Maintaining an Efficient Portfolio Requires Risk Management

Maintaining an Efficient Portfolio Requires Risk Management

Posted on October 31, 2016
Weekly Update

Market State 2: Bullish (27 days): Market State 2 represents a long term bullish environment and low market volatility. The S&P 500 closed Friday at 2126.41. This is getting very close to an important support level marked at the June 9th high of 2119. A decisive break below the 2120 area could signal a decline to the 2000 range seen on June 27th (see chart 1).
Volatility Alert:
Canterbury Volatility Index (CVI 50) Volatility, as measured by the CVI, continues to decline and has now squeezed down to a level where one or two day outliers (up or down,  2% or greater) are likely to occur soon. Please see chart 1 below.
Optimum Volatility Review: The optimum volatility range, as measured by the CVI, is about CVI 75 on the high side and around CVI 55 for the low. The market’s volatility is now below the optimal range. Canterbury’s studies show evidence that periods with extreme low volatility are often resolved by one, or more, outlier days. These “outliers” are substantially larger than the typical daily fluctuations expected during a bull Market State environment (see chart 1).
Chart 1 - S&P 500: Extreme low volatility can result in sharp one day outliers.
Source: AIQ
Market Comment:
Below is a recap of how the broad market indexes finished the week ending October 28, 2016.
Dow Jones Industrial Average           (Large Cap)               +.10%
S&P 500                                             (Large Cap)                     -.70%
NASDAQ 100                                     (Large Cap)                  -1.3%
Russell 2000                                       (Small Cap)                     -2.5%
Bonds                                                                                              -.60%
Oil                                                                                                   -4.3%
Source: Bloomberg
The recent deterioration in the mid and small cap stocks are reflected in a weakening Advance/Decline line (ratio of stocks going up vs. down). The S&P 500, stocks only, A/D line can provide an early indication of the future market direction, which in the current case would indicate down.
Last week saw another shift in leadership from growth to value stocks. Growth has been leading value through most of the summer and value led growth through the early part of 2016. This year will be known for many rotations in leadership. For example, the Utilities sector (XLU) was up more than 22% year-to-date through early July before falling about 11% through October 11th. During the same time, the Technology sector (XLK) made no gains through mid-July and then went up around 13% over the next three months.
Canterbury’s studies show that bullish Market States are always subject to random market noise as defined as a correction of about 8% to 10% from the previous peak. The S&P 500’s peak was at 2190 on 8/15/16. The market closed at 2126, or down almost 3% from the peak on Friday. A normal bull market correction (about 10% from the peak) could take the market down to the 2000 area mentioned earlier.
Limit Risk and Maximize Return:
As I have discussed many times in the past, bullish Market States are more predictive of risk than they are of upside returns. We can’t see into the future. That said we can identify markets and ETF securities that are in bullish Security States. These bullish ETFs have many of the same characteristics as those securities that have made substantial gains. What we do not know is how long an ETF will remain in a bullish Security State. The length of time that an ETF can remain in a bullish Security State will directly impact the eventual upside return. On the other hand, ETFs that have the required characteristics, to be in a bullish Security State, will tend to have limited risk.
Each ETF, in Canterbury’s universe of potential holdings, is evaluated by the Portfolio Thermostat’s indicators every day. Those ETFs that qualify to be in “bullish Security States” will always be subject to normal and random bull market corrections defined as about a 10% decline from the previous peak in price. ETFs that are in Transitional or Bearish Security States can see declines of 20%, 50% or more!
When an investor holds a number of ETFs that are in “bullish Security States” he or she will then own a portfolio of securities that, as a combined group, will be in a “bullish Portfolio State.” Such a portfolio should have limited risk while, at the same time, have the characteristics needed to produce substantial returns over time. The key word is “time.”
We know that markets and portfolios do not go up in a consistent and predictable manner. They tend to see most of the gains come over relatively short periods of time and when most would least expect. The Portfolio Thermostat methodology was developed with the idea of limiting risk to normal bull market corrections (about 10%) while participating in the upside potential of ETFs that can remain in bullish Security States for a long enough time to produce substantial gains. In other words, the Portfolio Thermostat’s goal is to limit risk to normal bull market corrections while benefiting from compound returns and unlimited upside connected to securities that remain in bullish environments.
A systematic rules based process should be designed for the purpose of managing the liquidity and fluctuations of securities to our benefit. The alternative would be to simply buy and hold a broadly diversified portfolio of securities and occasionally rebalance, back to the original percentage allocations, after the portfolio moves in one direction or the other. The problem with the traditional approach to portfolio management is that all traded securities will eventually experience bear markets. Meaning that there is substantial risk in holding securities (stocks or bonds) during the times when they are in bear markets. Even “conservative” portfolios can lose -20%, -30% or more during difficult periods. While on the other hand, the expected long term return, on traditional buy and hold portfolios, are typically about 10% or less.
Why would anyone be willing to accept two or three times as much risk as the long term expected return?
Bottom Line:
Long term returns come as a result of risk management. Financial markets are liquid and will experience both bull and bear markets. They always have and they always will. Therefore, the most efficient portfolio (the one with the highest returns and lowest risk) is a moving target. Constructing and maintaining an efficient portfolio requires an active process. In other words, why would one just hold the same portfolio during both, bull and bear markets?
A well designed portfolio management process should be able to limit risk to the 8% to 12% ranges. As long as the portfolio holds securities that have the potential for substantial gains; i.e., not only short term fixed income, then the passage of time should produce compounded returns.

Canterbury Investment Management: Tom Hardin

More About Tom Hardin
As Chief Investment Officer, Tom has more than 30 years of experience in the investment management industry and has a broad breadth of knowledge. He is known as an innovator, educator and has been revolutionary in the advancements of portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.