Managing Market Trends

The market itself determines 80%-90% of your portfolio’s volatility. That means that 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 — much more important — help manage the devastating portfolio drawdowns of bear markets. The KP Market Trend Model identifies three distinct market regimes, Each is associated with very different risk/return expectations.  These are critical tools for managing the market risk of a long-term, conservative portfolio

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

Despite the frequency (we would say, the inevitability) of financial Black Swans, Wall Street’s approach to portfolio management still focuses most of its resources on analyzing 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 “Lehman” event. What efforts the industry does make are almost all fundamentally based: economic forecasts, earnings models, relative currency movements, etc., all of which do not correlate with future market movements.

Our work focuses exclusively on the market itself and studies only the large volume of internal data that the financial markets generate on a daily basis. In effect, we try to follow the money. Therefore, we deliberately do not incorporate economic inputs.  With regard to the Black Swans, we cannot predict them, but we have found it possible to identify the market rumblings that almost always precede them, including some non-economic disruptions such as the 1987 crash.  Our work tends to pick up instabilities similar to those that precede earthquakes.

Our Model suggests a change of direction roughly 5-7 times a year and categorizes the market environment into three distinct “colors:” highly defensive (red), transitional (yellow) and fully exposed to equities (green).  Happily, the green condition is the most common, and accounts for over 50% of all trading days since 1979.

As one would expect, the KP Model doesn’t always get it right, but it ends up on the right side of the market 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.  Sharpe Ratios are one of the best metrics of client satisfaction.  Everyone is likely to be better off.