There is no shortage of opinions when it comes to the markets. Investors spend time and energy trying to determine which direction the market or a specific investment is going to go, often with disappointing results.
Market analysis doesn’t have to be openly complex. At any point in time, markets are in one of three states:
- Markets are going up (Bull Market)
- Markets are going down (Bear Market, or a longer-term decline of more than 20%)
- Markets are in some sort of correction (Shorter-term decline of less than 20%)
Unfortunately, it’s impossible to predict which state a market is going to be in, and nearly impossible to figure out what state it is currently in, except in hindsight.
The Holy Grail of investing would be to have a strategy that could perform well in any type of market environment, making money when markets are going up and avoiding losing it when they are going down.
Traditional approaches that buy investments and hold onto them typically fall into what some call a “Buy and Hope” category. These approaches might make money when the market is going up but will likely lose money when the market is going down. With no downside protection, there’s just the hope that markets don’t begin sliding.
Tactical Asset Allocation (TAA) gained popularity with investors frustrated with traditional approaches during the 2008 bear market. The promise of TAA rests in the ability to move an entire portfolio from “Risk On” to “Risk Off”. When the market is going up, the portfolio would be in stocks. When it is going down, the portfolio would be in cash or in some other type of defensive investment. This approach was, in theory, a Holy Grail, resulting in a portfolio that could do well regardless of what the market was doing. However, in practice tactical asset allocation hasn’t lived up to this promise. One of the reasons why stems back to a previous point: one cannot predict where the market is going to go, and it may be uncertain what state the market is actually in until it’s over. Consequently, a TAA strategy may often be wrong, remaining in stocks during a market downturn and/or adopting defensive positions when the market is going up.
Regardless of what state the market is in, human beings ultimately decide which direction prices are going to go. One could also argue that these decisions are often dominated by greed and fear. Greed can cause stock prices to go too far in an up market, whereas fear can cause stock prices to decline too much during a down market. Any investment methodology should have components that can deal with, and profit from, greed and fear. That can be done with Trend Following and Counter Trend Following:
Trend Following—Trend Following methodologies deal with greed. They buy an asset when it is going up and sell it when it starts to go down.
Counter Trend Following—Counter Trend Following methodologies deal with fear. They buy an asset once it is has gone down too far and sell when it snaps back towards equilibrium.
Another key aspect of market dynamics is the speed at which things happen. Being a long-term investor used to mean buying something and holding onto it for years. Now, that can be a recipe for disaster. Markets move more quickly than they ever have before, and as technology continues to adapt, various markets’ moves will also occur more frequently. Methodologies need to be able to move on a dime to keep up with ever-changing markets.
Trend Aggregation can be described as the next generation of TAA. Instead of trying to shift an entire portfolio from bull to bear mode, and then back again, based on one imperfect model, Trend Aggregation divides a portfolio into sleeves. Each sleeve is designed with the intent to do well in one or more market states without losing money in the other states. Money in each sleeve is managed using Trend Following and Counter Trend Following methodologies that can move on an intraday basis.
More often than not, markets are typically in a bull phase, and stocks are increasing. Therefore, the bulk of a portfolio should be allocated to models that are designed to make money during up markets. However, unlike buy and hold, Trend Following models and protective stops in Counter Trend models protect from market declines. The most effective way to make money in a bull market is through stocks and/or equity ETFs. Ideally, one would use a combination of the two. Individual equities offer the potential to add alpha to a portfolio, but they can diverge from the market. ETFs won’t add any alpha, but they will track whatever market they are designed to track.
Corrections are short and sharp declines in the market that can be as large as 20%. They often come with little, or no, warning. The correction part of a portfolio is designed to make money during these times, but because they can occur so quickly, these models need to have fairly constant exposure. This presents a problem since instruments and strategies that would make money in a correction, such as short selling, puts, and volatility, will generally lose money during a bull market. It doesn’t make sense to have something in your portfolio that will lose money most of the time, only to make money every once in a while when the market corrects. The only asset classes that typically work here are Treasuries and precious metals such as Gold. Unlike other “defensive” assets, Treasuries and Gold can make money in a bull market. The portfolio should have almost constant positions in these assets since a correction can come out of nowhere, but Trend Following and Counter Trend Following methodologies should still be used to move positioning up and down based on what markets are doing.
Bear markets are large sustained declines of more than 20%, and often more than 50%. They last longer than corrections and usually come with some warning. The bear market part of a portfolio would consist of securities and strategies such as short selling, put buying, and/or volatility. Trend Following methodologies would ensure that these models would trigger during a bear market, and Counter Trend methodologies would add protection at market peaks.
BUILDING A PORTFOLIO BASED ON HOW MARKETS REALLY WORK
Trend Aggregation attempts to produce the perfect portfolio, a part of which is designed to do well regardless of what the market is doing, without trying to predict what it is doing or going to do. Within the different parts of the portfolio, short-term Trend Following and Counter Trend Following methodologies are used to take advantage of market dynamics. The result is a portfolio that can beat the market while taking significantly less risk than traditional investing techniques.
The views and opinions expressed in this article are those of the CEO of Tuttle Capital Management LLC (TCM) and are current to the date of publication. The information contained in this article may be subject to change without prior notice. TCM may invest client assets in the securities or products referenced; however, references to the issuers of sponsors of such offerings are intended for illustrative purpose and, in no manner, should be construed as recommendation to make or to not make an investment. Investors should contact a financial professional for guidance prior to making any investment.
© 2021 Tuttle Capital Management LLC, a SEC-registered investment adviser. All rights reserved.