A Rules-Based Approach to Navigating Market Extremes
For several years now I’ve been experimenting with an asset allocation strategy based on a combination of market valuation and momentum. I have explained it in several posts tracking my overall portfolio that I employ a “value + trend” strategy.
I have become more fond of this approach over time and have increased my allocations to the strategy. The core of the strategy is dynamic allocation to equities (or other risk assets, depending on the portfolio) based on the valuation and trend.
I have recently had the realization that a better way to think about the strategy is as an attempt to navigate market fear and greed. I think market environments are shaped by human fear and greed. Greed propels asset prices to heights as the herd and enthusiasm grows and feeds upon itself in a feedback loop and at times, fear takes over and asset prices dive.
I also believe these forces likely explain much of the persistence of trends observed in market data (self-reinforcing feedback loops based on sentiment) and the clustering of volatility (cascades) when market momentum breaks down, or a regime changes from greed to fear, and market participants bolt for the exits. As the saying goes, “Stocks take the escalator up and the elevator down.”
While a long-term “buy and hold” philosophy has its merits and likely works best for many, I believe it may not be optimal for me (and many others). Simply stated, the best investment is one you can stick with. I have found it very helpful to have a rules-based “relief valve” allowing allocation changes intended to reduce risks in certain environments.
The Framework
I have implemented this by establishing rules that reduce my equity exposure when valuations are high and momentum is breaking down. The idea is to avoid environments where stocks are relatively expensive and momentum is negative. Or, when greed gives way to to fear.
I define valuations being “high” based on both historical observations and opportunity costs. For example, reviewing historical CAPE and Q ranges (a valuation measure based on replacement cost) and examining the opportunity cost/alternative (the current yield on T-bills or 10 year TIPS, for example). In order for the asset allocation to change momentum must also be negative.
The core of the Fear and Greed Portfolios strategy lies in its systematic approach to adjusting equity exposure when the market exhibits specific characteristics. It integrates two primary signals:
- Valuation Signals: Identify when the broader equity market, or specific asset classes, are trading at high valuations. This determination is discretionary and is based on historical observations and comparison to the relevant opportunity costs. This serves as an indicator of potential “greed” influencing prices, signaling that expected returns are lower going forward (and the cost of not owing the risk asset is lower).
- Momentum Signal (Time Series Momentum/Moving Average Rules): To confirm a shift in market dynamics, I apply time series momentum test, via a long-term moving average crossover rule. When asset prices fall below their long-term moving averages, it might signal a breakdown of the existing trend. This break in momentum is crucial; it can indicate that the prevailing greedy sentiment is eroding, potentially setting the stage for further declines or sustained periods of underperformance, often associated with increased market uncertainty. Volatility often clusters in these periods.
Implementation: When both the valuation signal suggests expensiveness AND the momentum signal turns negative, the strategy mandates a reduction in equity exposure. This could involve shifting capital into more defensive assets like cash equivalents (or whatever the predetermined risk-off asset is for a particular portfolio). The objective is not to perfectly forecast market tops or bottoms, but rather to mitigate the impact of significant drawdowns during periods of lower expected returns and elevated risk and volatility.
Realistic Goals
I do not really believe this strategy is likely to outperform a 100% long-only version of the same allocation. Trend-following rules are not a magic elixir. They usually bear costs in the form of whipsaws and additional trading and tax costs.
However, I do believe it will be easier for most humans to stick with this strategy because it allows a “relief” valve. When markets are expensive, you apply a rules-based risk reduction strategy.
In addition, the whipsaws should be lower under this Fear and Greed strategy than in a normal trend-following, long-flat strategy because there will be no testing (and potential whipsaws) when expected returns for the risk assets are fair to attractive (i.e., I’m only paying for insurance in environments where the payoff is likely to be attractive). I also only test once a month.
So, it is hopefully sort of like buying fire insurance, for a month, when it is dry and windy.
From all the research I have reviewed on long-only trend following rules, it seems that they generally slightly underperform whatever the underlying risk asset is but usually with reduced downside volatility or drawdowns.
As valuations become more reasonable, or momentum signals turn positive, the strategy will re-establish equity exposure, positioning the portfolio to participate in subsequent market advances. There will be whipsaws, but the rules do not allow the portfolio to remain in cash “until the coast is clear.”
Potential Implications
In sum, by systematically responding to market signals of overvaluation and a loss of momentum, the Fear and Greed Portfolios will aim to:
- Mitigate Drawdowns: Seek to reduce the severity of portfolio declines during significant market corrections.
- Enhance Risk-Adjusted Returns: By potentially avoiding some of the largest losses, the strategy seeks to achieve a smoother return profile over time for a given level of risk.
- Encourage Discipline and Mitigate Behavioral Risk: It imposes a rules-based framework, helping to counteract the natural human tendency to react emotionally during market extremes.
I will be track the ongoing development and performance of the Fear and Greed Portfolios on this page. In future, I may experiment with a Substack concerning this strategy. For now, I will begin assembling and aggregating some of my posts about the “Value + Trend” strategy on this page.
Fear and Greed Portfolio Posts:
October 2018: Trend Rule = Risk Off