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At BWM, our core portfolio construction process comprises three primary factors:
- Strategic Allocation – This is the percentage of stocks, bonds and cash that makes up the portfolio and will drive the bulk of returns. We focus on what we can control: asset allocation, fees, tax efficiency, and ensuring the recommended allocation is stress tested against the client’s risk tolerance and guidelines. This is a long-term allocation.
- Tactical Allocation – We believe there are periods to play offense (increase equity exposure) and other periods to become more defensive (reduce equity exposure). Doing this successfully can give us an opportunity to outperform the respective benchmark.
- Tailor-made Strategies – Since no two clients are alike, we believe a portfolio can be optimized by adding an additional layer of diversification with the addition of non-traditional investment (alternative investments, hedge funds, direct indexing, ESG style investments, etc.)
In this article, we will focus on the second factor – tactical allocation. Tactically adjusting the investment portfolio is the process of increasing/decreasing exposure to different asset classes within the portfolio over time. We believe this process can provide added value to the overall return of a portfolio, if done successfully.
Removing Emotion with The “Weight Of The Evidence”
Famed economist John Maynard Keynes is quoted as saying, during the 1930s depression, “Markets can stay irrational longer than you can stay solvent.”
Almost a century later, that wisdom remains true today. Fluctuations in the market are a top concern for many investors, and rightfully so. Periods of extreme market turbulence can rapidly erode wealth or create generous returns, but it is at random. Times of market volatility can also be the catalyst for irrational decision making. Psychological biases and emotionally-charged decisions can further derail an investment strategy. To make matters worse, the collective behaviors of investors can cause markets to deviate from their intrinsic value.
At BWM, we take a “weight of the evidence” approach to managing portfolios in an attempt to counteract irrational market behavior. By using objective indicators and adhering to a set of rules, we can remove emotions from the decision-making process. Our philosophy is centered on strictly following three key rules.
BWM’s Three Rules of Investing
Rule #1 – Don’t Fight the Fed
The first rule in our tactical approach is “Don’t fight the Federal Reserve (Fed)”. As the name suggests, this rule aims to help align our investment portfolios with the actions taken by the Federal Reserve. The Fed operates under a mandate from congress to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates”. The tools available to the Fed give them significant control over the financial markets.
When the Fed becomes more accommodative, this means they are trying to expand the overall money supply. One tool the Fed uses to do this is control of interest rates. When interest rates are low, corporations and consumers can borrow money more cheaply and decrease the cost of debt. This translates into higher spending by the consumer, higher corporate profits, and ultimately an increase in aggregate output. Additionally, the liquidity left over after demand is met can be invested into financial markets.
Because of this, it is not surprising that equity markets respond favorably when the Fed takes actions that are considered “accommodative”. The chart below tracks the performance of the Dow Jones Industrial Average (DJIA) after an interest rate cut from the Federal Reserve.
The chart shows that the DJIA has been up 16% on average in the first year following the Fed’s first rate cut. The performance has been even better when the rate cut has not coincided with a recession, with the DJIA up 24% a year later in these cases.
It should also be noted that when the US Federal Reserve eases, the rest of the world usually follows suit. Since the world’s economies are interconnected, it would make sense that economic weakness in the U.S. would be evident in other parts of world. This has typically prompted easing from other central banks which has historically been bullish for global equities.
Rule #2 – Don’t Fight the Trend
The trend is the overall direction of the market, either increasing or declining due to selling pressure. Understanding the trend can help gauge the technical health of the markets. In other words, how many stocks in the market are in healthy uptrends and how many are in unhealthy downtrends. If the overall trend in the market is healthy, we favor stocks over bonds. If the market appears unhealthy, we favor bonds over stocks.
One way we evaluate the health of the market is by using Ned Davis Research’s “Big Mo Multi-Cap Tape Composite”, which is pictured below. Big Mo provides an example of the technical health of the broad equity market. The model, plotted in the lower clip of the chart (orange line), aggregates the signals of over 100 trend indicators and generates a reading between 0% and 100%, reflecting the percentage of the indicators which are currently giving bullish signals (healthy trend) for the S&P 500 Index. The chart’s top clip (blue line) plots the S&P 500’s weekly closes. Buy signals are generated when the orange indicator crosses above 56.5 (upper dashed line) and sell signals occur when the model crosses below 45.5 (lower dashed line).
There are many use cases for analyzing the trend of markets. One of the best uses cases of trend indicators is knowing when to add or reduce equity exposure to a portfolio. Selling equities can be especially tricky. Often times, emotional factors can influence the decisions around selling an investment. Selling when a stock is down can feel like you’re giving up too early and can cause you to hold on for a little longer, hoping the stock will rebound. And selling when a stock price is rising can feel counterintuitive and bring fears that you’re missing out on future returns. This chart is just one example of an objective indicator we use in our “weight of the evidence” approach, to determine how long to let our profits run and when to cut our losses short. It aids us in maintaining the discipline to not let our emotional influences and predetermined beliefs drive the decision-making process.
Momentum is a closely-related component of the trend. While trend is the overall direction of the market, momentum helps us understand the strength behind the direction things are moving. In general, when equity markets rise significantly, we want to see broad participation across the entire market. If not, the advance may not be sustainable.
To identify broad participation in the market, we analyze the “breadth” of the market. One example of this can be seen in the chart below. The chart measures the percentage of stocks that are trading above their 10-day moving average. When 90% of all stocks trade above their 10-day moving average, the chart signals a “breadth thrust”, which is a large number of stocks advancing at the same time.
When this happens, it can set a new floor in the market. As illustrated by the red box below, since 1982 there have been 36 occurrences of a breadth thrust; 35 out of 36 occurrences were profitable 12 months later (253 trading days).
Breadth thrust indicators, like the chart above, can help us identify market bottoms and help us determine when the market has the “legs” to move higher. They can also help us know when to add exposure to equities in times of great uncertainty.
Using the history as an example, think back to 2007-2009 during the financial crises. The economy had just experienced an unprecedented crash which caused thousands of businesses to fail and cost many ordinary people their jobs, their life savings, and their homes. Under those extreme circumstances and the events that occurred, it’s easy to understand the hesitation to invest in the stock market at that time.
However, by looking at objective indicators like the breadth thrust indicator above, you will see a different story. This particular indicator gave a breadth thrust indicator on March 13th, 2009, just 4 days after the market bottom. This indicator was also successful in calling the market bottom in 2020, when investors were faced with the quickest recession in history due to the COVID-19 pandemic. The indictor gave a breadth thrust on March 26, 2020, only 3 days after the market bottom.
Rule #3 – Beware of the Crowd at Extremes
Market sentiment is the overall attitude of investors towards the financial markets. It is crowd psychology, revealed through the activity and price movement of securities. For centuries, economists have recognized that psychology plays a significant role in guiding financial decisions. Irrational human behavior, motivated by impulses, greed, fear, and other emotions, can influence financial markets and lead to events that defy normal expectations that rely on logic.
Only a fraction of the crowd needs to react for small things to cause big problems. When those few individuals react, it can cause people around them to act similarly. This is known as the “herd effect”. You don’t have to look further back than the year 2000 to see an example of this. Crowd euphoria created an unstainable appetite for technology stocks, which lead to excessive buying of the same group of stocks by many investors. Ultimately, this excessive optimism ended and the bubble popped. The “herd” rushed out of technology stocks like a stampede and the damage was significant.
The NASDAQ composite dropped a total of 78% by the time the crash ended and took nearly 15 years to recover. This basic pattern of greed, fear, and hope generally repeats itself in the stock market. Greedy crowd sentiment drives asset flows into specific sectors, and when the percentage of assets in any sector becomes extreme, risk rises substantially. Eventually, some incident in the market occurs, causing fear which destroys the crowd’s excessive optimism. The herd stampedes out of the crowded investment, causing severe downside along the way. Hope then leads the next bubble to form and the process starts over again in a new cycle. An illustration of this can be seen below.
History and the chart above show that the crowd is often wrong during market extremes (highs and lows in the market). To apply our third rule to our investment management, we take a contrarian approach by going the opposite way of the crowd. We use a combination of sentiment indicators to monitor crowd sentiment extremes and identify reversal in sentiment, which signals the herd is about to turn.
NDR’s “Daily Trading Sentiment Composite” is one indicator we use frequently to understand the crowds’ feeling on the markets. The composite combines over 15 different measures of market sentiment to give us a reading of what percentage of investors are classified as bullish on the stock market. The composite is useful because it aggregates different indicators and highlights levels at which investment sentiment has reversed in the past. This can help anticipate reversals in investor psychology, and thus stock prices, in the future.
The upper clip represents the S&P 500 index. The lower clip represents the sentiment indicator (orange line). Since 1994, if an investor bought the S&P 500 when the sentiment indicator was above the upper dashed line (excessive optimism), their annualized return is -6.97%. However, if an investor purchased the S&P 500 when the indicator is below the lower dashed line (extreme pessimism), their annualized return is 29.02%. Having this type of objective data can help us with dollar-cost averaging money into or out of a portfolio. It can help us understand, from a timing perspective, when might be a good time to enter or exit a concentrated position. And it can help clients understand when they are “going with the crowd”, displaying behaviors or greed or fear.
How to Implement
At BWM, we seek the highest risk-adjusted return for our clients. We know that humans are hard-wired to make poor investment choices and can fall victim to emotion-driven conclusions based on predetermined beliefs. In addition, we live in an era of constant “noise” from the financial news cycles which can make the investment selection process more difficult.
We believe the best approach to these challenges is to apply a rules-based process using objective indicators. We rely on Ned Davis Research’s library of indicators that have long historical precedents and consistent track records. We then use the weight of the evidence to objectively balance the risks and opportunities. Please contact BWM if you think your investment strategy could use a tune up using our rules-based approach.
Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.