Markets in 2015: Winning by not losing

After lacklustre performances on many global share markets last year, it’s time to review your asset allocation.

Summary: Shares posted a lacklustre performance outside the US last year. For 2015, investors face the puzzles of whether the US can keep recovering, whether Europe will keep deflating and if Australia can avoid a hard landing.

Key take-out: It’s time for investors to review their asset allocation, with a focus on both long-term and short-term approaches. Market timers use trend-following strategies and ETF rotation strategies to manage risk and exploit short-term movements.

Key beneficiaries: General investors. Category: Investment portfolio construction.

Outside America, 2014 was a lacklustre year for shares.

The Dow Jones Global Stock Market Index was up just 2.1% over the year.

The global index would have been negative but for America which was up 11.4%. The US accounts for over 40% of global share market capitalisation, Europe about 25% and Asia Pacific almost 30%.

The DJ European share market index was down 9.1% with the market now in a severe correction.

The DJ Asia Pacific share market index (which covers 18 major Asia Pacific countries including Japan, China, Hong Kong, India, Indonesia and Australia) was down 1.6%. The Asian Pacific market is currently bouncing back from a mild correction.

The Australian All Ords index rose a mere 0.7% in 2014 during which it swung between 5088.7 (February 15, 2014) and 5656.9 (September 2, 2014), a band width of 11.2%.

Financial outlook

As a market timer I don’t forecast markets. Instead, I trend follow them.

2015 starts with a number of contradictions looking for resolution. They are:

  1. Can America keep recovering without an increase in interest rates? And if interest rates rise will its bond and share markets correct?
  2. Can Europe keep deflating if its central bank steps up quantitative easing? And will the rise of anti-austerity parties cause a breakup of the Eurozone?
  3. Can Japan keep weakening notwithstanding massive monetary and fiscal stimulus? Or is its ageing population too big a drag on growth to be offset by a money splurge?
  4. Can China manage its property and shadow banking bust? And how does a centrally driven economy shift from top-down infrastructure to bottom-up consumption spending?
  5. Can Australia avoid a hard landing following the end of its mining construction boom? Will Australian dollar devaluation, low interest rates and a housing recovery offset falling commodity prices?

The biggest puzzle is how can price deflation with low interest rates persist with the global financial crisis behind us?

The optimistic view is that globalisation, technology and demographics are cheapening everything so even massive money printing won’t ignite inflation. Indeed the future is “lower for longer”; low inflation and interest rates for decades ahead. We are entering a new age of innovations that will super-charge world productivity and prosperity. Technological breakthroughs will overcome seemingly intractable problems.

The pessimistic view is that these same forces are redistributing income from developed to developing countries that will see America, Europe and Japan “eclipsed”, suffering lower economic growth, higher unemployment and falling real wages (other than for executive and professional elites). The world is hitting debt, environmental and political limits to growth. Painful structural adjustment is unavoidable.

Portfolio management

In 2014, American shares, Australian property and global bonds performed well whereas resource stocks and commodities did poorly.

Going forward an investor should review their:

  1. Strategic asset allocation
  2. Dynamic asset allocation
  3. Tactical asset allocation

Strategic asset allocation

This is for the long term and takes account of an investor’s income needs, assets and appetite for risk. A useful rule of thumb for deciding an appropriate strategic asset mix is to match holdings of defensive assets with one’s age.

For instance, someone 60 years of age would be 60% defensive (cash, term deposits and bonds) and 40% aggressive (property, shares and gold) whereas someone younger could take greater risk by holding a higher portion of their investment portfolio in aggressive assets. High net worth individuals sometime cap their defensive assets at 50% since they don’t need a higher portion for income security.

Fixed interest securities (e.g. fixed rate bonds) can improve the stability of an investment portfolio because medium to longer dated investment grade bonds tend to move in the opposite direction to shares when investors become fearful. That’s because investors fleeing the share market seek refuge in government and blue chip corporate debt securities, thereby bidding up their prices. See next chart:

Source: FIIG. Note Bloomberg Composite Index used by IAF ETF

Dynamic asset allocation

This involves medium-term (one to five years) adjustments to the strategic asset allocation. An important consideration here is the outlook for bonds given that interest rates are presently at historic lows. See US chart below:

If rates remain “lower for longer” fixed income investments will deliver low returns. But if interest rates were to rise such securities would lose value if they have medium to long maturity dates.

A solution to this dilemma is to hold mainly floating rate bonds (whose yields would rise if rates went up) or inflation-linked ones (which would benefit from any rise in inflation).

Another approach is to allocate more of a portfolio to share funds, but manage the extra portion using slow trend or momentum trading strategies that can reduce their volatility (i.e. downside risk) to that of bond funds in more normal times.

Tactical asset allocation

This involves changing your asset allocation to exploit short-term (under one year) movements in asset classes or stocks. This is done by day and swing traders using traditional technical analysis, active fund managers of a value or growth style and market timers using trend and momentum indicators.

Typical risk management strategies used by market timers are those shown in the next two charts.

The first is a trend-following strategy applied to a listed fund such as STW (SPDR’s Australian S&P/ASX 200 indexed share fund). When the fund’s red 50-day price line is above its blue 250-day price line hold the fund, otherwise be in cash. The vertical bars represent red sell and blue buy signals for the fund.

The second is an ETF rotation strategy using relative price momentum. Each month compare the annual percentage rates of change of the unit prices of a handful of the most liquid exchange traded funds and always back the strongest fund. At present that is IVV (iShares American S&P 500 indexed share fund) on the global front and SLF (SPDR S&P/ASX 200 listed property fund) on the domestic front.

These are simple tactics that work better than holding a share fund passively.

Winning by not losing

As a market timer my primary interest is capital protection. Over time aggressive assets such as property, shares and alternates deliver higher returns than defensive assets such as cash, term deposits and bonds. But most investors cannot cope emotionally with the roller-coaster ride in asset prices associated with riskier assets.

Source: Option Alpha

A market timer’s solution to this dilemma is to reduce the downside risk associated with shares by using only listed index equity funds (that are highly diversified to minimise specific stock risk such as an ABC Learning) and to time them using either trend or momentum trading strategies (as illustrated earlier).

The objective of slow trend or momentum trading is to beat the share market by taking less risk. That flies in the face of conventional portfolio theory which argues that achieving higher returns is only possible by taking more risk. Yet trend and momentum research has shown that avoiding crashes not only makes for a smoother journey, but beats the market over the long run. That requires staying on the right side of an equity fund’s long-term price cycle rather than holding it passively.

Percy Allan is a director of MarketTiming.com.au. For a free three week trial of its newsletter and trend-trading strategies for listed ETF funds, see www.markettiming.com.au.

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