Is it Better to be a Tortoise or a Hare?

There is a great deal of evidence that supports the belief that well-designed and thoroughly backtested tactical asset allocations can be expected to generate higher risk-adjusted returns than a passive portfolio over longer-time frames. However, as recent history so clearly demonstrates, yesterday’s backtests provide little insight into when the markets enter unchartered territory.

Tactical asset allocation relies on market and economy indicators to revise asset weights. Examples include changes in unemployment, retail sales, housing, the moving average of closing stock prices, investor sentiment, and stock market volatility, to name a few. Most indicators use data over a defined lookback period to identify current economic and market trends.

While market indicators are an essential portfolio management tool, they can come up short when unexpected events trigger a sudden and dramatic change in the stock market’s direction. That’s primarily a consequence of the economic data reflecting history while the markets tend to price risk based on expectations.

“Nowcasting” is a technique that attempts to at least partially overcome this drawback. Nowcasting can be defined as the prediction of the present, the very near future and the very recent past by using early interim data, rather than waiting for the final numbers. Unfortunately, interim data can be misleading and sometimes flat out wrong.

A second approach uses shorter time frames when generating a market or economic signal.

• Generally speaking, indicators that use longer lookback periods tend to generate more stable, but less sensitive, signals.
• Shorter lookback periods, by contrast, typically generate timelier, and less enduing, signals.

Incorporating shorter look-back periods into the indicators used by rules-based investment strategies can improve strategy performance by shortening response times, thereby reducing drawdowns, lessening whipsaw risk, and ultimately improving returns.

On the other hand, when used in isolation, shorter lookback periods can lead to false signals triggered by noise, as compared to a true, actionable signal. In addition, over-reliance on speedy indicators to direct investment decisions can lead to frequent trading, higher taxes, and ultimately lower profits.

The goal, then, is to combine fast and slow signals in a way that captures the best of both.

Recent research suggests that combining indicators that use both short and long look-back periods in a systematic way can lead to better results than using either fast or slow indicators independently.[1] In short, the research suggests that a combination of slow and fast indicators can improve a strategy’s responsiveness and accuracy by identifying what the authors refer to as “trend breaks” - turning points that mark the onset of market corrections and rebounds.

A strategy’s timeliness could be increasingly important if markets continue on their current path. Since 1929, the average time it has taken to recover from bear markets has been around 26 months. By comparison, the recent end to the pandemic-driven bear market represents the fastest recovery in history from a 30% drop from all-time highs, and the second-fastest recovery back to those highs.

No one knows whether the market’s quick recovery is an anomaly, or a sign of things to come. Perhaps the hardest thing in investing is to know when things have truly changed. That said, there’s an argument to be made that market cycles will continue to unfold at lightning speed in the future. Two possible catalysts include:

• The Great Recession appears to have opened the door to larger, faster responses from the Fed and other central banks.
• Technological advances have sped up the flow of market information and has made investing easier than ever.

In summary, it could be increasingly important to be agile when bear markets hit and bull markets begin. At the same time, market noise can be expected to continue, and so hasty decisions are likely to be punished. A combination of nowcasting, and the strategic use of both fast and slow indicators, are ways to adapt your investment strategy to the new normal.

[1] More specifically, see https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3594888.