I have been writing a lot lately about the new market environment and its implications for Tactical Asset Allocation. Now that it looks like we are back in a market correction this article will go into more detail about how to handle these types of moves.
In the past any type of tactical methodology could successfully navigate a market correction. Corrections gave plenty of warning before the majority of the decline and before the majority of the recovery. In this new market environment, corrections give little, if any warning, making navigating them much harder than ever before. If practioners implement the following steps then market corrections can be an opportunity rather than something to be dreaded:
1. Use multiple tactical methodologies. No one methodology works well in every market environment. Instead of trying to find the one “best” methodology, multiple, un correlated, methodologies should be combined.
2. Use some sort of optimization and/or regime switching approach to be able to move to the methodologies that are particularly suited to the present market environment.
3. The approach should take volatility into account so that you can increase risk when market volatility is decreasing and reduce risk when it is rising.
4. Emphasize counter trend models over trend following and fundamental. Counter trend models which seek to buy into short term weakness and sell into short term strength can offer better risk adjusted returns than other types of models. They also typically do this with much less time in the market than other methodologies.
5. Ladder your counter trend methodologies. During a correction markets can get very oversold and very overbought. Counter trend methodologies should be laddered just like a bond portfolio might be laddered so that they scale into and out of markets.
6. Use conditional filters. Looked at over a large period of time it may seem as if the performance of different methodologies is fairly uniform. However, when time frames are reduced you may find that a model has much better success with long trades when the underlying security is above a certain moving average, or corporate earnings are increasing, etc. These types of things can be used to filter trades and reduce risk.
7. Use a short side. You may not be comfortable being net short the market but using models that have the ability to short can offset the risk of models that may be long during a correction.
8. Incorporate extremely short term momentum models. Over long periods of time, extremely short term momentum models will not work well. However, they can navigate a correction very well, getting out near the top and back in near the bottom. If you apply an optimization or regime switching approach you can be allocated to these models when the environment is conducive and out of them when it is not.
9. Eliminate as much of the rebalance date risk you can. Because corrections are so sharp and come so quickly rebalancing a portfolio on one fixed date could bring a lot of extra risk. Instead of rebalancing portfolios on one fixed date they can be tranched. For example, a strategy that rebalances weekly on Mondays could be changed where 20% of the portfolio is rebalanced on a daily basis.
Incorporating these steps will help tactical strategies successfully navigate corrections in this new market environment.