I’m regularly surprised by how few asset managers have an investment strategy that can accommodate declining equity prices. Retaining equity positions in “good companies” through market declines is a fine strategy during long-term periods of economic expansion and rising profit expectations, but is an extremely uncomfortable one during periods of economic dislocation and declining profit expectations, e.g., during a bear market. Clients are particularly likely to question the efficacy of employing their advisor during these periods of declining equity values. By combining a long-term horizon with a tactical approach, advisors may improve both client returns and client experience.

Let’s start at the beginning and state some bases for our exploration. Normal operation of our capitalist economic system produces cyclical periods of growth and contraction. Equity market movements reflect this cyclicality. In free markets, investors determine individual equity price levels through price discovery (supply and demand).

However, since they are human beings, investors are not always rational. They are at times too optimistic (see the 2000 tech stock bubble) or too pessimistic (as in a common reaction to said tech bubble: “I’ll never buy another tech stock gain!”). Equity market extremes reflect the irrationality of market participants. An investment strategy that ignores this underlying structure of our equity markets is likely to prove unsuccessful.

Getting Tactical

The tactical asset allocation approach accommodates both the cyclicality of our economic system and the occasional irrationality of its participants by providing a framework for implementing an active investment strategy. While there are a variety of consumer and investment sentiment polls available, it is the price discovery mechanism that most accurately reveals investor sentiment. Remember that there is a buyer and seller for every trade and no trade can take place until they agree on a price. Price information is widely available, so everyone knows the last price. Prices can only move higher when someone is willing to pay more than the last price and prices can only move lower when someone is willing to relinquish their shares for less than the last price. Price action thus reflects supply and demand. Moreover, while any one trade may be meaningless given the wide variety of strategies employed by market participants, the overall direction of price movement is the most accurate and timely measure of investor sentiment available.

Investors’ attempt to anticipate future economic developments and their ability to do so is recognized by the inclusion of equity prices in the U.S. government’s Index of Leading Economic Indicators. Accepting price action as the most accurate and timely measure of supply and demand suggests that changes in price action reveal the direction of shifting investor expectations. Tactical analysis relies heavily on tools that measure the direction of price movement. The direction of price movement becomes the trend and the speed with which prices are moving becomes momentum.

Pitfalls and Benefits

The pitfalls of an active investment approach are in the increased amount of decision making generated by one’s indicator framework. No one wants to be shaken out of the market at the slightest sneeze, and a string of inaccurate allocation decisions is bound to hurt performance and raise doubts among an advisor’s clients. This is primarily a concern during the long periods of economic expansion and rising investor expectations known as a bull market. It is therefore recommended that advisors place a greater emphasis on indicators measuring the longer-term range of the advisor’s investment time horizon. In the simplest of systems, an advisor with a stated time horizon of six to 12 months might employ a set of four price moving averages (three, six, nine, and 12 months) with which to measure price momentum (investor expectations). An emphasis on the longer two of these moving averages will produce fewer signals.

The benefits of a tactical approach are that the approach is:

  • Rule Based. A rule-based approach delivers clear signals, and minimizes the impact of shifting emotions.
  • Adaptable. The tactical asset allocation system adapts to shifting economic and market conditions. This reduces client stress by assisting advisor recognition of both the best and worst markets, sectors, groups, or individual stocks.
  • Objective. Free from the overwhelmingly bullish bias of the analyst community.

You will notice that “foolproof” and “error free” do not appear on the list of attributes of a tactical approach. No system is perfect, but even the unrealistically simple example in the chart on page 90 has clear benefits, particularly when one examines any long period of declining price action. The three-month moving average of Citigroup (C 24.53), for example, remained above its 12-month moving average from the last day of November 2005 until the last day of July 2007 (see chart). Had one followed this perhaps unrealistically simple system, one would have bought at 48.55 at the end of November and sold at 46.57 at the end of July. If you said “Aha, it doesn’t work!” you haven’t been listening. It’s true that this particular trade did not make a profit, but examine it again for what was gained. A sell signal was generated at 46.57 and the stock is now at 24. The advisor following this system saved his clients $22 per share.


Protection, Preservation, Peace of Mind

By generating sell signals, the tactical approach displays its premier quality of asset protection and asset preservation. With the exception of the occasional overnight or bad-news-driven collapse, it functions as an insurance policy against large losses. By avoiding large losses, advisors gain the confidence and trust of their clients. Such confidence and trust is likely to lead to additional client referrals, any advisor’s preferred source of new business leads.

The tactical approach generates alpha (excess portfolio return) in two ways; first, by helping to limit the number of large losses in a portfolio and, second, by alerting the advisor to upside leadership. For example, 2007 was a year with clear winners and losers. The key element to outperforming the S&P 500 was not picking the hottest emerging market, but avoiding the big losing sectors. Reviewing the nine S&P 500 SPDRs (there are 10 sectors, but only nine SPDRs), we see that financial (XLF) lost 23% and consumer discretionary (XLY) lost 17%. All seven other sectors were in the black. It did not require financial wizardry or a math PhD. to identify the winning sectors. Using another simple tool–relative price action–one would note that the financials broke into a clear price decline at the end of February from which they never recovered. The same analysis would reveal an outperformance bias by the energy sector (XLE +31% for the year).

Summing Up

Tactical asset allocation does not rely on any more exotic principles than supply and demand. A tactical approach does require recognition of the cyclical nature of our capitalist system and the occasional irrationality of investors. A tactical strategy relies on either quantitative or technical indicators based on price activity. These indicators are nearly infinitely customizable and may provide anywhere from many short-term signals to very few long-term signals. That adjustability allows a tactical approach to be incorporated into whatever system of indicators one currently uses. The clear and unbiased signals produced by this approach function as an insurance policy against long periods of price decline. Reducing, by any amount, the number of large losing positions in client portfolios, the advisor improves investment returns and reduces the kind of stress that so damages client confidence. A collateral benefit is the identification of leading sectors, groups, individual stocks, or foreign markets that produces alpha and increases client returns. Incorporating a program of tactical asset allocation is a key element for any advisor who wishes to enhance client returns, reduce client stress during periods of excess market volatility, strengthen client relationships, and grow a successful business.

Ken Tower, CMT, former chief market strategist for Charles Schwab Cyber Trader and former president of the Market Technician Association, is chief market strategist for Covered Bridge Tactical, LLC, in Yardley, Pennsylvania. He can be reached at ktower@cpaginc.com.