor of Finance at the MIT Sloan School of Management, director of MIT’s Laboratory for Financial Engineering and a money manager. He is putting his research to work at AlphaSimplex Group, the investment firm he founded and now chairs, where he and his team run several alternative investment mutual funds under the Natixis ASG name. In his words, they are “designed to help investors achieve greater diversification than traditional stock and bond funds, while actively controlling risk and liquidity.”

I began the interview by asking Professor Lo why he believes market volatility has not disappeared.

ANDREW LO: Well, one of the things about volatility is that it’s triggered by real events. And I think probably the biggest issue hanging over markets today is political instability. It turns out that government has become the biggest source of systemic risk. And until we work out the implications of Dodd-Frank and what’s going on in Europe, I think we’re going to continue having that hanging over the heads of investors.

CONSUELO MACK: So give me a time frame for that, because I don’t have really any particular optimism that we’re going to solve the solutions of Dodd-Frank and government regulation in Europe anytime soon, so this is a multi-year process that you think we’re going to go through?

ANDREW LO: This is definitely a multi-year process. It’s probably going to take between two to five years before we see any real differences. For example, here in the U.S., we’re not going to see much movement on the political scene until after the 2012 elections. And even after that, it’s going to take some time for the new President, whether it’s the incumbent or the challenger, to be able to put in place his or her implementations of various different policies. At that point we’ll see a little bit more clarity, but even then it’s going to take years before the actual implementation of Dodd-Frank becomes clear enough for us to understand.

Even the Volcker Rule is something that is not going to be clear for another two or three years. And in Europe, my guess is that that’s going to be a very slow-burning fuse. Things might come to a head this year, but more than likely they’ll figure out a way to push it off for another year or so. And then we’ll see what happens with Greece, Spain, Portugal and other countries.

CONSUELO MACK: So therefore, get used to market volatility. It’s a way of life for now.

ANDREW LO: I think for now it’s the volatility of volatility that we have to be aware of.

CONSUELO MACK: So talk to me about, what is the volatility of volatility.

ANDREW LO: Well, the idea behind the volatility of volatility is that we’re really on a volatility rollercoaster ride. During periods of time when markets look calm, volatility will be low. The VIX will be at a reasonable range of, say, 15 to 20%. But within a matter of days, after any kind of political change, we may see that volatility going up to 25, 50, 60%. And at 60% volatility, investors are really going to have to be very careful about what’s going on with their portfolios.

CONSUELO MACK: So are there new rules of investing that we need to apply in this new market that we’re seeing?

ANDREW LO: Well, I think there are definitely some new rules. And I would probably focus on three of them. The first new rule is that markets are not stable. That they can change at a drop of a hat. So we have to be more active about managing our risks. So the case in point is volatility. In the past, if you had a 60/40 portfolio- 60% stocks, 40% bonds, you had an idea that you were going to be getting something on the order of overall, ten or 11% volatility for your overall portfolio.

CONSUELO MACK: And let me stop you there. So ten or 20% volatility’s within any given year. that the market would move or your portfolio would move up and down ten or 20%, that was kind of a range that you could depend upon.

ANDREW LO: Exactly. And what we’re seeing now is that even with a 60/40 stock/bond allocation, there are periods of time when your portfolio can have 30/40 percent volatility, which are swings that no investor has signed up for. So the first new rule is that we have to start getting more active about managing our risks and being aware of those risks.

The second new rule is that we all suffer from a disease that I call diversification deficit disorder. That means that we think we’re well diversified with some stock and bond funds, but in fact, we have to be much more proactive about getting diversification across stocks, bonds, currencies, commodities; across different asset classes, across different countries, and over time. So it’s actually harder work now to achieve the same level of diversification that we had before.

And that third new rule is that we have to be aware that while stocks may provide good returns in the long run, that in the long run, we may be dead and we have to make sure the short run doesn’t kill us first. That is that we have to manage our way around these market dislocations. And so it means that we have to pay more attention to our portfolio, we have to spend more time thinking about it. Basically we have to become more educated about our own finances.

CONSUELO MACK: One of the really interesting things, Andy, that you’ve written about and talked about, is the fact that there’s something called the efficient market hypothesis, which is that the markets are efficient. That we’ve been dealing with and have assumed it was going to be the case for the future. And then you’re now talking about something called the adaptive markets hypothesis. What’s the difference between the efficient market hypothesis and the adaptive markets hypothesis?

ANDREW LO: Sure. Well, let me first start by saying that the efficient markets hypothesis has been a very important part of modern finance theory. And it says that prices generally fully reflect al available information. It’s hard to beat the market. And I would say that that hypothesis is still very important, but it’s incomplete. It’s not wrong, but there’s a piece that’s missing. And the piece that’s missing is that, while most of the time, markets do work quite well, and they do reflect most information, and it is hard to beat the market, that every once in a while, markets can be punctuated by periods of dislocation and irrationality. And the important thing to note is that people react to these kinds of market conditions, they adapt.

And so the adaptive markets hypothesis starts with market efficiency as the baseline and asks the question, do investors maintain that baseline all the time? And from looking at the empirical evidence, or the financial crisis, the evidence is pretty clear that, no, they don’t. That when market conditions change abruptly, people react. And they react in fairly predictable ways. When there’s a fire, people will run out of the room. And when there are losses, people will unwind their portfolios and seek safer ground. So the adaptive markets hypothesis focuses on that dynamic. It tries to understand under what conditions are markets efficient, and what other conditions might make people panic and move into other asset classes, thereby changing the traditional risk-reward relationships.

CONSUELO MACK: So right now, are we in a situation where the markets are not acting as we had assumed they would, and they actually have for, let’s say, the last four years; and in fact, so that the adaptations that individual investors are making, that number one, we’re making possibly wrong decisions. And then are there right decisions? What kind of adaptive behavior should we be adopting?

ANDREW LO: Well, I think there’s definitely some change afoot. And the best way to look at it is by taking the great expanse of market history, say from the 1930s to the most recent period, and just looking at our experience with, say, U.S. equities. From the 1940s to the early 2000s, that six-decade period is a period that I call the Great Modulation. And the reason I call it the Great Modulation is because during that period of time, we had a relatively stable financial regulatory system. In fact, today’s regulatory structure for mutual funds was actually built in the wake of the Great Depression, the 1930s and the 1940s. And those regulations haven’t changed a whole lot since then. Over that six-decade period, we had a relative period of calm and very, very healthy growth. So that no matter what ten or 20-year period you pick in that six-decade-long period, you would have done probably equally as well in terms of investing money in equities. I think that that’s changed. Over the last five or ten years, we have had some very significant shifts.

CONSUELO MACK: So that’s where the stocks for the long run thesis, you know, looking back, it worked.

ANDREW LO: Absolutely.

CONSUELO MACK: So your traditional approach of buying large cap or U.S. stocks, and reinvesting your dividends on a yearly basis, that in fact that was a pretty good strategy to adopt. Now what kind of a market are we in, and what’s changed and what should our investment strategy be?

ANDREW LO: Well, so there are a couple of things that have changed, and I think those changes inform how we want to think about changing our investment approach. One thing that’s changed is population. In 1900, the estimate of the world population was about one-and-a-half billion people. The most recent estimates for our current population of the world is about seven billion people. That is a big difference. And if you think about those seven billion people, most of them are going to need to have some type of financing and saving activities throughout their lives. And so that makes markets much more complex, and much more interdependent.

The second thing that’s changed is financial technology. We now have the ability to invest in a variety of assets, but at the same time we also have the ability at the click of a mouse to wipe out half of our retirement savings. That’s a very dangerous set of technologies to give to ordinary investors who may not really understand all of these kinds of risks.

CONSUELO MACK: Even professional investors make big mistakes.

ANDREW LO: It’s complicated, no doubt. And so I think one clear implication is that we actually need to spend more time thinking about our finances, in the same way that we have to spend more time thinking about our health. In the 1950s we didn’t know about cholesterol, we didn’t know about carbs, we didn’t know about a lot of things that we know now. And so now, to be an intelligent consumer, you really have to spend time learning these new concepts.

CONSUELO MACK: So, Andy, from an individual investor’s point of view, how can we more actively manage our portfolio, realistically- what should we be doing?

ANDREW LO: Yes. Well, first of all it’s hard. It requires work. And what investors should not be doing is becoming day traders. That’s not going to be successful. One thing they can do, though, is to spend more time learning about the investments that they do make. In other words, asking questions like, “what kind of risk profile does this particular investment have over the last ten years, five years, three years,” as opposed to asking “what kind of risk profile it has right now.” Because what looks relatively calm and conservative today may have looked very differently in 2008 or 2009, and may look different yet again next year. So start asking questions about how stable the risk is for each of these funds, that’s the first thing.

The second thing to ask about is liquidity. We haven’t really talked much about liquidity for mutual funds, because by definition, they seem to be liquid. You should be able to get in and out of them every day. But as we saw from the last four years, there are certainly mutual funds that are much less liquid than others and could create all sorts of difficulties for redemptions, if and when they all occur at the same time.

Third, there are a variety of financial instruments available to investors today, including ETFs, and other kinds of fancy securities. Before getting too fancy, investors need to spend time trying to really understand the various different kinds of circumstances under which those products will help or hurt their portfolios. So in other words, each investor now has to become a bit of a financial manager. They are managing their portfolios, and ultimately they’re going to be responsible for those decisions.

CONSUELO MACK: Which is a terrible thought. A very scary thought.

ANDREW LO: It’s scary.

CONSUELO MACK: You have a concept, an approach that I think is really fascinating. We’ve done a lot of work on WealthTrack on asset allocation, and if you go to any financial advisor, they’re going to talk to you about asset allocation, and your risk tolerance, et cetera. But you’re saying that we shouldn’t just manage our asset allocation anymore, that we really need to manage our risk allocation. Can you tell me what it means to manage your risk allocation, and what the difference is?

ANDREW LO: Sure. Well, the first point to start with is that investors generally respond to changes in risk. Most investors are happy to take risk. They’re perfectly willing to take risk. They even, I think, understand what risk means. What they aren’t willing to do is to be uncertain about their risks. If you’re going to take a particular kind of risk- ten percent swings in your portfolio over the course of the year- you want to know that that’s by and large what you’re going to see: ten percent swings in your portfolio over the course of a year. If you see 30% swings, that’s not good news. And so the idea behind risk allocation is to reduce the surprises in risk. If you think you’ve signed up for ten percent swings, then you need to be given ten percent swings. And there’s a way to manage your portfolio to make sure that that’s more likely than less. And the way to do that is to start with a particular risk budget.

Say that ten percent figure that we talked about. And say that if ten percent swings are what I’m comfortable with, let’s divide that up into three percent of that for equities, another three percent for fixed income, another two percent for commodities, and so on. And it’s a little bit more complicated because the risks don’t necessarily add up to 100% because of correlations among these various different investments. But with some help from literature online, or from financial advisors, it’s actually pretty easy to work that out so that you put your money in categories where you know you’re going to get a certain amount of risk. And this way, after the fact, the surprises will be far fewer and far less extreme.

CONSUELO MACK: So if I look at all the asset classes that are available to me as an investor to invest in, are there certain risk profiles that I should be adding to a portfolio that might not be in the traditional portfolio? Are there certain assets that are actually going to steady and provide ballast to my portfolio that I really don’t know about?

ANDREW LO: Well, I think there are other assets and certainly other approaches to investing in different asset classes. Stocks and bonds are the most traditional asset classes that most people have in their portfolios, and we’ve seen over the last few years that the volatility of volatility of those asset classes is quite high. It’s very hard to predict where that volatility’s going to go. But if we now increase the universe of assets to additional alternatives- commodities, currencies, interest rates, and investing long as well as short- if you mix all of those into these new multi-alternative asset classes, I think that there’s a better way to make that kind of diversification and to be able to manage the type of risks across these different asset classes.

CONSUELO MACK: So let’s talk about what you’re doing at the Natixis ASG Funds that you’re replacing the traditional asset allocation approach with what you call a new narrative. And that is, it’s how many dollars that you invest in different asset classes, instead of that, it’s how much risk you allocate to different asset classes. So just give us an example of what you’re doing, for instance, with your flagship from the Natixis ASG Global Alternatives Fund, which you’ve established an eight percent volatility. That’s your goal. So how do you achieve that?

ANDREW LO: Well, it’s actually pretty easy. What we do is to use futures contracts, which are very liquid, and we invest in futures across a variety of asset classes; stocks, bonds, currencies and commodities. And we are trying to capture the broad exposures of the entire hedge fund industry. But what we do that’s different from what hedge funds do is that we manage our volatility on a daily basis; where we balance our futures exposures to these various different asset classes so that we’re achieving a relatively steady level of volatility of around eight percent. And so when the underlying instruments that we invest in become much more volatile, as they did during the fourth quarter of 2008 after Lehman went under, we will reduce our exposures to those contracts, and thereby achieve a relatively steady rate of volatility. When that volatility of the underlying instruments comes down to a normal level, we’ll put back that market exposure.

So it’s a lot like cruise control in your car. Your car knows when it’s going uphill, it’ll put on the gas; your car knows when it’s going downhill it’ll put on the brakes. All the while achieving a relatively steady speed of 60 miles an hour. And if eight percent volatility’s what you’re trying to achieve, by using this kind of cruise control mechanism and by doing it on a daily basis, you can actually manage your risks more effectively than if you just rebalanced once a month or once a quarter.

CONSUELO MACK: Basically you’re managing volatility on a daily basis. Individual investors really can’t do that. If I went to a traditional asset allocator, they would tell me, well, you know, what you need to do, Consuelo, is put more TIPS in your portfolio or more treasuries in your portfolio, or more managed futures in your portfolio. Is there any way to manage the volatility that we’re talking about, without actually managing it on a daily basis?

ANDREW LO: Well, I think it’s a matter of degree. So obviously managing it on a daily basis is one extreme. Not looking at your portfolio for a year is another year. Trying to be more sensitive to correlations is one way of managing it. So for example, you mentioned managed futures and TIPS. Those are two asset classes that are not part of the traditional investment portfolio which could actually help in terms of dampening some of those fluctuations and reducing the volatility of volatility. So by being more aware of different investment alternatives, by asking questions about how stable the risks are, by looking at the potential correlations of those risks, it is possible to put together a more robust portfolio than just simply picking stocks and bonds.

CONSUELO MACK: Are there any specific segments or products that are out there that we should have ourselves and our financial advisors look at?

ANDREW LO: The ones that I think might be most useful for an investor are these multi-alternative categories, managed futures, because they provide opportunities that are not easily accessible from the traditional stock/bond perspective. And many of these products are properly risk-controlled, so that they won’t provide the kind of unpleasant surprises that you might find in some traditional mutual fund products and ETFs. So I think that having a broad exposure to a variety of asset classes across different countries, across different securities, is really the best way to go and to spend more time thinking about these opportunities; to work with a financial advisor to get the best advice possible. But in the end, to answer the question, how much risk am I willing to take? What kind of portfolio swings can I withstand? And then to maintain as much of an investment in those types of securities with that level of risk that you can.

CONSUELO MACK: How important is it to pay attention to macro trends, number one? And to react to them, number two, in our portfolios? Do we need to time macro trends, not time the market, but possibly what’s going on in the macro level?

ANDREW LO: Well, I think it’s incredibly important to pay attention to macro trends. How we react to them is also critical, and there I think that most investors need help. I don’t think it’s possible for individual investors to understand, necessarily, how to interpret a European default. We need help from financial advisors, from various institutions, to understand how our reactions may or may not be beneficial to our portfolios. But I do think that it’s important for us to try to react in a sensible way as opposed to simply assuming things will work out in the end. Depending on what one’s horizon is, maybe that is true, but if your horizon is less than 50 years, I’m not sure that things will work out for you, with any degree of confidence. We need to think a little bit about how to change our behavior in the proper way to react to these market conditions.

CONSUELO MACK: And final question is for a long-term diversified portfolio, what is the One Investment or one strategy we should all adapt?

ANDREW LO: Well, I think that right now, the one idea that we should all adopt is to think very carefully about risk, is to manage risk actively. And that means thinking about diversification, thinking about broader asset classes like multi-alternatives or managed futures. Thinking about how our portfolio may change over time and over market conditions, and to do that soon. Not after the disaster hits, when we’re all going to be panicking. But rather do it now, while we’re relatively calm, and when we have some idea of what kind of consequences we can or cannot tolerate.

CONSUELO MACK: We will leave it there, Andrew Lo. Always wonderful to have you on WealthTrack.

ANDREW LO: Thank you, it was a pleasure.

CONSUELO MACK: Thought-provoking, you are an original thinker from AlphaSimplex Group and from MIT, thanks so much for being here.

ANDREW LO: A pleasure, thank you for having me.

CONSUELO MACK: At the conclusion of every WealthTrack, we try to leave you with one suggestion to help you build and protect your wealth over the long term. This week’s Action Point picks up on a major theme of Andrew Lo’s investment approach, which is to manage portfolio risk. So this week’s Action Point is: consider the risk allocation in your portfolio.

Investors have traditionally thought in terms of asset allocation, assuming relatively predictable returns and behavior in stocks and bonds over time. As Lo points out, for a number of reasons, the markets have changed. They have become much more complex, uncertain and volatile, so managing risk has become much more important. Building a portfolio around risk expectations for different asset classes can help you manage and control the risk according to your personal preferences.

Next weekend, as many public television stations start their spring fund raising drives, we will revisit our conversation with Sheryl Garrett and Mark Cortazzo, two top rated financial advisors who are catering to small investors. If you want to see WealthTrack interviews ahead of the pack, subscribers can do so 48 hours in advance. Go to our website, wealthtrack.com to sign up. And that concludes this edition of WealthTrack. Thank you for watching and make the week ahead a profitable and a productive one.

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,
Posted in Markets | Comments Off

Andy Lo: Managing Portfolios in Volatile Times (In-Depth)


Thursday, March 1st, 2012

MIT’s Andrew Lo, “Financial Thought Leader,” and the dean of Adaptive Market Hypothesis, discusses managing your portfolio’s risk in volatile times with Connie Mack.

Tags: , , , , , , ,
Posted in Markets | Comments Off

Rob Arnott – Strategy for Volatile Times


Monday, October 17th, 2011

This week on Wealthtrack, Consuelo Mack interviews Robert Arnott, founder and chairman of Research Affiliates. He has pioneered several investment products which outperform markets with less than market risk, discusses his current strategy for these volatile times.

Source: Wealthtrack, October 14, 2011.

Tags: , , , , , , , , ,
Posted in Markets | Comments Off

Inter-Market Analysis in Guiding Cross-Asset Allocation


Sunday, October 2nd, 2011

Inter-Market Analysis in Guiding Cross-Asset Allocation

Monthly Strategy Report September 2011

Alfred Lee, CFA, DMS,
Vice President & Investment Strategist, BMO ETFs & Global Structured Investments. BMO Asset Management Inc.
alfred.lee[at]bmo.com

Although it is debated in financial academia as to what percentage asset allocation contributes to portfolio volatility1, we can perhaps agree that it is significant. Therefore in a volatile market environment, in which the CBOE Implied Volatility Index (“VIX”)2 remains elevated, as we have recently witnessed, portfolio construction becomes increasingly important. In fact, we will go further and say that going forward your asset allocation will be one of, if not the most, important drivers in the returns of your portfolio strategy. This month we wanted to take a closer look at the recent trends developing between the three major asset classes we track: equities, fixed income (or credit) and commodities. For our own purposes, we also monitor currencies and volatility as alternative asset classes, to better understand the inter-market relationships between the three major asset classes previously mentioned.

About a month ago, shortly after U.S. Treasuries were downgraded by the credit rating agency Standard & Poors (S&P), we issued a special bulletin recommending investors increase their allocation to bonds. Although, we wouldn’t be surprised to see frequent relief rallies in equities, we anticipate stock market volatility to remain elevated over the short-term. This is due to increased shorting activity in the market, leading to short-covering, causing upside and downside moves to be exaggerated. In addition, macro-economic uncertainty remains, further compounding price movements as the market will have difficulty pricing the fair value of assets.

As a result, we believe bonds at this time are a good solution to increase stability in volatile times. Furthermore, as we have mentioned in previous reports, the amount of leverage in the financial system makes diversification within one asset class ineffective in providing downside protection as intra-market correlation remains elevated.

Although, we came into the year more bullish on equities, our appetite for risk has deteriorated as the year has progressed. Economic data now suggests that the market weakness is more than just seasonality or a soft-patch largely caused by supply chain disruptions, and the market awaits clues of further monetary stimulus after the market’s negative reaction to “Operation Twist3.” In response, the bond market has rallied significantly against equities over the last month, as global investors seek out safe-havens. This recent trend in both U.S. and Canadian fixed income over their respective equity markets supports our thesis that fixed income is the preferred asset class for the time being.

Fixed Income Exposure:
In terms of traditional fixed income, investors may want to consider slightly extending their duration exposure. With the Bank of Canada (BoC) taking a much more dovish tone towards monetary policy at their last meeting, interest rate hikes, barring surprise inflation, is likely pushed-off until 2012. Some have even called for an interest rate decrease before the end of this year. A change in direction of lending rates is more significant than the amount of a rate move in our opinion and unless conditions deteriorate dramatically, the BoC will likely stand pat. Regardless, this should benefit the long end of the yield curve, especially if the U.S. Federal Reserve’s (Fed) Operation Twist impacts the Canadian yield curve by bringing down the long end. For traditional fixed income, increasing duration to the middle of the curve may be warranted, which would also help increase yield.

Potential Investment Opportunities:
- BMO Mid-Corporate Bond Index ETF (ZCM)
- BMO Mid-Federal Bond Index ETF (ZFM)

Commodities Losing Ground to Equities, Target Your Exposure Wisely As we have highlighted in the past, we believe commodities to be in a super-cycle and for that reason, we have a secular bias towards commodities. However, the Thompson/Jefferies CRB Index, which is a broad commodity index, recently started losing ground to equities in the short-term. As the different commodity sub-groups react very differently to macro-economic and political risk, a more targeted approach to investing in commodities is warranted at this point.

As our readers are aware, we have been positive on gold over the long-term. However, we stated that we wouldn’t be surprised to see some retracement over the short-term. Moreover, any temporary band-aid solution to the European sovereign debt issues could lead gold to quickly fall. The recent rally in the U.S. dollar could also serve as a temporary headwind.

Potential Investment Opportunities:
- BMO Precious Metals Commodity Index ETF (ZCP)
– Buy on pullbacks and use stop loss order
- BMO Junior Gold Index ETF (ZJG)
– Buy on pullbacks and use stop loss order

We also believe agriculture commodities are a good long-term investment despite short-term pressure. The Economist magazine has estimated world population to hit 7 billion at the turn of the year, a factor contributing to food shortages, driving prices higher. Moreover, with elevated oil prices, the demand for bio-fuels is placing further demand on corn. Agriculture based futures allow investors to gain pure price exposure to the underlying grains.

Pages: 1 2

Tags: , , , , , , , , , , , , , , , , , , , , , , , , ,
Posted in Bonds, Brazil, Canadian Market, Commodities, ETFs, Gold, Markets, Oil and Gas | Comments Off

Investing During Volatile Markets (Feldman)


Thursday, August 18th, 2011

by Kevin Feldman, iShares

My phone has been ringing a lot more than usual the past two weeks, mostly from family members seeking guidance or reassurance as market gyrations test their nerves.  Is this 2008 all over again?  Have we just transferred liabilities from banks to governments?  And so on.

I’ll leave the post-downgrade economic analysis to the far more capable Russ Koesterich on our team, but I would like to weigh in on some financial planning considerations for volatile times like these.  Let me start by sharing how I evaluate my own portfolio choices, and some changes I’ve made over the past year.

I’ll warn you upfront: My personal portfolio is not very sexy, and there’s no “market-beating” formula below.  But I do take risks at times when I think I will be compensated for them.

Like most of my friends and colleagues who are also in their forties, my biggest savings goal is retirement.  As I’ve blogged about previously, getting your retirement assumptions right is both critically important and a bit tricky.  I opt to be more conservative on assumptions, so I’ll hopefully end up saving more than I need for retirement.

With 20 plus years to go until I retire and then (I hope) 30 plus years enjoying retirement, I have a long time horizon.  Normally, planning for a longer retirement would encourage me to tilt toward riskier assets like stocks, which are more volatile in the near-term but have historically produced higher returns over longer periods.

On the other hand, given my profession, I would also like my asset allocation to tilt a bit toward bonds to help balance the volatility of future income which tends to rise when markets are doing well and fall when they are doing poorly.

Lastly, we’re in this highly unusual extended period of zero interest rate policy (ZIRP).  Shouldn’t I do something to improve on the 2.2% the US government is offering to pay me for holding its bonds for the next ten years?

The short answer to all of the above is yes: I do think about all of this when reviewing my asset allocation, and I occasionally make adjustments as a result.

My “default” allocation the last few years has been 60% equities / 30% bonds / 10% alternatives (mostly real estate and gold).

In terms of how I implement this asset allocation, it’s pretty straightforward.  I use mutual funds and ETFs.  I’m more of a passive investment type of guy, but I do have a few favorite active managers and have owned their funds for many years.  Since I still have a few investing scars following the dot-com era, I rarely invest in individual stocks, but I do own one—BLK— the firm where I work.

So, what changes have I made in the past year?

  • Equities: I usually prefer broad market exposure both domestically and internationally without any long-term preference to size or style.  I have been favoring US large caps recently, partly for their tax-favored dividends (might as well take advantage of qualified dividend income (QDI) while we have it; who knows how long it will last) and partly based on Russ’s thoughts on relative value.  I’ve been pushing past my own home country bias the past few years and now hold 60% US equity / 40% international.  I was overweight to EM for many years, but am now back to market weight as both valuations and correlations to other markets have risen.
  • Fixed Income: No great options in a ZIRP environment, but remember bonds are in most portfolios primarily to balance equity risks and even at very low yields, government bonds have historically done that better than higher yielding bonds, as we’ve been reminded the past few weeks.  With that said, I have reallocated half of my previous aggregate bond exposure (AGG) to a combination of high quality corporate bonds, munis and a stable value fund (unfortunately, only available in 401(k) plans, but at 3% yields, a handy option in the current environment).
  • Alternatives:  The only change I’ve made here recently was to significantly reduce my allocation to REITs (consistent with the rationale Russ discusses here) and also because unusually strong market appreciation had taken them far above the original allocation target.

At work, I’m surrounded by a lot of very smart people with very interesting investing strategies, but I know my limitations in terms of the risk I’m comfortable with and the amount of time I have to review my portfolio.  So I try to stay pretty disciplined on this and not fiddle with it too much.  My aversion to paying capital gains taxes usually keeps that impulse in check!

Copyright © iShares

Tags: , , , , , , , , , , , , , , , , , , ,
Posted in ETFs, Markets | Comments Off