Traditional Beliefs are Hard to Kill

Traditional Beliefs are Hard to Kill

Posted on December 23, 2013

Canterbury Portfolio Thermostat Weekly Update – 12/23/2013

Market State 1 – (1 trading day) - Long term Bullish; short term Bullish - Market State 1 is the most predictable of the Portfolio Thermostat’s 12 Market States (environments). The expected risk is typically in the -2% to -4% ranges measured from the previous market peak. The most recent S&P 500 peak was registered on Friday at 1818.32.

Canterbury Volatility Index (CVI) = 52 (rational market environment) The CVI was up 2 points for the week. Last Tuesday tied the lowest volatility reading (CVI 48) since the first quarter of 2007. The CVI spiked 5 points when the S&P 500 popped up 1.67% last Wednesday. A CVI reading below 75 is considered to be a "safe zone.”

Market Comment:
Last week was a good one for stocks. The S&P 500 closed up 2.42% for the week. In just one week our overbought/oversold indicator moved from 92% "oversold” (extremely short term oversold - Bullish) to 80% "overbought” (moderately overbought - Neutral). The market may take a little time to digest its recent gains. That said the US stock market is on a roll. There are only six trading days left in 2013 and there are more investors who wish they were more invested in the stock market than those who want to get out. In other words, there is more short term demand than supply.

Our previous Weekly Update was short and to the point. US Stocks Remain the Place to Be. This is the time to own US stocks. As of today, the Portfolio Thermostat’s indicators would not justify any "hedging” techniques on major US stock market indexes. Weekly Update 12/16/2013

Observations Leading to Confusion then Followed by Clarity:

What, own stocks with no allocation in "safe” bonds! What about my fixed percentage pie chart asset allocation based on my risk tolerance? My "pie chart” is highly diversified based on my personal risk tolerance. It looks like the NBC turkey… I mean peacock?

Traditional investment management, asset allocation and diversification were based on theories and assumptions formed in the 1950s, "60s” and ‘70s.” Many things have changed between then and today. Advancements in 21st century technologies have made it possible to test the relevance of many traditional theories and practices. Specifically, are traditional methods effective at managing the risk/return relationship in a portfolio?

Investopedia on asset allocation and the risk/return trade off: Asset allocation is a process that attempts to balance risk versus reward by adjusting the percentage among stocks, bonds and other asset classes according to the investor's risk tolerance. Risk Tolerance is the degree of variability in investment returns that an investor is willing to withstand. Bonds are safer investments than equity securities, but riskier than cash.

The assumption that bonds are safer than equities is not always the case. The truth is that most investment classes will experience variable volatility and returns based on their success or failure in the global competition for investor’s dollars. The variability of the risk and return relationship is precisely why static asset allocation and diversification are not effective ways to "balance risk and reward according to the investor’s risk tolerance.”

Markets and the Weather have Many Similarities

Traditional fixed percentage asset allocation and static diversification simply can’t manage the risk of variable markets. Think about it. Markets are dynamic and ever changing, similar to the changing temperatures north of the Mason Dixon line.

The practice of assigning a fixed percentage asset allocation and Static diversification will have the same result as fixing your home’s thermostat to produce 12 degrees heat, all the time, based on an average outdoor temperature of 58 degrees. The problem is that the average almost never happens because temperatures and markets are variable.

During 2013, most bonds had historically high volatility and negative returns. The 20 year Treasury bond (TLT) is down -13.97% year to date and has had higher volatility (more risk) than the S&P 500. The "ultra conservative” 7 to 10 year Treasury note (IEF) has dropped -7.01%. Is that Conservative?

In contrast, the S&P 500 is up an amazing +30.16% and has had less volatility than Treasury bonds. The S&P 500’s largest peak to trough decline (maximum drawdown) was only -5.76% (between 5/21 and 6/24). All other short term corrections were less than -5%. Is that Aggressive?

The traditional risk and return assumptions were turned upside down during 2013. For the most part, what is considered conservative was risky and what is risky was conservative.

2013 - Year to Date through 12/20/14

Traditional asset allocations in order of the traditional definitions - Conservative to Aggressive:

Traditional Risk Year to Date Return 2013 - Highest CVI (volatility) Lower Number=Lower Risk
"Ultra Conservative”
7 to 10 Year Treasury Notes (IEF)
-7.01% CVI=42
"Very Conservative”
20 Year Treasury Bonds (TLT)
-13.97% CVI=87
"Conservative”
50% S&P 500/50% T. Bonds
+ 7.34% CVI=80 (High Risk/Low Return)
"Conservative/Moderate”
60% S&P 500/40% T. Bonds
+11.63% CVI=78.6
"Moderate”
70% S&P 500 30% T. Bonds
+16.06% CVI=77.2 (Low risk/High Return)
"Aggressive”
S&P 500 Index (SPY)
+27.49% CVI=73
"More Aggressive”
NASDAQ 100 (QQQ)
+32.81% CVI=69

Bottom Line:
All markets are dynamic and ever changing. As a result, the risk and return characteristics, on all investment classes, constantly change. High and increasing volatility is one of the primary Bear market characteristics. The Portfolio Thermostat’s objective is to maintain low or declining portfolio volatility to avoid substantial declines and to achieve the benefits of compounding returns. Substantial declines kill the ability to compound returns over time.

This year the Portfolio Thermostat was successful in avoiding holding positions Bonds, Gold, Commodities, and other investment classes that experienced substantial losses. In fact, the model currently has a gain in the "Inverse” Gold ETF (DGZ) and locked in a profit in the "Inverse” Treasury bond ETF (TBF) earlier in the year.

Today, we have all the technologies and innovative investment tools that make it possible to benefit from any market environment – Bull or Bear.

Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom Hardin, Chartered Market Technician (CMT), makes all the final decisions on all investment and portfolio management decisions for Canterbury Investment Management. Tom has more than 30 years experience in the investment management industry and has broad breadth of knowledge. He is known as an innovator, educator and been revolutionary in the advancements in 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.