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It is much easier to identify bottoms in the market than tops. I am confident that most investors were able to find value in the spring of 2009. The margin of safety increases drastically after a major correction. As a market expansion matures (our current expansion is just over three years), market direction becomes murkier as data from the business cycle becomes more challenging to interpret. Any hiccups in the market are scrutinized as to whether it is only a breather in an otherwise longer-term upswing or the signaling of a momentum shift toward a more substantial reversal. Thus the mid-cycle pickle.

The current business mid-cycle is doing its part to present mixed or conflicting economic data. An unseasonably warm winter has added to the confusion. Conflicting data creates choppy markets as market participants weigh incoming data and update their investment positions accordingly. The most recent data clearly is mixed with a light ADP private payroll report on Wednesday and the positive manufacturing data earlier this week from both the U.S. and China. Friday's U.S. jobs report will be a key report as well.

As we enter the summer months, I am quickly reminded of the uncertainty that we faced in 2010 and 2011. The challenge we face is centered on determining on how to be positioned when the economic expansion is in the mid innings hits a soft-patch. Is the data signaling a breather before resuming growth or a material shift in the business cycle. As part of exiting the financial crisis, we have seen some unprecedented actions from central banks across the globe in stimulating the world economies that have made identifying where we are in the cycle very challenging.

There is reasonable evidence of the challenges faced by investors in the past two mid-cycle breathers as seen in Figure 1. As uncertainty increases, direction changes in the market are amplified, which in turns drives volatility higher. The rapid rise in volatility is associated with great uncertainty about the future. And it is precisely during this uncertainty that we are our own worst enemy.

Figure 1: Broad Market Adjusted Prices and Underlying Volatility

(Click charts to enlarge)

Normally a diversified portfolio incorporating low-correlated assets is supposed to limit this volatility (according to Modern Portfolio Theory). However, diversification has been muted given that correlations between asset classes have been elevated and subject to some extreme shifts since the 2008-2009 global financial crisis. The result has largely been identified as the "Risk on - Risk off" phenomenon. Some thought research from HSBC has shown its interpretation (pdf) of the rising correlation phenomenon. Morningstar (via Seeking Alpha) has also recently published its view on the correlation conundrum.

While there is evidence that correlations are increasing both across and within asset classes, one must also consider the drastic shifts between various investment classes. Figures 2 & 3 highlight the rolling three-year correlation between the broad U.S. equity and bond markets and between the U.S. large- and small-cap stocks, respectively.

Figure 2: Rolling 3-Year Correlation between U.S. Stocks and Bonds

Figure 3: Rolling 3-Year Correlation between US Small and Large Stocks

Standard or static asset allocations were never designed to adjust for such shifts in asset class correlations. Positioning portfolios for the potential impact of the 2012 mid-cycle challenge in my opinion remains rooted in 1) asset class diversification and 2) limiting asset level volatility. Therefore diversification must be used along with some sensitivity to volatility at the security level. Tilting portfolios with factors including dividends, value, or low volatility makes sense in this environment. This works for fixed income as well for equity as one can consider iShares Barclays CMBS Bond Fund (CMBS) as a low volatility compliment to the Barclays Aggregate Bond Fund (AGG).

I am partial to this approach when looking abroad such as for International Equity allocations. PowerShares International Dividend Achievers (PID) or iShares Dow Jones EPAC Select Dividend Index (IDV) can be used as an alternative or compliment to the traditional iShares MSCI EAFE Index (EFA). In the Emerging Markets, one can consider WisdomTree's Emerging Markets Equity Income Fund (DEM) as a compliment to the iShares Emerging Market Index (EEM).

While lowering the volatility can help, as I hinted in my article on valuation and passive investing -- a time-series based trend following system can also be used to keep the volatility of the portfolio down. I am partial to this system given that it is mechanical in nature and provides a protective barrier between our emotions and our investment returns.

The great values of 2009 have obviously passed. Professor Shiller's Cyclically Adjusted PE (CAPE) ratio dipped to 13.3X in March of 2009, only to rebound to 22.2X as of April. (The average since 1881 is 16.4X.) While that might give value investors some pause - I think with strategies designed to handle these mid-cycle volatility spouts, reasonable returns can still be generated.

To end with a great line from Brad Jones, a macro investment strategist from Deutsche Bank:

"Play Defense First - Just Stay Clear of Big Bear Markets, and the Long-term Equity Risk Premium Will Look After You!"

Source: The Mid-Cycle Pickle: An Asset Allocation Primer