Timing the market is inherently difficult. Investment strategies that attempt to predict the turning points in markets need to be very precise and there is little room for error. That’s why, rather than trying to time the market, active allocation specialists employ a strategy of what they call ‘dynamic asset allocation’. The way we think about it at To the pound, dynamic asset allocation involves an assessment of known knowns, known unknowns and unknown unknowns to make decisions about how and when to change the positioning of a multi-asset portfolio.
Known knowns
Very few things are certain in financial markets, but some reasonable assumptions can be made about the behaviour of asset prices through time. Equities are a junior claim on a company’s assets, while corporate bonds are a more senior claim. You’d therefore expect that equities would deliver higher returns than corporate bonds over the long term, to compensate investors for the higher risk that they take on. We call this the equity risk premium. As a starting point, portfolios that aim to deliver capital growth over the long term would always have exposure to the equity risk premium. Government bonds are a senior claim on a country’s assets, which makes them less risky than corporate bonds, because countries are typically less likely to default than companies are. Neither government nor corporate bonds are necessarily guaranteed a place in a growth portfolio, given these known knowns. In fact, as with all other assets, they must compete with equities for a place in the portfolio.
Known unknowns
While we know that there will be times when government bonds, corporate bonds and other assets perform strongly and times when they perform badly, what we don’t know is when these periods of relative performance will occur. That’s why we need to look at a number of indicators to make a judgement on how we think they’ll perform.
First, valuation. All else equal, cheaper is better, and over the long term, cheap assets outperform expensive ones. However, between now and the long term, it is possible that cheap assets could get cheaper (perhaps they’re cheap for a reason) and expensive assets could get more expensive. In fact, this ‘possibility’ is true almost all the time. The turning points, where cheap assets start to get more expensive and expensive assets start to get cheaper, are few and far between. That doesn’t mean we shouldn’t keep an eye on valuation measures; it means that valuations are only informative over the long run (sometimes only the very long run), and we should supplement our assessment of valuations with information from other indicators to make investment decisions in the medium and short term.
Between turning points, asset prices – by definition – go in one direction. That is, increases in price are followed by further increases in price, and vice versa, until the next price inflection point.
This is price momentum, and it has two components: fundamental momentum and price expansion (the ‘anti-valuation’ effect). If the price of a stock keeps going up because the company’s earnings keep going up, then it’s not really getting more ‘expensive’; the stock price is being driven by earnings (fundamental) momentum. We can look at earnings momentum to gain insights into whether stocks will continue to display price momentum or whether they may be nearing a turning point. Price expansion is momentum in valuation itself. An asset displaying price expansion is truly getting more or less expensive, and it is a function of supply and demand for the asset. We can look at things like the cost of borrowing (short term interest rates), inflation or the opportunity cost of other assets to determine how likely it is that an asset will continue to display price expansion and, combined with fundamental momentum, whether it will continue to display price momentum. For example, during 2019, the US equity market was driven almost entirely by price expansion (a ‘re-rating’ or ‘re-pricing’ of earnings, defined as an increase in the price-earnings ratio) as opposed to increases in company earnings. This was symptomatic of the fact that, even before the crisis of 2020, growth was weak but central bank liquidity was plentiful. The resulting flows of cheap money into assets that didn’t have fundamental (earnings) momentum led to positive price expansion and overall positive price momentum.
At the aggregate level, we can look at measures of the economic cycle as our primary gauge of what might drive forward-looking asset price momentum. Understanding where we are in the economic cycle allows us to understand which assets are likely to perform well. In a global economic growth expansion, when the global economy is operating above its long-run trend rate of growth, growth-sensitive assets such as equities are likely to perform well. During the economic expansion, then, equities will likely display positive price momentum. As the economic expansion matures, central banks tend to raise interest rates to keep inflation in check. This causes the economy to slow somewhat, and equities begin to show signs of slowing momentum suggesting that a turning point might be nearing. Because interest rates have typically risen, bonds offer higher returns and so investors switch out of equities into bonds in expectation of future rate cuts by central banks as the economy goes into recession.
Unknown unknowns
This all sounds like a smooth ride, but of course the reality is not such a precise science. There are different ways of measuring valuations and the economic cycle, there are unique features in each cycle, and there are unknown unknowns that can disrupt the cycle from its expected path. In fact, experienced multi-asset investors know that “this time is different”, every time.
Volatility of asset prices reflects market participants’ attempts at trying to know the unknown, and for investment teams this often takes the form of a scenario analysis. This is investors can try to make unknown unknowns known unknowns, so that they can prepare their portfolios for the bumpy ride as markets inevitably oscillate around conceivable risk scenarios based on their changing probabilities. As market participants collectively express their fears and seek opportunities, they cause asset prices to change in volatile fashion.
A scenario analysis can result in investors identifying hedges for inclusion in the portfolio where, naturally, they will be more likely to hedge against risks that they feel are severe in nature, high probability, or both. Crucially, hedges must be efficient, which means they must be effective and inexpensive. Effective means they must gain value when the risk they intend to hedge against plays out, and inexpensive means that the cost of the hedge is not punitive. The cost of a hedge could be in the form of an absolute cost such as the premium on options, a spot-forward price differential for currency pairs, or simply an opportunity cost of not holding assets that would otherwise have performed well. Since the cost of a hedge is often time-variable (the cost is higher the longer you own the hedge), the focus on hedge efficiency can reduces the requirement to time the hedge. The ideal hedge is one that has an asymmetric payoff profile and is inexpensive to hold.
In this way – by creating hypothetical risk scenarios – investors can position their portfolio for a spectrum of upside and downside situations, rather than binary direction. They can take action in the portfolio to account even for unknown unknowns: this is asset allocation that doesn’t require ‘market timing’.
But some unknowns could never have been conceived; for example, the outbreak of the novel coronavirus Covid-19 took the world by surprise in December 2019 and January 2020. Markets began to aggressively price in the economic impact in February when a spike in cases in Italy was reported, suggesting that contained epidemics in China and some parts of Asia could become a pandemic. The rest is history. Dynamic asset allocation in examples like this is necessarily more reactive than it is proactive. As more information becomes available, action taken in the portfolio is intended to contain losses, reflect new expectations, adjust exposures, and even take advantage of opportunities that emerge as some markets over- and under-react to news. In this example, the selloff in stock markets was one of the fastest and most severe in history, but the recovery was also fast – US equities recovered their losses within six months.
The best defence against unknown unknowns is to recognise that they are inevitable and be humble in the construction of your portfolio. By humble, we mean preparing a portfolio that has a balanced set of risk exposures, rather than a high concentration of exposure to a small number of (known) risks. That doesn’t mean we don’t have strong views at To the pound, it just means that only high conviction views are expressed. On that basis, we’re honest with ourselves about our investment decisions, to ensure that our portfolio remains humble. While we can’t be immune to all risks, we can build up a strong immune system for our portfolio, such that when unknown unknowns do play out, our portfolio doesn’t perform in such an extreme manner as it otherwise might. And, crucially, humility in asset allocation helps us to minimise emotional decision-making and reduce behavioural risk, a factor that we believe is an important driver of investment performance.
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