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With the U.S. election just days away, the "fiscal cliff" looming and equities falling below QE3 levels, there are storm clouds ahead. Market leaders Apple (NASDAQ:AAPL), Qualcomm (NASDAQ:QCOM) Microsoft (NASDAQ:MSFT) and Amazon (NASDAQ:AMZN) amongst others, are all under short term pressure, it would appear we are at yet another crossroads where portfolio management and asset allocation are of critical importance. But how can we diversify when asset market correlations are converging to 1.

For sure there's two sides to every argument and plenty of reasons to be confident in the days ahead. Recent data has been strong; robust retail sales, ISM has moved back above the 50 boom-bust level, a rebound in housing starts, Unemployment at 4 year lows and 5 year highs in consumer confidence. China's Q3 GDP data surprised to the upside, and in Europe; Italian and Spanish bond spreads have narrowed to the German Bund, with CDS prices also closing in aggressively. Credit distress in the money market is also disappearing with both the FRA-OIS spread and the Cross currency swaps narrowing as LIBOR rates grind lower.

But on the flip side recent earnings excluding the banks has been weak. Most concerning is the weak revenue reports from firms spanning the broad economy. Profit margins are being squeezed due to rising costs, weak demand and over-capacity. IBM sales slid 4% in the Americas and 9% in Europe, Africa and the Middle-East. Intel (NASDAQ:INTC) had a 5% y-o-y drop in revenue, and 14% y-o-y fall in profits as PC demand crumbled. Google (NASDAQ:GOOG) and Microsoft missed on the top and bottom line, and we also saw misses from General Electric (NYSE:GE) and McDonald's Corp (NYSE:MCD). Only 42.3% of S&P 500 reported companies beat Q3 revenue expectations, 57.7% missed, and 64.9% have missed EPS estimates. In fact of the 20 S&P companies that have provided guidance for the 4th quarter during the current earnings reporting season, 18 have slashed their profit forecasts, that's 90%. Friday saw a 1.6% fall in equities, and a sharp move higher from the VIX which has been historically low this year. In 2012 it has been below the 14 level on 13 occasions in; March, August, September and October, before that it was last below the 14 level in June 2007. Currently at 17.06 a break above the 200 day moving average at 17.89 could set off alarm bells.

So at this juncture how should we manage our portfolios ? In a recent "A Conversation with Ray Dalio", the hedge fund legend said that

in every generation there is some period of time that will ruin .... there is a ruinous asset class that will destroy wealth, and you don't know which one that is going to be in your life time. So the best thing you can do is to have a portfolio that is immune, that is well diversified, that is what we call an all weather portfolio. That means that you don't have a concentration in that asset class that is going to annihilate you. And you don't know which one it is.

This is all the more alarming when we see from the chart below how asset market correlations have converged towards 1 (and at an increasing pace) in the last few years. The S+P index now has an 87.8% correlation to the S+P Global Property Index, surprisingly also an 86.6% correlation to the HFRX Global Hedge Fund Index, and also a 77.2% correlation to commodities (from near zero in 2005). In 2010 the portfolios correlated at over 90%. Portfolio risk has increased tremendously.

(click to enlarge)Annual asset market correlations

So where is an alternative? The answer is systematic CTA (Commodity Trading Advisor) type strategies. These are NOT high frequency algorithms, but automated, program trading funds that give low risk, consistent returns. Since January 2000, CTAs have generated monthly average returns of more than 2% in periods when global equities were experiencing strongly negative monthly returns of at least 5%. They have also enjoyed annual average returns of 7.1% since 2000, and incurred only one year of losses -4.3% on 2009 - according to the NewEdge CTA index.

With their disciplined, automated risk management procedures they also have low volatility of returns. Usually non-discretionary, there is no human emotion involved in the trading process. Trade entry signals can be programmed on a whole host of different filters; technical analysis, mathematical pattern recognition, and even fundamental analysis are common options. The computer continuously scans the market for trade signals, enters positions, balances risk-size, enters stop loss and take profit levels and continuously manages the positions. It's a numbers game, no single trades hit huge outsized profits, instead over time losses are cut immediately and winning trades are left to run to optimal take profit levels (using for instance; DeMark exhaustion levels, extreme standard deviations, reversal patterns, changes in volatility etc). The chart below of the NewEdge CTA Index plotted against the S&P since 2000 highlights the consistency of such strategies. While the S&P is still fractionally below is January 2000 level, the NewEdge CTA index has doubled, not only with consistent returns, but also without significant draw downs.

(click to enlarge)S&P vs NewEdge CTA Index

The beauty of such strategies is that they can be profitable in falling as well as rising markets, they can (and usual are) trend following, but also mean revert, identify trading patterns and even respond to macro data. They will never hit huge short term returns, but that is not the purpose; rather the goal is consistent, low risk returns, non-correlated to the main asset classes, DIVERSIFICATION as well as alpha generation.

Several hedge funds specialize in such strategies and the RBS family of Trendpilot ETNs follow a similar trend following style; (NYSEARCA:TRND) U.S. Large Cap Trendpilot ETN, (NYSEARCA:TRNM) US Mid Cap Trendpilot ETN, (NYSEARCA:TBAR) Gold Trendpilot ETN, (NYSEARCA:TCHI) China Trendpilot ETN, (NYSEARCA:TNDQ) Nasdaq Trendpilot ETN, and (NYSEARCA:TWTI) Oil Trendpilot ETN.

Foreign exchange is also becoming an increasingly popular focus for such program trading strategies. While S&P volume has fallen back to levels not seen since 1999, average global currency turnover has risen from $3.98 trillion in 2010 (Bank for International Settlements) to $4.71 trillion in July 2012 (Dow Jones Newswire).

However what continues to surprise is investors fear of program trading, fearing the unknown they prefer to hold more tangible assets. This is not high frequency trading, but instead automated identification of market trends, extreme levels, price patterns and even pre-determined macro levels, followed by automated trade entry and risk management. Ignoring this leaves investors highly exposed to potential downside risks and blissfully unaware of potential non-correlated returns.

With weak price action in the Nasdaq and other market leaders, poor earning season and the S&P trapped between 1475 and 1395 (not to mention the upcoming election and the "fiscal cliff") this may be the optimal time for those "seeking alpha" and true portfolio diversification to look to add systematic strategies to their portfolio.

Source: How About Alpha AND Diversification?