A lot has happened in the stock and bond markets since the publication of our most recent Monthly Market Monologue. (If you have not watched that video, you can find it on our YouTube channel at this link.) In the video, I talked about what could be interpreted as a "bullish divergence" in the advance-decline lines. However, I also mentioned that I was shooting the video on Friday, August 2nd and knew how the trading ended on Thursday, August 1st.
Since then, we've had a couple of clients reach out and ask if we should be shifting into a more conservative posture given the market's condition. The short answer is: we already did. But this gives us a good opportunity to remind our clients how our investment management process works.
However, before discussing how our models work, I thought I would first discuss stress. Whenever we go through a particularly volatile time period, I am asked about my personal stress. Do I get stressed during market environments such as this?
No. Not anymore.
The reality is that going through the Dot Com crisis and the Global Financial Crisis lead me down a path of creating a well defined investment management process because I did not want to go through that stress again. That does not mean that we are going to be able to avoid high volatility periods. It simply means that we are prepared for those environments.
Considering the fact that we have Hurricane Debby's winds and rains lashing us as I write, it seems appropriate to compare the high volatility environments in the stock market to a storm on the high seas. While I cannot say for certain, I would venture a guess that there is no such thing as a ship Captain that enjoys going through big storms while on the open water. But I also imagine that going through such a storm is inevitable for those Captains. While I have never been on a cruise, if I were to be on a such a ship during such a storm, I would want to know that the Captain is not stressed. I would want to know that the Captain is able to remain calm and steer the ship through or around the storm as safely as possible.
So are we stressed?
No. We are not stressed because we have a detailed investment management process. Said differently, we have a rules-based investment process. As a result, we are not guessing. We are not hoping. And we are certainly not stressing. Conversely, we know exactly what to do - we will follow our rules.
That does not mean that we will avoid losses. That does not mean that we will get every decision correct. It simply means that we are able to remain calm and steer the ship.
That said, let's now turn to how we steer the models.
Most of our clients are exposed to three or four of our equity based investment management models. (We do have a fixed income model and most clients do have exposure to that model as well. But the focus of this blog post is our equity based models.) We have two "quant" models and two "discretionary" models.
Quant Models
In short, a "quant" model - or quant strategy - is simply an investment management model that uses strict buy and sell rules to determine what the model buys and when it buys and sells. The objective of our quant strategies are to keep us invested when the general trend of the market is up. However, when the trend changes, we want the rules designed to help us shift the model to seek shelter in either cash or bonds.
For example, one of our quant models has three different potential holdings: cash, an equity position, or a bond position. The rules determine which of the three options we are holding at any given time.
The key is that these rules can be back-tested. Furthermore, it is the reliance on the rules that allows us to remove our emotions from managing these models. We simply follow the rules.
Most of our client accounts have exposure to at least one of these quant strategies. At the time of this writing, so far, neither of our quant models have given us either a partial or full sell signal. As a result, our quant models remain fully invested ... for now.
Discretionary Models
Two of our equity models are discretionary models. In short, we determine what to buy and when to buy it. We have general rules for what we are looking for, but it is our human judgement (or "discretion") that determines if we are going to buy or sell any particular position.
A key aspect of managing these models is for us to manage our stats. Specifically, at any given time, we know our average win, our average loss and our win to loss ratio. In general, if we maintain a good win to loss ratio and our average win is greater than our average loss, then we know that the outcome is merely a function of math.
Another key component to the discretionary models is the cliche to "Cut our losses short and let our profits run." This is especially true in an environment where there is no trading costs to either our firm or our client. So, if we buy a stock but it starts moving against us, we have a pre-determined price where we will sell that position. It does not matter what we think of the company, the sector, the market, etc. The only thing that matters is our adherence to keep our losses small. If that stock reverses again and starts moving higher, we can always buy it back if we want. But, in order for these models to do well, we have to adhere to the principle of keeping our losses small.
As a result of this discipline, our Stock Model (not every client is exposed to this strategy) was 100% in cash for several days or even a week prior to the beginning of this month when the sell-off began. We had no clairvoyance that this month was going to be difficult. We were just maintaining our discipline.
Likewise, going into this Monday's trading session, our Sector Rotation strategy (not every client is exposed to this strategy) was 43% in cash. By the end of the day, it was 48% in cash and, as of this writing, is still 48% cash.
Both of our discretionary models are holding as much cash as they are simply because we either took profits off the table or the pre-determined stop prices got hit and we exited the trade.
In summary, you do not need to wonder if we have shifted into a more conservative allocation. We shift each of our models according to the rules that govern the model.
If you have read this far and are still confused, I will conclude by returning to the analogy of a ship in a storm. Rest easy - or as easy as possible - knowing that your ship's captains have studied storms. We do not study storms because we like them. We study them because we know we are going to face one sooner or later and want to be as prepared as possible when that inevitable storm strikes. While we cannot guarantee anything, we can tell you that we are calm amidst this storm, navigating the ship according to pre-determined rules.
Naturally, if you have any questions, please do not hesitate to reach out to any member of the team.
This information is intended to be educational. Hicks & Associates Wealth Management does not provide tax or legal advice. You should consult with a qualified tax, legal or financial professional before making any decisions.
Investment advisory services are offered through Hicks & Associates Wealth Management, LLC (“Hicks & Associates”), an investment adviser registered with the Securities and Exchange Commission. Registration as an investment adviser does not imply a certain level of skill or training. More information about Hicks & Associates can be found in Form ADV Part 2 or Form CRS which is available on our website.
Past performance is no guarantee of future returns. Hicks & Associates reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. The visuals shown are for illustrative purposes only and do not guarantee success or certain level of performance. This material contains projections, forecasts, estimates, beliefs and similar information (“forward looking information”). Forward looking information is subject to inherent uncertainties and qualifications and is based on numerous assumptions, in each case whether or not identified herein.
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