Managing Risk and Finding Opportunity in a Changing Market  

By Victor Sperandeo and Adam Watts

The current market regime, which has persisted since the end of the financial crisis, has sharply elevated stock and bond prices, and made winners of passive investment vehicles that seek to replicate these markets.  Active approaches, be they discretionary or systematic, largely depend on market turning points to demonstrate their relative effectiveness, and the current central bank-driven markets have lacked such turning points.

However, the election of Donald Trump combined with the likelihood of a December rate increase may signal an end to the current prolonged regime where markets are driven almost exclusively by monetary policy. If that turns out to be true, we believe stock and bond markets are more likely to experience volatility and “turning points” as these markets adjust to new policy imperatives, in which case, more active strategies that employ dynamic approaches to changing market conditions will have the potential to outperform passive, long-only investment strategies.

Unwinding a “Time Bubble” 

Bubbles are often measured in terms of the magnitude of price increases.  However, another dimension exists: time.  The accommodative monetary policy introduced during the financial crisis was meant to be a temporary action.  Yet, its prolonged nature has made it appear more like a permanent government program.

Eight years within the same regime, especially one where investors have become so accustomed to central bank support, is likely to have significant consequences.  The longer a given market regime exists, the more likely investor behaviors change, perceptions of risk change, and crowded trades are formed.  As a result, the unwind of this regime is unlikely to be a smooth process.

By design, for the last eight years, central bank policies have artificially inflated traditional assets like stocks and bonds.  Until recently, both asset classes were at all-time highs.  However, the prolonged nature of this current cycle has clearly changed behaviors.  For example, yield starved investors have accepted, knowingly or unknowingly, greater levels of risk for less reward.  Further, elements of financial engineering, most notably the excessive use of corporate stock buy-back programs during a period of declining earnings, have detached many stock prices from their historic fundamentals.

With the election of Donald Trump, we believe that the time bubble is looking ever more fragile.  Bond yields have already risen dramatically.  Additionally, notwithstanding the post-election bounce in equities, both global stock and bond markets, especially over the near term, may face headwinds in a number of forms, any one of which has the potential to be the catalyst for a major retracement. The situation could be exacerbated by a “rush for the exits” in the event of a market selloff.

Dynamic Strategies and the Case for Managed Futures

As the current market regime wanes, we believe a case can be made for dynamic strategies that are responsive to changing market conditions, in particular, managed futures strategies that take long/short positions across a diversified basket of commodity and financial market futures.

Managed futures as an asset class are historically non-correlated to the stock and bond markets over long term periods and encompass a wide range of trading strategies (generally taking long/short positions in futures contracts on equity indices, commodities, financials and currencies). As such, although there is no necessary correlation or non-correlation between assets classes, managed futures as an asset class offer a potential diversification benefit over long-term periods, particularly during periods of significant market turbulence. For example, while managed futures as an asset class have generally underperformed stock and bond markets in their current bull market, if one compares the rolling 12 month returns of various asset classes (bonds, hedge funds and managed futures) against the S&P 500 from 1994 to 2014, managed futures as an asset class rose when the S&P 500 declined.

Asset Allocation for the Coming Regime Change

While central bank policy and financial engineering have supported a nearly uninterrupted run-up in stock and bond markets over the last decade, it has also led to significant distortions in the valuation of stock and bond markets.  To potentially manage downside risk in a relatively uncertain market environment, we believe investors must avoid complacency and should reevaluate their portfolio allocation strategy. In our opinion, modifying the traditional 60/40 stock/bond allocation by including a 5%-15% exposure to managed futures offers the potential to offset the market impact of the coming regime change.

However, managed futures involve substantial risk and are not suitable for all investors. Accordingly, investors should carefully consider whether managed futures are appropriate for them in light of their investment experience, trading objectives, financial resources, and other relevant circumstances.

Victor Sperandeo

President & CEO

Enhanced Alpha Management, LP

Creator of the Trader Vic Index

Adam Watts

Managing Partner

Enhanced Alpha Management, LP