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How Conservative Should Investors Be Given Economic And Market Conditions?

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Adaptive regime-based investment strategies should incorporate the financial cycle. Given the absurd decision by mainstream macroeconomics to ignore credit, money and the financial cycle, as I discussed in prior articles (here and here), it is not much of a surprise that they completely missed the oncoming crisis in 2008. In fact, twice since 2000, investors have suffered losses of 40% of their portfolios. My firm’s motto is: “Better not to lose in the first place.”

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In response to this shortfall, we have created an adaptive regime-based investment framework that generates multi-asset and equity-sector-rotation model portfolios. The investment objective of these model portfolios is to combine downside protection with upside participation. Many firms say they do this – but our process integrates macroeconomic and financial cycle risk.

Our market state (or regime-based) investment framework utilizes more than a dozen variables that include measures of (1) market sentiment, (2) interest rates, (3) balance sheets, (4) real economic activity, and (5) asset prices. Once this information is distilled using a proprietary statistical process, we apply our adaptive regime-based framework, described below:

Our framework consists of five regimes. Each regime must offer different features. If the regimes are not sufficiently distinct from one another, performance will be inferior. For example, in our back tests, from September 2008 to February 2009, we were in a seeking safety regime and the portfolio was invested in safe assets, such as U.S. Treasury securities, cash and gold. Alternatively, in 2009-2010, we were invested in a risk-on market state, which included extensive exposure to risk, including equities, commodities and risky bonds, such as high-yield and emerging-market debt. Our process is intentionally designed to adapt to changes in market conditions and macro-financial risks.

The movement in market states from one year-end to the next is provided in the figure below – we ran back tests from 1990 to 2016. Note especially that the portfolio at the end of 2008 was at an extreme (“off-the-chart”) seeking-safety market state, before recovering in 2009.

By John M. Balder, read the full article here.

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