Rules-based adaptive approaches to multiasset-class investing can be designed that protect investors from potentially devastating losses while participating when market conditions are more favorable. Such an approach is intended to adapt to shifts in risk appetite, financial markets and the real economy. Based on history, all of us know that markets do not behave “efficiently” at all times. Sometimes investors benefit from owning risky assets (e.g., equities, real estate investment trusts, commodities, high-yield bonds and emerging market debt), while at other times (think 2008) holding these assets generates significant losses.
A first step toward developing this framework is to examine the history of annual returns, risks and correlations for a series of asset classes. These asset classes include equities, bonds, commodities, REITs and cash. A second step is to identify the macroeconomic and financial market factors that favor or work against each of these asset classes. In our opinion, these factors comprise the following data series: (1) measures of market sentiment, (2) interest rates, (3) household and business balance sheets, (4) real economic factors and (5) asset prices.
To illustrate how one might design this framework, in the chart below we construct a simplified regime framework that uses three data series: GDP, the VIX and the S&P 500. The chart below standardizes and plots quarterly data for these three indexes.