Fifty years ago, in 1959, Harry Markowitz proposed that investors expect to be compensated for risk and that an infinite number of “efficient” portfolios exist along a curve called the “efficient frontier”. The formula used to create this “efficient frontier” is known as mean variance optimization or MVO. It is the basis for what has become known as Modern Portfolio Theory. Markowitz and William Sharpe, the inventor of the Capital Asset Pricing Model shared a Nobel Prize in 1990 for their work.
This highly theoretical and academic work was widely adopted by the investment community. The “method” became: Choose a risk level you are comfortable with and then build a portfolio of diversified investments that match the efficient frontier and you can predict your probable or expected return. Wait long enough and your return would most surely be the magic number predicted by the efficient frontier curve for your level of risk. Maybe….
The efficient frontier is defined by three variables: standard deviation, correlation coefficient/s, and return. The basis of MPT is that investors are rational and that they will always seek out the most efficient portfolio—the highest return for their acceptable risk level.
After Markowitz came another academic, a Eugene Fama who postulated that markets are efficient with all participants acting rationally with complete information and therefore securities are accurately priced most of the time. This was expanded by Burton Malkiel who wrote the book, The Random Walk Down Wall Street. This led to what is now known as the Efficient Market Hypothesis or EMH.
All this academic theory and hypotheses essentially got wrapped up into one big concept: “Buy and Hold”. Hire a professional to build an “efficient” portfolio and keep and eye on it—wait a sufficient period of time and make money! Maybe not…
Rational Expectations versus Rational Beliefs
Most economic theory is based on Rational Expectations. In other words people act with their best guess of the future (the optimal forecast) that uses all available information. It somehow assumes that everyone has the same information and therefore everybody’s “rational” best guess is the same. If they act differently, then they are irrational. This has always seemed a little silly to me, but it seemed to help explain many things.
A Stanford University Professor named Mordecai Kurz began to question the concept of Rational Expectations, and became known as the father of Rational Beliefs Theory. It is a subtle difference, but essentially it says that people will act according to their “beliefs” and that many different beliefs exist at the same time. As long as people act according to their beliefs, they are acting rationally.
Kurz essentially explains how markets can be crazy without having to refute that people have similar access to the same information. It does not require us to assume that people are crazy. Different people have different beliefs while having the same information. People change their beliefs when proven wrong either by facts or sometimes by herd behavior. It essentially states that people change their minds.
Post Modern Portfolio Theory and Downside Risk Optimization
Post Modern Portfolio Theory assumes that people seek to avoid loss more than they seek large gains. (Fear of loss is exponential and there is a leakage of utility on the upside.) It also assumes that most investors have a minimum acceptable return or MAR. Returns below the MAR are what investors fear much more than mere “fluctuation”. Modern Portfolio Theory has been developed and promoted by Frank Sortino of the Pension Research Institute. He developed a measure of risk called the Sortino Ratio.
Dynamic Asset Allocation vs. Buy and Hold
While MPT leads to “static” Buy and Hold portfolios, PMPT and the Rational Beliefs Theory assumes that the world is a changing place—concluding that a “Dynamic Asset Allocation” is more appropriate. Dynamic Asset Allocation requires a changing portfolio. Changes will be based on exploiting inefficiencies in markets and adapting the portfolio to the current situation as well as possible future situations. The current situation is created by varying beliefs regarding the future held by all the different market participants. In other words, the optimum portfolio is that that which addresses the owner’s MAR and belief/s regarding the future--thereby optimizing downside risk. It is also based on our ability to have some idea how other investors beliefs are correlated and how they may change in the future.
Reasonably Reliable Leading Indicators (RRLI’s)
I have always assumed that technical analysis was sort of like the “reading of the bones” by shaman and witch doctors---looking for meaning in meaningless patterns. However, since human nature drives markets, and human nature tends to be relatively constant, we may be able to ascertain present investor beliefs based on market behavior—to a degree. These present market beliefs may be part of a pattern that has occurred in the past, and certain market behavior may signal a future change in how investors’ beliefs will be correlated in the future. Some indicators are considered technical and others may actually be more fundamental where they signal a situation that will actually cause a change in markets.
None of these “indicators” are perfect. They may be predictive only 60-70% of the time. One thing we know, when many indicators point to the same conclusion, the probability of that conclusion being correct increases significantly. They provide a useful set of tools when the goal is a Dynamic Asset Allocation. Remember that Dynamic Asset Allocation is not the same thing as market timing—we are seeking return with downside risk considered and not just the highest possible return. We may avoid a possible profit opportunity if the risk of loss is small but the possible size of the loss is too large for us to tolerate.
Here is a limited list of some relatively powerful Reasonably Reliable Leading Indictors: A) The US Treasury Yield Curve; B) The Corporate to Government Bond Yield Spread; C) The occurrence of Black and Golden Crosses, and D) The Relative Strength Index.
The US Treasury Yield Curve or the difference in rates for short term vs. long term is a very useful indicator. When it goes inverted it is a strong indicator of a down market coming. When it has a steep upward slope, it is a reasonably strong bull market indicator. It becomes more accurate the longer it stays in one phase.
The spread or difference between “riskless” government bonds and “risky” corporate bonds tends to correlate with markets being euphoric or risk averse. Inappropriate pricing of risk is a reasonably strong indication that beliefs are highly correlated and likely to change. Euphoria and Emotional Depression are never permanent. They usually represent opportunity for a Dynamic Asset Allocation strategy. As Warren Buffet has said, “buy and be greedy when others are fearful; sell and be fearful when others are greedy”.
Black and Golden Crosses are bear and bull market predictors. The “cross” occurs when the 50 day moving average crosses the 200 day moving average. When the short term average moves higher than the long term, it is a bullish indicator. According to research from one large brokerage, “The S&P500 has had 15 Golden Crosses associated with NBER recessions—these signals on average led to a 19.2% gain one year later”. Golden Crosses tend to be more predictive during a recession. Black Crosses tend to be more predictive after a bull market has become a bit long in the tooth.
The Relative Strength Index is one of many created by J. Welles Wilder and published in his book: New Concepts in Technical Trading Systems in 1978. It can be as complicated as the user desires, but most people use a smoothing factor/period of 14. Most users believe that around 30 is a strong buy signal and 70 is a strong sell signal. The RSI may be useful when entering markets or determining the best time to adjust a dynamic asset allocation.
WS Wealth Managers Inc. uses the above mentioned RRLI’s along with others not mentioned when making judgments about changing asset allocations.
Remember that RRLI’s are never perfect—they increase the probability of being correct, but do not guarantee being correct. That is why we call them “reasonably” reliable. A diversified portfolio made up of quality assets that are somewhat negatively correlated is always more important than attempting to predict the short term future behavior of market participants.
The argument whether markets are random and therefore completely unpredictable, or just chaotic where they appear to be random but are in fact orderly is the same debate that is going on regarding Brownian Motion, Chaos Theory and Fractals. Now that is truly a scientific technical discussion and a topic for another day.
This paper is for educational purposes and for the sake of discussion. It is not a complete discussion regarding portfolio management. It is not a sales presentation and not a recommendation. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process and fundamental analysis.
