Avoiding Black Swans

The market itself determines 80%-90% of your portfolio’s volatility. The trend of the market is far more important than the selection of individual securities, although CNBC would have you believe otherwise. Keller Partners offers market analysis tools, that enhance portfolio performance, but — even more important — help manage the devastating portfolio drawdowns that occur in bear markets. The KP Market Trend Model identifies three distinct market regimes, each associated with very different risk/return expectations.  These are critical tools for managing the market risk of a portfolio

When we make an effort to identify the underlying trend regime, we also begin to address a core problem of investing: the recurring tsunamis in the financial markets. These “Black Swan” events are extremely destructive but also, by definition, unforeseeable. With the exception of a handful of individuals who were subsequently celebrated for having “predicted” these meltdowns, the financial services industry is embarrassingly inept at managing client portfolios through disruptive events such as 1987, 1998, 2001-02, 2007-08, or 2011.  Any one of these was traumatic enough to cause conservative investors to abandon their investment programs.

Despite the frequency of financial Black Swans, Wall Street’s approach to portfolio management still focuses its resources on economic prospects and the outlook for individual companies.  Wall Street makes almost no effort to align client portfolios with the prevailing market trend, not to speak of building defensive strategies to cope with the next Black Swan (or “Lehman” event). What efforts the industry does make at market analysis and prediction are almost all fundamentally based: economic forecasts, earnings models, relative currency movements, etc., which have not been shown to correlate with future market movements.

Our work focuses exclusively on the market itself and studies only the large amounts of internal data that financial markets generate on a daily basis. In effect, we try to follow the money. We deliberately do not incorporate economic inputs because they don’t add much value. With regard to Black Swans, we cannot predict them, but we have found it possible to identify the market rumblings that almost always precede them, including non-economic disruptions such as the 1987 crash.  Very much like the instabilities that precede earthquakes.

Our Model suggests a change of direction roughly 5-7 times a year and identifies three market environments: highly defensive (red),  transitional (yellow) and fully exposed to equities (green).

As one would expect, the KP Model doesn’t always get it right, but it ends up on the right side of the trend, most of the time. Our disciplined process is highly likely to reduce portfolio drawdowns  in volatile markets — typically by more than half compared to a long-only (“stocks for the long term”) strategy. If we can truncate drawdowns much of the time, returns improve almost immediately and, most important, Sharpe Ratios rise.

Since Sharpe Ratios are one of the best metrics of client satisfaction, everyone wins.