Welcome to our active management update on the market
Capital flow refresher
Let’s start today with a refresher of how money generally flows through the world’s liquid investment markets. I stress the word “liquid” because there are many illiquid investment markets, including those specializing in art, real estate, collectibles, and precious stones. Money that flows into those markets stays there for many years and does not flow freely as it does in the world’s liquid markets. The primary markets are also considered asset classes.
It is for this reason that we often see capital (money) move from one or two of the markets into one or two of the other markets as it did last Thursday (8/1) and Friday (8/2). A diagram of this two-day flow is shown in the following illustration. Note that money was leaving stocks (which drove stock prices down) and flowing into gold and bonds (which drove the prices of each of those higher). This is a normal flow of investor capital driven by a news stimulus and the resulting investor expectations.
Recent asset class performance
Let’s use that understanding to look at the market of the past six months. Historically, when we have a structural change in the economy, it has had a prolonged effect on the markets. Sometimes it positively or negatively affects all markets in a similar way. The most recent structural change took place when the trend in interest rates changed from up to down. Such a trend reversal in a major asset class is supportive of both stocks and bonds. As a result, stocks and bonds have both rallied similarly over the past six months. Gold has also benefited but to a lesser extent. Nonetheless, all three asset classes have advanced together as shown in the following six-month daily-basis graph.
What this means for core strategies that invest in all three asset classes is that it has not made much difference what asset class the strategy has favored because all three are advancing nicely. What has made a difference is how heavily the strategy has been invested in any asset classes.
Let’s take a step back to get a bigger picture of these markets. Looking back over the past year (as shown in the following graph), we see a hostile battle for leadership with a significant flow of investor capital from stocks to bonds and gold in late 2018 and a return to the battle for leadership in early 2019. However, when looking at the entire one-year period, we see an underperforming stock market that is clearly more volatile than the other asset classes. Both of these are significant to note for strategies that incorporate volatility and performance over various “lookback” periods when determining what positions to take within the strategy. Three, six, and 12 months are common lookback periods used by many rules-based strategies such as those developed by Flexible Plan.
While lookback periods are fresh in our mind, let’s see what happened in a similar period: 2015 through 2017. In this example, 2015 was much like 2018: a battle for leadership among the asset classes. In 2016, a rally started that had all three asset classes moving higher together (marked A in the following graph) until about July. Then, late in the third quarter, bonds and gold headed lower (C) in a well-defined downtrend while stocks set course on a powerful, low-volatility rally (B) to new all-time highs.
It was at the point where stocks parted ways with gold and bonds later in 2016 that many of our equity-based strategies (including growth and aggressive risk profiles of core strategies) with lookback periods began to accelerate in performance.
Given what we know about the rule sets for the strategies that have lookback periods and that appear to be lagging the stock market in performance today, it is reasonable to expect that as we move through time, strategies will be dropping some of the market history out of the current positioning calculations. As sideways market history is dropped and uptrending stock market data is added, we can expect an increase in opportunistic allocations toward equities and leverage. As that happens, periods of catch-up performance begin to unfold in the strategies that use leverage.