After deteriorating over the course of the first nine months of the year, the weight of the evidence has turned more positive as we have entered the final quarter of 2015. The weight of the evidence turned cautious in August, but had improved by the end of September amid signs that a pessimism extreme was in place (Investors Turn Fearful).
Broad market trends provided evidence of positive divergences over the course of September and early October, to the point that we upgraded market breadth from bearish to neutral, and as a result the overall weight of the evidence turned bullish (Market Breadth Improves) for stocks for the first time since mid-April.
Through a challenging third quarter and at the onset of a more hopeful fourth quarter, our approach to our Tactical Portfolios, which focuses more on managing risk than chasing returns, remains the same. In our view, risk management is primarily about acknowledging limits and not losing balance.
Risk management is the financial market phrase of the moment. It is often used, but poorly or variably defined. The following are some of our thoughts on the subject, offered in the wake of a difficult quarter for stocks and with the continued proliferation of increasingly niche-focused ETFs. We see two sides of the risk management coin. On the one side, it is a disciplined approach to developing and testing views of what might happen in the financial markets. On the other side, it is the implementation of investment strategies and tactics that could benefit from these developments.
From the perspective of developing strategies and tactics, our approach to risk management relies on the weight of the evidence. This is a balance of things that could (or should) come to pass offset by an evaluation of what is actually being seen. To the extent possible, our views do not hinge on a single indicator. Our approach allows for the testing of hypotheses and adapts as conditions change. It is not a market timing device to be used for calling tops and bottoms in the stock market. Additionally, it is relatively modest in its scope – we value general clarity over a false specificity. By design we push against the seemingly inherent need to make things more complex. Our focus is really about evaluating changing dynamics, and to the extent that complexity for the sake of comfort blurs the larger vision, it is an impediment.
Having a view of what to do (in terms of exposure to various asset classes) is not sufficient. We must also be risk managers in how we achieve that exposure. To the extent that ETFs allow easy access to broad and liquid areas of the financial market they are a useful tool. When they allow or encourage easy access to more specific exposure and less liquid areas, they can increase risk rather than mitigate it. Investors, professional or otherwise, need to lean against the proliferation of niche products and the lack of understanding that accompanies them. Just because an exposure can be quickly added does not mean it belongs in a portfolio. Hereto, complexity can give a false sense of security while actually increasing risk. Our approach has been to try to eschew a more complex approach in favor of one that is more clear.
From portfolio construction perspective, this means paring back positions in periods of stress and not chasing new offerings that appear to over promise. There are times to reach and expand. There are times for paring, and trimming and consolidating.
Thanks for reading.