Analyzing Market Trends

At the end of the day, market trends, not investment selections, dominate the performance of an investment portfolio.

Forecasting these trends is a highly challenging undertaking, but it is critical that an investment manager make the effort. Even a partially-successful approach to managing market risk wil likely significantly impact volatility and portfolio drawdown.

Long-Term Directional Analysis. The KP US Equity Trend Model is a seasoned, relatively slow-moving “top-down” "regime overlay" for US equity markets. Its key elements have been in use by our firm since 2005. The KP Model guides portfolio exposure and drawdown management decisions and generates roughly seven changes of exposure a year.

Over a full market cycle of several years, the Model often delivers only modest improvements in long-term returns. However, it typically delivers significant reductions of portfolio volatility and drawdown. As a result, risk-adjusted performance measured by Sharpe and Sortino Ratios, is usually greatly enhanced — these scores are often double those of an unmanaged passive portfolio.

Here is a link to a 24-year (288 month) heat map that illustrates the monthly risk/return characteristics of a managed index investment in the Standard & Poor’s 500 Total Return Index, where exposure to the index is guided by the KP Trend Model, versus a buy/hold passive investment in the same index.

The formulas and parameters of the Model remain unchanged over the 24 years of this exercise.

Short-Term Long/Short Index Trading. The past several years have also seen the development of a more responsive (15 signals a year, avg.), shorter-term, long/short model, based on data series generated by the 10×10 analysis process for individual issues. This study currently supports a long/short S&P index strategy that shifts allocations roughly once a month.

An interesting characteristic of these top-down regime filters is that their effectiveness tends to increase with the volatility of the asset class.  These models improve the pasive return of the Nasdaq 100, for example, to a greater degree than they enhance the performance of the S&P500.