CPM Investing LLC - Investment Publications
14 minutes (2019)
This article will help you understand stock market resilience and the Market Resilience Indexes (MRI) used in Focused 15 Investing’s model portfolios.
The stock market has great gains sometimes, but it also experiences periodic losses. For many years —and still, to an extent, today—the widely-held idea in the investment interested was that one cannot time the stock market. Instead of trying to determine when stock prices hit a peak and rotating out of stocks, it became ingrained in the industry that it is better to maintain a stable allocation to stocks over long periods of time and to allow the benefits of asset class diversification provide lower risk.
Often, a 60% allocation to stocks and 40% allocation to bonds was (and still is) selected for the appropriate long-term allocation. When market movements pushed the portfolio away from these target allocations, one rebalanced back to the 60/40 weights. This is done monthly or quarterly. The prevailing view was that no one could time the market. No one could determine when the stock market was at a low point or a high point. Thus, it is better to simply hold stable weights of asset classes and derive benefit from the diversification benefit promised by modern portfolio theory and mechanistic rebalancing disciplines. The subjective view was more harsh: Only fools try to time the stock market.
The chart below shows the stock price levels of the stock market index for Japan (TPX) over the period of 1985 to 1995. During the subsequent five years from 1985 to 1990, as depicted on the chart, stock prices moved higher in both Japan and around the world.
In 1990, I was transferred to Japan to head the consulting group in the Tokyo office of the Russell Investment Group. Russell evaluates money managers and makes recommendations to pension sponsors to help them earn a higher return and meet their obligations more efficiently. When advising our Japanese clients on asset allocation, we maintained that it’s a good idea to have a stable allocation to stocks because, again, no one can time the market. This view against market timing was deeply entrenched—something that I thought was just a fact of life.
But at the beginning of 1990, the Japanese stock market began to decline. Over the subsequent couple of years, it declined by 61%. Therefore, anyone we had advised to maintain 60% allocation to stocks and 40% allocation to bonds was hurt quite a bit by that decline.
This experience seared in my mind that avoiding stock market losses would be an important component of achieving higher returns. Yet over the subsequent ten years, I still professed quite adamantly that no one could time the market. My colleagues and I had evaluated hundreds of investment managers and few possessed skill that leads to repeated success in timing the stock market.
Our response to institutional clients experiencing the kind of major declines shown in Topix chart above was that, a) one must have a long-term time horizon, and b) one must hold the position of 60% stocks over an “entire market cycle” in order to get the benefits.
In the 2000s, I began doing research on market timing, fully expecting to find statistical proof that few, if any, professional investment managers could time the market. I used Russell’s extensive database of investment manager performance and did a rigorous test using performance measurement tools I had developed. The conclusion of the research was that most investment firms did not display repeated success in rotating their portfolio among groups of securities.
Yet the startling finding was that certain types of investment processes did indeed display repeated success. This finding pushed me to develop the investment approach we use in Focused 15 Investing today. The following comments describe that approach and contrast it to general beliefs about what drives changes in stock prices.
The Event-Driven Model — and Its Shortcomings
A common belief of stock market price changes is that current events drive stock prices. Those events can include announced company growth figures; changing growth expectations of investors in general; news at the company, economy, and political levels; and natural disasters. If one can assess whether an event is good or bad for stock prices and also the magnitude of event, one can determine how stock prices will change. If you can forecast events, you can forecast the direction of stock prices. In the diagram below, stock market price level is shown in the brown line moving left to right horizontally over time.
People tend to see price movements related to news of the day, and this suggests to them that they can determine where stock prices are going by determining the directional impact of the event – good or bad for stock prices – and its magnitude. We hear in the news that an event has happened, and stock prices drop. This might be like Bad Event A, which, as shown in the chart above, drives prices lower. But eventually Good Event B comes along and pushes stock prices higher.
Based on the magnitude of the price change, Good event B must be very strong – prices move higher and pass the level where Bad Event A occurred and continue higher. However, Bad Event C must be very bad because stock prices move down dramatically thereafter. Good Event D must be very weak because it didn’t push prices very high.
There are problems with this approach. First, it is very difficult to find any single person or any single investment firm that can accurately forecast a long series of events—good or the bad— over long periods of time. There will be investors who can do that for a period of time, over couple of years or so. But then it might appear that they have a cold hand and are no longer successful in doing so.
Second, if one can forecast an event, the next challenge becomes determining its magnitude and impact on the stock market. Sometimes what seems like bad news can actually move stock prices higher. For example, if unemployment rates go up – clearly a bad sign for the health of the economy – stock prices may move higher because investors as a whole may conclude that the central banks will lower interest rates to promote economic growth, which is very good for stock prices. Thus, forecasting events and how the market will respond to them is extremely difficult to do successfully over long periods.
The Focused 15 Investing Approach
We do things differently. We don’t make long-term forecasts of political or economic events. Instead, we make short-term forecasts of how investors are going to react. By systematically evaluating how markets tend to react to news over time, we can see cycles of reactions. Over some time periods, the investors in general tend to react optimistically to news – be it good or bad. At other times, investors react pessimistically to news.
I am not the first to observe this. Many experienced strategists describe the tone or sentiment of the market as being important to understanding whether stock prices will move higher or low. What is unique to Focused 15, though, is how we measure this optimism and pessimism and integrate those techniques into an integrated approach to create model portfolios.
We describe the optimism of the market as creating market resilience. A lack of optimism results in a lack of resilience (which can also be called vulnerability). The concept behind resilience is that in a resilient market, prices recover quickly from bad news and events, and there is support for higher prices. Bad evens happen, but the rebound is complete and quick.
During the period depicted in the above chart, we can say that resilience is actually what’s driving prices higher. Yes, Bad Event A and Good Event B influence stock prices, but the major influence on the trend is the market’s resilience. As we move forward in time and toward the right of this diagram, the market has low resilience, or high vulnerability. Bad Event C is, therefore, seemingly driving prices quite a bit lower.
The good thing about resilience is that we can determine it using readily available data. This enables us to test decision rules for creating model portfolios over long period of time. While it is exceedingly difficult to assess events over a long period of time, we can look at resilience over as much price history as exists for particular index.
After we measure resilience over a long period of time, we can see that changes in resilience are rhythmic: there is a cyclicality to them. History doesn’t repeat itself, but it rhymes. Since market resilience is a function of human optimism and pessimism, we see that markets oscillate between overreactions related to excessive optimism and excessive pessimism. This human driver of market moves is remarkably consistent over time, regardless of whether the economic system is dealing with the Great Depression in the 1930s or the Global Financial Crisis of 2007-9.
An important point is that panic-selling tends to set in during periods of low resilience. Market prices decline surprisingly quickly in response to bad news when resilience is low (vulnerability is high). The extent of declines surprises investors who forecast events, and they question what they understand about the events they have focused on. In this time of questioning, they conclude that other factors must be at play and become uncertain. In times of high uncertainty, they tend to sell. More selling causes prices to decline further, and this sometimes leads to a panic.
Our model portfolios rotate out of asset classes with low resilience without waiting for any particular event to occur. If panic is going to occur, the vulnerable periods are when it will occur.
Market Resilience Index® Series
The Market Resilience Indexes (MRI) are what we use to measure resilience. The brown line from the last two charts is below decomposed into the larger trend.
The Macro Market Resilience Index (Macro MRI), in blue, measures these longer trends, which usually last for several years. The level, direction, and slope of that Macro MRI are important to assessing how investors will react to news of the day over the longer end of our 15 day to 15 week horizon for forecasting investor reaction to good and bad news . The Exceptional Macro is an alert on the slope change of the Macro. We want to know when the Macro MRI is likely to turn positive, and that is the primary purpose of the Exceptional Macro. The Micro MRI is like a heartbeat going across time, and the cycles are rhythmic and reasonably consistent cycles over time. These MRI indexes give us a good idea of where we are relative to historical norms for a given index.
Resilience is a function of the enthusiasm of investors worldwide: the greater the number of different views considered the better, and we can assess investor reaction to news. Unlike many investment approaches that depend on finding some overlooked opportunity or threat, the Focused 15 approach works best on widely-followed indexes like the Dow Jones Industrial Average. It is also more helpful for very liquid, widely-traded indexes. Resilience is measured by the small market price movements and return changes that take place in the index, so it is driven by price movements as opposed to price levels.
At its simplest level, the Focused 15 approach buys low and sells high on the MRI. We are not trading the price, because the price is influenced by good news and bad news events that play out over time. Determining rotation trades based on resilience level is much more reliable than looking at price.
In general, if there is a cycle of resilience, shown by the green line in the chart above, a downward-trending line indicates lack of resilience, and an upward-trending line indicates resilience. We wait for the trough of an MRI and buy as it is moving up, and then we hold it as it’s moving up, and when it arcs over, establishing a peak, we will sell that asset in the declining leg of the cycle.
This chart shows the actual MRI for the period 2005-2009, the time of the Global Financial Crisis. The brown line indicates the Dow Jones Industrial Average price level, and the blue line is the Macro MRI, indicating the long-term trend in prices due to resilience. The green line is the Micro MRI, indicating short bursts of resilience on the up-leg that take place over time.
The unique feature of the Focused 15 Investing approach is that we can identify peaks and troughs in resilience cycles very close to when they occur, as opposed to a few weeks or months later. Thus the Macro MRI coincides nicely with the long-term peak in prices, and the peak in the Micro MRI coincides with the shorter-term peaks in index prices. If we combine the influences of these two MRI, we get a good indication of how resilience the market will be over the next few weeks. When the Macro trend is negative and the Micro MRI is approaching the top of its cycle, we have a pretty good idea that when the short-term Micro MRI ceases to be positive and moves down, prices will decline dramatically. These indicators can let us know what’s likely to take place in terms of a rebound after any kind of good or bad news.
This slide shows the price level of the Dow Jones on a log scale, moving from 2000 to 2017. Pictured are the decline of 2002 and 2003, the peak in 2007, the decline that bottomed in 2009, and then subsequent run up in prices. The Exceptional Macro is shown as vertical green lines in both series. The Macro MRI is shown in the lower panel. You can see that it coincides generally with peaks and troughs of the price levels. So, for example, when prices peaked in 2007, that coincided with the peak in the Macro MRI. At this point, we can see that the market would be vulnerable and that dramatic price declines could take place. That happened again in 2015: The Macro MRI peaked, and there was a general peak in the prices of the Dow Jones at that same time.
If we want to buy low on the MRI, looking for the Exceptional Macro can help us do that. When the stock market declines, the appearance of the Exceptional Macro is a good indicator that it is time to get back into the stock market. The Exceptional Macro indicated by the vertical green line, typically precedes a trough in the stock market. That is followed by a major run-up. The Exceptional Macro appeared in early 2009, which preceded a longer run-up in prices.
The same pattern is evident in 2016. The Exceptional Macro occurred, and the Macro MRI turned positive very quickly, which began its longer-term move higher that continued through the beginning of 2018.
But if we add the Micro MRI to the chart, we get higher-resolution view of the various cycles of resilience. If we look at just a couple of bigger inflection points described above - specifically the appearance of the Exceptional Macro indicating that it’s time to get back into the market - the addition of the Micro MRI allows us to anticipate the smaller inflection points in overall resilience. In the presence of the Exceptional Marco, it is still beneficial to wait until the Micro MRI is at its low point before buying stocks. This occurred in 2003, 2009, 2015 in the chart shown above.
If we trade on the MRI—buying low and selling high on the MRI, looking at the Micro, Macro, and Exceptional Macro together—we can make trades that give the green line shown on the chart above. We can hold stocks when the stock market is resilient and hold cash when it’s vulnerable. We can see that there are declines in the green line - we didn’t avoid the decline in 1987. But the overall pattern is very positive, nonetheless.
In summary, the Focused 15 approach’s response to current market dynamics looks at the current levels, directions and upcoming inflection points of these different market resilience indexes. There is no long-term forecast of events. Instead, we are just making short-term forecasts of how the investors will react to events. However, there are false alarms, meaning that we follow signals to move out to the market, but a large decline does not follow. We have found it is better to be careful and trade away from a vulnerable asset class even if it turns out that it does not decline. After a false alarm, we quickly rotate back to the asset class in order to be in sync with the market’s natural cycles of resilience. Trading is cheap and easy and the moves related to false alarms have a minor negative impact.
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