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April 01, 2008 at 04:00 AM
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
