Adaptive Regime-Based Framework: Real World Investing

by: John M. Balder

Summary

We illustrate how a regime-based framework works using three data series: VIX, GDP Growth and the S&P 500.

This framework is designed to reduce losses and participate in upside markets.

This type of framework also reduces the role of emotions ("buy high and sell low") in investing.

A regime-based framework can be constructed to protect clients' money when markets deteriorate and to add value when conditions are more favorable. This process identifies macroeconomic and financial market indicators that matter - these are then used to monitor the macro-financial cycle. Rigorous statistical and quantitative methods are then used to identify distinct market regimes based on these factors.

Our portfolio is allocated across equities, bonds, commodities, REITs and cash according to the performance of each asset class in the specific regime throughout history (we make rules-based adjustments for valuation).

In developing our regime-based framework, we examine five distinct types of macro-financial data: (1) measures of market sentiment, (2) interest rates, (3) household and business balance sheets, (4) real economic factors and (5) asset prices. We apply a statistical process to more than a dozen data series that we use to generate our regime framework. Our use of balance sheet information links the financial markets with the real economy.

To illustrate our process using a simplified example, in the chart below, we examine the relationship between three data series: GDP, the VIX and the S&P 500. The chart below standardizes and plots quarterly data for these three indices.

In this chart, when GDP growth is strongly positive and the "fear index" (VIX) is declining, for example in 2003-2004, the S&P 500 index tends to increase in value. However, when the VIX increases and GDP growth slows, the S&P 500 tends to decline in value (e.g., in the financial crisis in 2008). Our framework is designed to adapt to changing market conditions. Average quarterly correlations between the three variables during the 1990 to 2016 period are:

Average Correlations: VIX, GDP Growth and the S&P 500 Index:

5/90 to 12/2016

GDP

S&P 500

VIX

-0.33

-0.44

GDP

+0.29

As a general rule when the VIX rises, the growth rate in GDP and the S&P 500 tend to fall. Growth in GDP and the S&P 500 are positively correlated. Standardized data (standard deviations from the mean) is presented below for several periods, including:

(1) January 1993 to September 1996: Boom

(2) January 2001 to March 2003: Tech Bubble/Recession

(3) July 2003 to March 2006: Housing Boom

(4) January 2007 to March 2009: Great Recession

As illustrated in the chart below, the VIX fell and GDP Growth and the S&P 500 added value in periods (1) and (3). These relationships reversed in periods (2) and (4).

Standard Deviations from the Mean: Select Periods

Start

Finish

VIX

GDP

S&P 500

Jan-1993

Sep-1996

-0.78

+0.40

+2.92%

Jan-2001

Mar-2003

+1.01

-0.38

-5.56%

July-2003

Mar-2006

-0.64

+0.83

+3.74%

Jan-2007

Mar-2009

+0.78

-1.33

-4.67%

Our framework uses the following regimes to capture changes in the macro-financial cycle:

SEEKING SAFETY - when markets are in this regime, we invest in relatively low risk or risk-free assets, such as US Treasuries, cash and, for protection against broader systemic (e.g., currency/banking system) threats, gold.

RISK-ON! - generally follows a crisis and/or recession and is an optimal time to increase risk-taking. This regime evolved following both the tech bubble/recession in 2000-2002 and the financial crisis in 2008.

ADJUST RISK - as the financial cycle matures, there is a need to make some adjustments to the allocation. In this regime, the portfolio composition tends to shift away from REITS, high yield bonds and emerging debt toward equities and commodities.

FADE RISK- The financial cycle often weakens ahead of a slowdown. In this phase, our allocation shifts to a less aggressive portfolio with an increased allocation to US Treasuries, TIPS and cash. The financial cycle was in this phase from 2005 to mid-2007. This regime often serves as a precursor to a recession or crisis.

NEUTRAL - In this regime, our allocation is balanced across the various asset classes. We tend to be in a Neutral regime about one-third of the time. The framework shifts from a Neutral Regime to one of the four regimes.

As a general rule, the macro-financial cycle tends to move sequentially from SEEKING SAFETY to RISK-ON! to ADJUST RISK to FADE RISK and back to SEEKING SAFETY, with periodic interruptions from the NEUTRAL regime. However, this sequential process is non-linear and sometimes reverts - for example, it can shift from FADE RISK to ADJUST RISK, if the macro-financial cycle suddenly re-accelerates. Or in the case of a slowdown, it can revert from RISK-ON! back to SEEKING SAFETY. And the NEUTRAL regime is in place about one-third of the time.

Conclusion

This regime framework is designed to capture the interaction between the financial markets and the real economy. Our process is defined to reduce losses in difficult periods and to add incremental value when markets are improving. Our rules-based framework removes the role of emotions ("buying high and selling low") and provides a sensible approach in today's highly uncertain markets.

For more information, please see these articles.

http://www.pionline.com/article/20150716/ONLINE/150719937/in-pursuit-of-the-holy-grail

https://seekingalpha.com/article/4039734-multi-asset-class-investing-adaptive-approach.

Background is available at:

https://seekingalpha.com/article/4008292-adaptive-vs-static-asset-allocation-addressing-potential-portfolio-losses.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.