The Investor's Guide to Active Asset Allocation: Using Technical Analysis and ETFs to Trade the Markets

By Martin Pring

The Investor's Guide to Active Asset Allocation offers you the background and analytical tools required to take full advantage of the opportunities found in asset allocation, sector rotation, ETFs, and the business cycle.

Written by renowned technical analyst and best-selling author Martin Pring, the book presents Pring's unique Six Business Cycle Stages, explaining why certain asset categories perform better or worse during different phases of the business cycle, and demonstrating how to use intermarket tools and technical analysis to recognize what business cycle stage the market is in.

Pring shows you how to apply active asset allocation, rotating among sectors and major markets (stocks, bonds, and futures) as the business cycle stage changes, to develop optimum allocation strategies. He focuses on exchange traded funds (ETFs) as the best vehicle for asset allocation rotation, since they are easily traded and have much more flexibility than mutual funds. He also offers specific guidelines for what sectors to be in, depending on the business cycle stage.

The Investor's Guide to Active Asset Allocation provides you with proven investing expertise on:

Basic Principles of Money Management

How the Business Cycle Drives the Prices of Bonds, Stocks, and Commodities

The Pring Six Business Cycle Stages

Technical Tools that Help to Identify Trend Reversals

Putting Things into a Long-Term Perspective

Recognizing Stages Using Easy-to-Follow Indicators as well as Models

How the Ten Market Sectors Fit into the Rotation Process

How Individual Sectors and Groups Performed in Each of the Six Stages

Asset Allocation for Specific Stages

This dynamic investing resource also gives you access to downloadable content, which contains supplementary information that will help you execute the strategies described in the book. You'll find links to useful websites that contain a wide-ranging library of ETFs, database sources, historical data files in Excel format, and a collection of historical multi-colored PowerPoint charts.

An essential tool for improving your analytical skills, The Investor's Guide to Active Asset Allocation shows you how to move from a passive to an active allocation model and explains the link between business cycle and stock market cycle for more effective - and profitable - trading and investing.

• Language: English
• Publisher: McGraw-Hill Education
• Release date: Jun 15, 2010
• ISBN: 9780071491594

Book preview

1

Some Basic Principles of Money Management

Introduction

Diversification

Psychological Barriers to Diversification

The Investor’s Two Biggest Enemies: Inflation and Volatility and How Diversification Can Help

Using Diversification to Reduce the Risk from Owning Individual Companies

Using Diversification to Reduce Risk from Market Fluctuations

Diversification Can Result in Bigger Gains as Well as Smaller Losses!

ETFs and Diversification

The Power of Compounding

Compounding and Interest

Compounding and Dividends

Introduction

A couple of decades ago I was driving from the airport with a client and his Swiss banker. We were going over the incredible performance that we had achieved in a matter of less than six months. He remarked that in order to achieve such a performance I had to have taken a tremendous amount of risk. That statement has stayed with me ever since because it is not something I had thought about at that time, and yet cutting losses and managing risk is the first rule of investing. I had been focusing on the reward side of the equation, alsost totally unaware of the risk. I had made money for my client, not because of any exceptional skill but because I had been extremely lucky. Leverage works both ways and I had enjoyed the positive aspects. I was soon to learn the negatives, but that’s another story. However, it does underscore the point that when committing money to the markets, most people focus on how much they are likely to make. Professionals, on the other hand, first ask how much risk they need to undertake in order to achieve those gains. If the risk is determined to be too great, the investment is not made.

This means that once you have established that the conditions for a specific investment are positive, the final step before committing money is to set up an exit strategy. If you are sympathetic to the technical approach of market analysis, this would involve searching for a chart point below which a change in trend would be signaled. A stop loss would be set accordingly. If you are not technically oriented, you do not have the luxury of setting a specific price level. You will need to tackle the problem another way by establishing the reasons why you are investing in that particular entity and then deciding what would have to happen for those conditions to no longer be in force. If and when that happens you would have mentally rehearsed your exit strategy. In practical terms we have to take this risk management strategy one step higher by managing the risk of the overall portfolio.

There are a number of ways in which risk may be managed. The most obvious is to diversify into several asset classes so that the risk can be spread. A second method is to control the volatility of your portfolio. Stocks with a high gain potential often come with a commensurate degree of risk, measured as volatility. Reducing the number of such securities clearly reduces risk. Third, invest in assets only when the condition for that particular class is favorable. You wouldn’t think of planting seeds in the middle of winter when the snow is on the ground. Similarly, do not buy assets when the environment for them is unfavorable. The first two points will be dealt with in this chapter and the third throughout the rest of the book. First, though, let’s begin with the principle of diversification.

Diversification

There is a well-known saying that you should not put all your eggs in one basket. That principle applies very much to the investing process. This is because investing in more than one asset or asset class simultaneously helps to cushion your portfolio in case one of your holdings does not turn out to be as profitable as originally anticipated.

Diversifying means more than buying different stocks. It also involves cash, bonds, inflation hedge assets, and so forth. We could also include real estate, oil leases annuities, and many other types of assets in the mix, but these fall outside the scope of this book. Here we are concerned solely with bonds, stocks, cash, and commodity-related assets because these are all liquid, freely traded, and marked to market on a regular basis.

One way of allocating assets is to use what we might call a static approach. Under this scenario we would hold a little of everything and never sell. Such a portfolio would limit losses from such events as the 2000-2003 bear market in stocks or the 1987 crash, when the stock market declined by 25% literally overnight. By the same token it would have participated in the great bond bull market that began in 1981, in the 1970-80 bull market in gold, etc. However, such an approach suffers from two drawbacks, not to mention putting brokers and financial planners out of business! First, if one particular asset class does particularly well, it would increase its proportion of the portfolio well in excess of the original intention. Worse still this overweighting would take place at exactly the wrong time–i.e., when that particular asset was peaking. Our objective here is to increase the proportion of an asset when it is in the area of a major bottom, not a major peak. Eventually, the portfolio would have to be rebalanced or this static approach would lead to such inequalities that it would lose most, if not all, of its diversification qualities.

Equally as bad, the static approach fails to capitalize on emerging opportunities and offers little protection from downside risk. No approach is perfect. However, does it not make sense to make hay while the sun shines? In other words, when the economic, technical, psychological, and monetary environment turns positive, it makes sense to alter the asset balance in order to take advantage of such opportunities.

A key objective in the money management process is to improve the risk/reward ratio as much as possible. It’s not possible to avoid risk altogether, but if you can limit risk but not give up too much on the reward side, you are well on the way to success. Major buying opportunities arise when the news is blackest and market participants have responded by liquidating their stocks. One way of measuring these swings in sentiment is to plot a two-year change in prices. When the indicator is very low it indicates that sentiment is extremely negative and virtually no one wants to own equities. Chart 1-1 shows a history of this indicator back to 1900. When the ROC falls below –25% and then rallies above that level, this is usually a low-risk time for entering the market. Examples are flagged by the upward pointing arrows. Even though this technique has worked well in the 100 years covered by the chart, no investment approach is perfect. Just refer to the dashed arrow that gave a false buy signal in the late 1930s. Similarly, when prices have been rallying for a long time, investors become more confident and careless in their approach. That’s when the risk is greatest. The chart clearly shows that on those few occasions when the indicator has risen above the 50% level and then fallen below it, the risk has been high and the reward negative.

These examples have been flagged by the downward pointing arrows. The dashed arrows reveal those periods when weakness was incorrectly forecast.

Chart 1-1 S&P Composite and a 24-Month Rate of Change (Source: pring.com)

This same data is reflected in Figure 1-1, where the annualized rate of return over the ensuing 24 months from these signals is represented on the y axis and the risk on the x axis. The place to be is high on the return and low on the risk. In effect, as close to the top left as possible, in the Northwest Quadrant as it is known in the investment business. The place to avoid is the Southeast Quadrant, where the risk is high and the reward low or negative. Obviously in the real world it is not possible to get to the extreme of the Northwest Quadrant, because there is always a trade-off. Fortunately there are some techniques at our disposal that help us to gravitate in this direction. This can be done through diversification and overweighting specific assets at the appropriate time in the business cycle. A final approach is to buy when an asset is historically cheap and sell when it is historically expensive. This does not mean buying at the bottom and selling at the top because what is cheap can become cheaper and, as we discovered in the late 1990’s tech bubble, what is expensive can become superexpensive.

A good example of the benefits of diversification can be seen by comparing Chart 1-2 to 1-3. Chart 1-2 shows the daily price action of Merck in 2004 and 2005. The downside gap at the end of September reflects some bad news when the company withdrew an important drug from the market. It could easily have been good news. The point being that investing in an individual stock can be more risky than you may have bargained for because you are always at the mercy of the market’s reaction to unexpectedly bad news.

Figure 1-1 Risk versus Reward for the S&P Yield 1948-1991 (Source: pring.com)

Chart 1-3 also shows some downside action at the end of September 2004, but this time it features the Holders Pharmaceutical ETF, a diversified portfolio of drug stocks that includes MRK. In this case the price drop was less dramatic. Whereas MRK had fallen from $44 to $33, the ETF was only down from $74 to $72, a difference between a 25% and a 2.7% loss. Quite often the spillover effect from one stock in an industry will be greater than this, but it is still substantially less risky than exposure to one stock. Note also that while the performance of neither series was very impressive in the ensuing period, that of the ETF was at least slightly positive.

Diversification can be justified on two grounds, partly on the factor of chance and partly to protect us from the possibility that our assessment of the situation turns out to be incorrect. Obviously when we purchase, say 12 different stocks the odds of the risk of a setback increases twelvefold. However, the odds of the whole portfolio being wiped out are extremely low, substantially lower than if we were exposed to just one stock. By the same token we may think of diversification as the spreading of risk and limiting bad luck, but it also increases the chance that one of our stocks may be a big winner. One could be the beneficiary of a takeover, an oil find, a technological breakthrough, and so forth.

Chart 1-2 Merck (Source: pring.com)

Chart 1-3 HOLDRS Pharmaceutical ETF (PPH) (Source: pring.com)

A hidden advantage of diversification is that it allows us to make gradual changes in our portfolios. Market conditions do not change overnight but move in a slow and deliberate fashion. Diversification permits us to rebalance the portfolio as more evidence of a change in economic, financial, or monetary conditions evolve. For example, we will learn later that market tops experience a gradual change of industry leadership as early cycle leaders peak out and late cycle leaders improve in relative action. If we were just exposed, say to a bank stock, an early leader, and felt that energy, a laggard, was about to emerge it would be a difficult call. However, if we are diversified into several groups it would be easier to gradually phase out of the early leaders as more evidence emerged.

Diversification needs to be a dynamic, not a static process. For example, we could be diversified in cash, bonds, and stocks, split into equal amounts. However, if the next 10-20 years is one of strong price inflation, such a portfolio could easily lose purchasing power. This is because the stock portion, which has traditionally beaten inflation over long periods, would not be sufficient to offset the decline in the income-producing assets, which are harmed by rising prices.

Psychological Barriers to Diversification

There are several reasons why diversification is not widely practiced, and they basically come down to one—laziness. In the most simple of terms it is much easier to buy a stock or asset that is presented to us in glowing terms by a media story, brokerage report, or a friendly insider, than to undertake some difficult and tedious research on a number of different stories from which we will make our final picks.

Alternatively, many are tempted to buy a particular asset theme. Perhaps the Administration is talking down the dollar. In anticipation there could be a rush to purchase companies that derive a substantial part of their profits from foreign currency sources. This may or may not be a perfectly legitimate investment idea, but it is not a sufficient one to allocate all of our stock portfolio to exporters. Conceivably the news or its expectation may already be factored into the price. Perhaps our assumption is wrong because these foreign economies are just entering a slump and are not in a position to absorb our exports. In either situation this one-idea overly simplistic allocation strategy leaves no room for error.

A common mistake made by everyone is to extrapolate the recent past into the future. It’s easy to fall into this complacent mode because we are surrounded by commentators and media stories that are sympathetic to current trends. It’s not only easier to go along with the crowd, but the emerging economic statistics support such a view: nonfarm payrolls, industrial production, and so forth. Because the markets look ahead, this type of data has already been discounted. It might flinch for a day or two when unexpected numbers are published, but unless a particular number is the one that starts to signal a change in the economic environment, the market dye has most probably already been cast. The reason is that markets look ahead and are concerned with indicators that lead the economy, such as the Index of Leading Economic Indicators, money supply, housing starts, etc. By observing these leading economic series, it is possible to look ahead and anticipate possible changes down the road. For example, monetary policy leads the economy, and we may have noted that inflationary conditions are intensifying due to easy money policies adopted several months earlier. On the basis of this we may be tempted to buy precious metal shares. This decision may be perfectly sound, but only for a limited time because the economy, as we shall learn later, has its own self-correcting mechanisms. It goes something like this. The Fed injects liquidity into the system that eventually gets the economy going again. As the central bank realizes that commodity prices have started to rise and easy credit is no longer required, the price of credit, interest rates, start to rally. Eventually rising interest rates kill the commodity bull market because they curtail consumer spending and business investment. The economy then falls back into recession, interest rates decline, and the Fed adopts an easy money policy. Thus for every action there is a reaction. In effect we can say that every inflation eventually breeds its own deflation.

In this example the rise in prices causes interest rates to rise as well. Eventually the higher rates make it unprofitable for businesses to invest and prohibitively expensive for consumers to borrow and the economy heads south. When this happens, inflation hedge assets suffer and deflation hedge assets come into their own. The investment in precious metal shares may do well for the time being, but by putting all your eggs in the inflationary basket, the final result will eventually turn out to be disappointing unless you are able to spot the change in the investment environment and take action accordingly.

Intellectual laziness can also be a barrier to diversification when an investor chooses to concentrate on one security or asset class in the hope of making a financial home run. Inevitably this quick reach for riches will fail. The demoralization caused by this failure will unbalance the emotional state of our investor. Under such circumstances it will be almost impossible to make any rational decisions. Performance is certain to suffer and valuable emerging new opportunities will be passed over.

Diversification involves a certain degree of patience, thought, and discipline. Unfortunately, beginning in the 1970s, the time horizon of most investors started to shrink. More recently the tech boom has placed the (perceived) virtue of instant analysis, quotes, and greater leverage at the fingertips of everyone, leaving us all to believe that fast and painless financial rewards are just around the corner. With such temptations in front of us, an even larger barrier to the principle of diversification has been thrown up.

In conclusion, profitable investing is best made in an environment of objectivity. Quick home runs and off-the-cuff analysis, where the focus is on profits, are not the way to achieve this. A far better approach is through a program of diversification, where assets are rotated slowly, incrementally, and thoughtfully. No single asset can make or break the portfolio, nor, by the same token, can it emotionally unbalance the investor.

The Investor’s Two Biggest Enemies: Inflation and Volatility and How Diversification Can Help

A history of the markets indicates that over the long haul the returns on stocks have been superior to both bonds and cash. However, it is possible to lose a considerable amount of money if stocks are bought and sold at an inopportune time because of their volatility. Bonds too can be volatile but, barring a bankruptcy, they always come back to their full face amount on maturity. Even where they sell at a premium the holder is assured of a rate of return throughout the life of the instrument.

In all cases, though, the longer the holding period, the lesser the volatility.

Inflation can also adversely affect the purchasing value of a portfolio. It is perhaps a more dangerous risk because it develops slowly over a long period of time, and unless the rate of inflation is particularly robust, it is almost invisible. In a sense, the inflation risk is inverse to that of volatility because the former becomes greater over time, whereas the passage of time reduces the effects of volatility.

Diversification can help reduce both problems. On the one hand, if a portfolio always includes some stocks and some bonds, the inclusion of bonds will cushion some of the effects of a volatile stock market. At the same time a portfolio that rotates part of itself over the course of the business cycle will be able to emphasize inflation hedge assets at the time of the cycle when inflation is emerging as a threat. This part of the portfolio could also include exposure to a mutual fund that seeks to replicate a commodity index. Alternatively, when deflation is the greater problem, deflation-sensitive assets such as bonds and utilities may be overweighted. Under such circumstances diversification becomes both a static and dynamic process.

Using Diversification to Reduce the Risk from Owning Individual Companies

The risk associated with individual companies independent of market fluctuations is known technically as unsystematic risk. It is generally accepted that risk declines as more stocks are added to the portfolio. Figure 1-2 demonstrates this principle, where the risk is measured on the y axis and the number of stocks on the x axis.

See how the average risk for the portfolio falls sharply with the addition of six stocks and then begins to flatten out. By the time seven or eight stocks are added there is very little to gain from risk reduction. Thus, from the point of view of the individual, it does not make much sense, from a risk management point of view, to increase the portfolio to more than nine stocks.

Using Diversification to Reduce Risk from Market Fluctuations

Diversifying into a number of different stocks does not necessarily protect you from a general market decline. This type of risk is called systematic risk.

In this instance we are assuming that these stocks are in different industries and sectors. For example, if the portfolio consists of nine issues, all of which are energy related, it will be very vulnerable, for example, if a sharp drop in oil prices takes place. This is because each of the components will be energy price sensitive to one degree or another. Such a portfolio would not fit the curve featured in Figure 1-1. In this instance the curve would probably experience a shallower descent and would certainly flatten out at a higher (i.e., more risky) level.

Figure 1-2 Risk versus Diversification (Source: pring.com)

On the other hand, if these nine stocks were representative of nine widely differing industries or sectors, the effect of diversification would be far more beneficial. This is because specific adverse industry developments would be cushioned by the other stocks in the portfolio. However, because these industries would represent a reflection of the overall market, they would not offer much in the way of protection from a general market decline.

This problem can be addressed by including other asset classes. The degree of systematic (market) risk can therefore be controlled by changing the balance of the assets it contains. This is only possible because bonds, stocks, and commodities are often moving in different directions. Cash, our fourth asset, is always static, of course. The concept of similar and dissimilar price movements simultaneously taking place is known as correlation. In our example discussed earlier, the nine energy stocks would be closely correlated. Let’s call this portfolio A. On the other hand, the nine securities in the widely diversified stock portfolio would not. Let’s call this one portfolio B. Taken together, though, portfolio B would closely correlate with overall market movements.

A well-diversified portfolio should therefore be balanced to include assets that are not closely correlated. Thus if one asset, say stocks, is performing poorly, the diversification implied in portfolio B will not be of much help. However, if this is combined with an asset that does not closely correlate with stocks, say precious metals or cash, the portfolio will be to some degree cushioned.

Table 1-1 shows several asset classes and how they correlate. A perfect correlation is indicated by 1.0. Thus aggressive growth correlates perfectly with aggressive growth, as does money market with money market. The lower the number, the weaker the correlation. In this case the weakest correlation is between growth and money market at -.0.09.

Diversification really comes into its own when the correlation between asset classes and industry groups is greatest. If the correlations are high, this means that the performance will be very similar, so not much will be gained from diversification. This is a major reason why an investor is advised to maintain some portion of the portfolio in each principal asset class. In this way the overall performance is hedged in the event that an incorrect market call is made in any asset class.

Returning to Table 1-1, it is possible to use the data by way of an example. Let’s say for instance that a retiree requires substantial income. His stage in life immediately places him in the conservative camp. He obviously requires an income-producing asset. Corporate bonds represent an acceptable vehicle. Putting all of the assets into corporate bonds would give him lots of income but no protection against rising rates. Precious metals correlate poorly at 0.07 and would offer some sensible diversification because they move in the same direction as corporate bonds less than 10% of the time. While they provide a hedge against inflation, their income stream leaves a lot to be desired. Cash (0.04) and growth and income (0.51) would also represent good diversification because each has an income component, important to our investor, and neither correlates closely with corporate bonds.

Table 1-1 Correlations of Various Asset Classes

Correlation can also be extended to the equity market. Most people refer to it as the stock market. However, it is more like a market of stocks, where companies in different sectors are simultaneously going their different ways within given time frames. Obviously there are bull markets, where most issues are rising most of the time, and bear markets, where the opposite conditions hold. However, there remains a dichotomy of performance among the individual industry groups and their component stocks. Consequently, it makes sense to construct a portfolio among industry groups with a low correlation. For example, utilities tend to outperform the averages during the late stages of the bear market and the early phase of a bull market, when the economy is typically in a recession. On the other hand, energy stocks put in their best relative performance when the economy is close to capacity and pricing pressures are greatest. That is also a time of rising interest rates, which adversely affect the high-dividend-paying and capital-intensive utilities. Just look at the diverging paths of the two momentum indicators reflecting disparate industry groups in Chart 11-14 (in Chapter 11).

Diversification Can Result in Bigger Gains as Well as Smaller Losses!

Diversification, when correctly applied, reduces risk, but it does not necessarily imply smaller rewards. In fact, it is possible to enhance the performance. For example, if we are interested in including a small cap growth stock, the volatility of the portfolio is obviously increased. The result could be spectacular gains or it could all end in tears. However, if we take this same allocation and spread it among several stocks, we may still reap most of this reward yet better manage our risk. For example, let’s say we buy 10 promising growth candidates. It’s probable that one or two of them will turn out to be a dud, that most of them will be mediocre, and that possibly one or two might experience substantial gains. At first glance it may appear that this will result in a zero sum game, but that is not the case. This arises because it is quite realistic to expect a good company to gain two to three or more times in price over, say a three-year period. By the same token, some of the losers may drop by 40-50%, but they are unlikely to go bankrupt. If one does, the $10 stock that goes to zero is more than outweighed by the $10 stock that moves to $30.

Table 1-2 shows that even with one issue losing $12 for a 100% loss and two others experiencing sizeable losses, the overall portfolio still experiences a nice 11% gain.

ETFs and Diversification

One way of obtaining diversification in one easy stroke is to purchase securities that already have a diversified portfolio. Years ago this involved buying a broadly based mutual fund, either directly or indirectly from a mutual fund company or as a mutual fund listed on an exchange. The former are called open-ended funds because their size is literally open ended. As new money pours in, so the fund grows in size, provided, of course that new money is not dwarfed by redemptions. Funds listed on the exchanges or over the counter are known as closed-end funds because their portfolio size is set at the time of listing. They are pools of professionally managed investment capital that have a fixed number of shares that can only be purchased from other shareholders. The capitalization of these funds, barring the raising of new capital through subsequent offerings, is therefore closed. The principal difference between the two is that closed-end funds can be purchased any time the exchange is open, whereas open-ended funds can only be bought and sold after the market has closed. When sales commissions are not involved, as with no load open-ended funds, these securities always sell at net asset value—i.e., the value of the fund based on previous closing prices. Closed-end funds, on the other hand, sell at a premium or discount to their net asset value, depending on investor attitudes. If they are bearish the fund sells at a discount to net asset value and if they are optimistic at a premium.

Table 1-2 Diversified Portfolio of Aggressive Stocks

Both types of funds offer special baskets of targeted securities, such as type of capitalization, low cap/high cap, country, Japan/Brazil, etc., differing types of fixed income (corporate/tax free) and so forth. They therefore offer some measure of diversification.

The latest kids on the block are the Exchange Traded Funds (ETFs). These are described at great length later in the book, but for our purposes here they may be regarded as possessing the characteristics of a closed-end fund that never trades at a significant premium or discount to the targeted index. They also have lower management fees. ETFs then are a great way to obtain some quick diversification because they embrace a substantial number of asset possibilities such as cap plays, sectors, industry groups, country indexes, and fixed income. We will have much more to say about them in subsequent chapters.

The Power of Compounding

It is normal to think of investing as primarily returning capital gains, but current income should by no means be overlooked because the compounding factor of interest and dividends can be a significant ingredient in the long-term performance of a portfolio. We alluded earlier to the fact that time horizons have shortened with the ability of technology to present us all with instant analysis, quotes, and news. This is a shame because compounding requires a large amount of time, together with the discipline and patience to take advantage of this important investment principle, and that is not within the grasp of most investors today.

Compounding and Interest

Once you receive interest or dividends you are faced with a choice: spend the money or reinvest it. If you are in a position to reinvest your money, it will obviously grow faster, but probably faster than you might think due to the interest-on-interest effect.

We can see this from Table 1-3. In column four the cumulative total increases only by the amount of the payment. This compares to column seven, which reflects the reinvested proceeds as interest is earned on interest. As with all compounding effects, the difference is very small at the beginning but gradually increases with the passage of time.

The timing of interest payments can also influences the performance. The