Divergence of Signals

On a monthly basis, I update a Asset Allocation matrix (Link) which this month recommended a reduction in allocation to Equities. A day or two later, I wrote that we are maybe at the start of a new bull run (Link). Now, with both being in conflict has meant quite a few readers raised as to what is happening and what should be the way forward.

Before I venture out there, a word of caution. I am not a Registered Investment Advisor nor should you take my views as Advise to Buy / Sell. The idea of this site is to help Do it Yourself investors get access to research I carry out for my personal investments. Since sharing of ideas provides opportunities for critical review, I do share whatever research I carry out.

Now that, that’s done, let me first try and explain what the Asset Allocation Matrix is all about and how it works. On the web, you can find hundreds and thousands of research reports / tests that emphasize that most investors are better off with a simple 60 / 40 (Equity / Debt) allocation balanced regularly (generally Yearly).

While 60 / 40 is indeed a great way to get the best of both Equity (higher growth) as well as Debt (solidity in returns), it still means that at peaks you will have too much exposed to equity and if your re-balancing month doesn’t coincide with the best, you miss out on the profits that were there for the taking but couldn’t be taken.

Let me provide you with a realistic example of where it would have hurt. Lets assume you followed a 60 / 40 allocation matrix and re-balanced it every year in June.  In June 2007, you would have re-balanced and then saw Nifty move up by around 47% by Jan 2008. So far, so good. But you will re-balance only in June 2008 and by then, markets were 36% below the highs and closer to where they were in June 2007. Since there would not be much change, you would have just left it as it is and waited for the next re-balancing date – June 2009. But in between, markets first cratered to a low which was 55% from the peak and then rebound to square one in June 2009 (level similar to what we saw in June 2007 and June 2008). In other words, we participated in the best rise and the worst fall and yet nothing much to show.

In itself, that is not bad since at the very least we did not reduce allocation when markets were down, but my thought was using a combination of macro, can I do better. The Allocation Matrix is the out-put of one such idea. Once again, do remember that most of the things I post are generally work in progress and a updated matrix is being tested as we speak.

The concept of the allocation matrix is not to maximize gains but to minimize the risk of capital loss. Its all nice to quote Buffett on buying when there is blood on the streets, but given that more often than not, its out blood, we generally get scared away from investing at the best possible time.

Take for example, PSU Banks. Isn’t there blood on the street to justify checking it out (investing maybe a different matter). After all, if India has to grow, Banks will need to power the same and unless you believe Banks will go belly up, at some point they start becoming attractive.

But I am digressing. The whole idea of the AA matrix is to provide you with a view on whether one should take a high risk bet at the current juncture or a low risk. And remember, that like all models, this too can go wrong (whipsaw). Nothing is fool proof.

Hopefully that addresses the question though shall be happy to answer any queries you may have (either use the comments or send me a mail using the Reach Us page.

Now, coming to my post about the start of a new bull market. The reason I added a Question Mark was one is never sure even though logic may suggest it being right.

I derive Income by trading and for that I need to constantly analyze the odds of taking a particular stance. For example, in bear markets, shorts would provide more meat than long trades and vice versa. The reasons I spelled out for saying that maybe we are at the start of a new bull run were all based on Momentum Indicators.

While Momentum is said to be pervasive, there is also a risk that even the best set-up’s can fail. As a trader, one needs to be nimble to reduce exposure / leverage when the odds aren’t in one’s favor while increasing them when it is.

At market peaks, most momentum indicators are generally in buy mode though that would be the worst time to be fully invested in markets by investors. While momentum traders generally shift fast, same is not advisable for investors since it means higher costs and may actually be not practical for many who have full time jobs.

While I do see this as start of a new bull rally, in a way we are accepting the market’s premise that sooner or later, earnings will pick up. If it does, the passive allocation may once again shift to being more invested (whipsaw of current cutting down strategy) but if it doesn’t, traders hoping for a new bull run would end up being disappointed.

Personally while as a trader, I am neck deep in longs (which could change as early as first hour of tomorrow 🙂 ), as a investor, rather than reducing at this moment, I am switching from Nifty Bees to Kotak PSU Bank ETF since chart  wise, I see a bottoming formation. The low’s may once again get broken, but that would be the risk I need to take if this rally is to turn out for real.

Ben Franklin — ‘Nothing ventured, nothing gained!!!