When to re­duce the volatil­ity of an eq­uity port­fo­lio

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Hav­ing worked as a money man­ager with man­dates that al­lowed me the free­dom to move at will be­tween cash, bonds and eq­ui­ties, while still be­ing mea­sured against the world eq­uity in­dex, my key as­set al­lo­ca­tion de­ci­sion was al­ways when to re­duce the port­fo­lio’s volatil­ity be­low that of the bench­mark—and which tool to use in pur­suit of this goal.

This prob­lem is some­thing of a holy grail for money man­agers and any­body who thinks they have found a per­ma­nent so­lu­tion should be dis­patched with due haste back into a re­search po­si­tion. That said, it is as a re­searcher that I of­fer up a sug­ges­tion to this old prob­lem. I will start with a few state­ments that are eas­ily ver­i­fi­able by ob­ser­va­tion: (i) in an in­fla­tion­ary pe­riod, gov­ern­ment bonds and eq­ui­ties have a pos­i­tive cor­re­la­tion, (ii) when in­ter­est rates de­cline, the stock mar­ket rises. Not so in a de­fla­tion­ary pe­riod: when in­ter­est rates de­cline, the stock mar­ket de­clines as the im­pli­ca­tion is that the econ­omy is fall­ing out of bed.

Hence, a long-dated bond is a good hedge against a de­fla­tion­ary bust as has been shown in al­most ev­ery bear mar­ket since 1987. This, of course, re­quires the long-bond not to be stupidly over­val­ued as is now the case in Europe, with 30-year bunds yield­ing 1.30%. Re­mark­ably, this is just be­low the yield of­fered on 30-year Ja­panese gov­ern­ment bonds. In fact, long-dated bonds in Ja­pan and Ger­many of­fer risk with no re­turn—never a good bet. This means that it will be hard to pro­tect against de­fla­tion risk in Ja­panese or Ger­man eq­uity port­fo­lios us­ing their re­spec­tive long-bonds.

In the US things are dif­fer­ent as 30-year trea­suries yield 3%, putting them in the mid­dle of the range of my val­u­a­tion model. Should a de­fla­tion­ary shock hit (then) yields could quickly fall to Ger­man or Ja­panese lev­els, im­ply­ing a cap­i­tal gain of up to 50%, which, if enough pro­tec­tion is in place, should off­set a big fall in eq­ui­ties. So the idea that 3% long­bond yields are “too low” to de­fend against a de­fla­tion­ary bust is just plain wrong. It hap­pens to be a view of those who have been ex­pect­ing US growth to re­bound strongly and for in­fla­tion to come back.

I con­clude that if an eq­uity port­fo­lio is to be pro­tected from a de­fla­tion­ary bust, the only ef­fec­tive tool left on the rack is the 30-year US trea­sury. The next ques­tion is how this tool should be used. One op­tion is to keep a con­stant 50:50 al­lo­ca­tion in the style of late 19th cen­tury in­sti­tu­tional in­vestors which, in fact, de­faulted to a 60:40 mix fa­vor­ing bonds as the over­all cli­mate was un­am­bigu­ously de­fla­tion­ary. For those minded to time their moves, a more dy­namic sys­tem is needed.

What is clear is that a bal­anced port­fo­lio gen­er­ates su­pe­rior re­turns than a long-only equiv­a­lent com­prised of just bonds or eq­ui­ties, and of­fers much lower volatil­ity (in­ci­den­tally bonds beat the hell out of eq­ui­ties, pretty much go­ing back to 1982). And to make this port­fo­lio as us­able as pos­si­ble I have es­chewed my pre­ferred 30-year US ze­ro­coupon bond in favour of the Mer­rill Lynch gov­ern­ment bond in­dex, with du­ra­tion ex­ceed­ing ten years. This, I be­lieve, is a “buyable” propo­si­tion.

Those more in­clined to time the mar­ket may choose to ap­ply a bond hedge only when the dan­ger of a de­fla­tion­ary bust ap­pears. As such, my “new” US re­ces­sion indi­ca­tor may be a use­ful tool. In the chart above, shaded ar­eas de­note pe­ri­ods when the re­ces­sion indi­ca­tor is be­low 0 (cur­rently it is at -5). History sug­gests that per­for­mance could have been sig­nif­i­cantly im­proved by keep­ing a 100% weight­ing in eq­ui­ties dur­ing pe­ri­ods when the indi­ca­tor is pos­i­tive and then shift­ing to a 50:50 po­si­tion when it turns neg­a­tive.

Since the be­gin­ning of last sum­mer the indi­ca­tor has been in neg­a­tive ter­ri­tory and hence on the ba­sis of his­tor­i­cal ex­pe­ri­ence, this should be a pe­riod when a hedge is war­ranted. Such rea­son­ing runs con­trary to the gen­er­ally bullish com­men­tary sur­round­ing the US econ­omy’s tra­jec­tory, but I am deeply skep­ti­cal of th­ese ar­gu­ments and would tend to have greater faith in a tool that has con­sis­tently de­liv­ered re­sults.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.