I believe it is worthwhile to make occasional changes to asset allocation when warranted by changes in the economic and market environment, rather than always holding a fixed asset allocation such as 60% stocks / 40% bonds, or remaining fully invested in stocks at all times.
I disagree with the view that market timing is impossible.
The figure below shows a long-term monthly chart of FXI, an ETF of Chinese stocks. This asset class had a dramatic rise in the 2005 – 2007 period, and by October 2007 it had reached a parabolic overbought condition.
Figure 1 Chinese stocks reached a parabolic overbought condition in 2007
Clearly in October 2007 it made sense to reduce exposure to this asset class, because of its extremely overbought condition.
In other situations, asset classes sometimes become extremely oversold, presenting good buying opportunities. An example was the U.S. stock market in late December 2018 (see chart below).
Obviously no one can predict the market on a day to day basis, but various situations occasionally arise in which the risk/reward position of an asset class is tilted in one direction or the other. Such situations may occur only a few times a year, but when they do, it makes sense to take advantage of them and make the appropriate adjustments to asset allocation.
Figure 2 U.S. stocks became extremely oversold in late 2018
In general, I believe the investment process should include assessing the risk / reward condition of various asset classes on a regular basis. This can be done with a variety of fundamental, technical, and valuation indicators.
Long-term asset allocation:
- The U.S. stock market tends to stay in long-term bull markets for years at a time, and during these periods, portfolios should be positioned with a high level of equity exposure (percentages would vary based on client risk tolerance, etc).
- However sometimes market conditions change.
- I have performed a detailed study of the 2008 stock market crash. As 2008 unfolded, there were numerous bearish warning signs in place, signaling that the previous bull market had ended and that it would be prudent to reduce equity exposure. These bearish signals were clear well before the worst part of the market crash, which occurred in late 2008 and early 2009.
- Reducing equity exposure in such situations can make a major contribution to preserving clients’ wealth.
- Based on this type of analysis, I have done a lot of work on building models to analyze market conditions. When combined with other indicators, this approach can make a valuable contribution to the asset allocation decision.
- Please see the article entitled “Long-term Market Analysis” in the “Excerpts from White Papers” section for a more detailed discussion of the 2008 market environment, including charts.
Short-term asset allocation:
- In some situations we can identify market turning points, and we can draw additional conclusions on sector weights and stock selection, all in an integrated way.
- For example in January 2016, the market experienced a sharp 10% correction, but by mid-February 2016 it was clear that the correction had ended and a new uptrend had begun.
- I have performed detailed studies of market behavior in various time periods, including early 2016.
- Please see the article entitled “Short-term Market Analysis” in the “Excerpts from White Papers” section for a more detailed discussion of the first quarter of 2016, including charts.