What can the past tell us about today’s market? Is the risk of nuclear war with North Korea just like the old cold war with Russia? No, that was worse. Is the political risk the same as Nixon’s exit from politics? No, these allegations are worse: money laundering, conspiring with foreign governments and tax fraud. Is the market risk the same as 2008? No, this is worse, we are trillions of dollars in debt and going deeper by the day and so is the rest of the world.
Then, what good does it do to sift through the ashes of past returns to predict future returns? Bernardo Kuan, a former researcher at the Pension Research Institute, replicated the methodology of a study done in 1998 at the Schwab Center for Investment Research that was published in their Mutual Funds Performance Guide, second Quarter 1998. The study separated mutual funds by style and then ranked them by eight different measures: Sharpe Ratio, Geometric Sharpe Ratio, Selection Sharpe Ratio or Information ratio, Jensen’s Alpha, Benchmark Jensen’s Alpha, Holding Period Alpha, Appraisal Ratio and the Modigliani risk-adjusted measure. The study found the rankings to be similar and concluded they had very low predictive power based on the Spearman rank correlation coefficient. Bernardo’s study showed the PRI performance measures to be statistically significant.
Subsequent studies at PRI developed a methodology we called Post-Modern Portfolio Theory. Instead of sifting through the ashes of the past we reassembled the atoms of past monthly returns into thousands of annual returns that painted a picture of uncertainty that appeared to warn of a top in 2000 and 2007 (see videos at http://www.pmpt.me). Once again this methodology is warning investors to seek liquidity.
Table 1 presents the output from the full-blown asset allocation model developed at PRI. Only 2 of the 9 indexes, developed by Ron Surz (email@example.com) to describe the U.S. stock market, have positive Upside Potential ratios (yellow highlight in columns A & B). All the rest of the U.S. indexes plus real estate (REIT), emerging markets (EMM) and Europe (EURO) have more downside risk than upside potential. In other words, while the market has mostly gone up for the last 29 years, there is currently much more downside risk in most of these market ETFs than upside potential. Using 29 years of bootstrapped data is meant to provide a picture of the inherent risk-return relationships.
Empirically, we found the best results were produced with three year rolling intervals. Those are shown in columns C&D. The 3 yr UP ratios for all U.S. ETFs ending 2017 were lower than the previous year (column C versus D). The most bullish forecast is Large Centrix (Lrg Cen), which Surz calls all stocks in between value and growth styles, but that is down from 83% more upside potential than downside risk in 2016, to 1% more downside risk in 2017. Small growth stocks now have 74% more downside risk than upside potential. Also, all 9 of the U.S. three year average returns in 2017 (column E) were lower than they were in 2016, indicating the momentum is slowing down.
The last time this happened was mid 2007. PRI was then managing five trust accounts at FISERV. We went to a minimum of 50% cash in all accounts at that time. Yes, the market was also at an all time high then. Yes, nobody believed us then either. Then in October of 2007 PRI signed a contract with a unit within a large wire house to provide an overlay service. A condition of the service required PRI to turn over all asset allocation decisions to the wire house. That was a mistake.
An Upside Potential ratio of .26(SG) is not a 74% probability of a negative return. It is the potential to exceed an actuarial rate of return of 8% versus the risk of falling below 8% and signals 74% more downside risk than upside potential. The probability of a return below 8% does not begin to capture the pain of not being able to retire…ever. That’s why the Pension Research Institute (PRI) developed downside risk and upside potential concepts, which you can watch in a 4 minute video at the right side of this Home page.
However, most investors focus on the average return for the past X number of years and just hold on. Yes, that buy-hold strategy worked well since WW II but things are changing faster than in the good old days and catastrophic events are occurring more frequently.
For example, scientists have been predicting an event like the 2017 Hurricane in Huston for years but they didn’t predict 50 inches of rain and they didn’t predict the day it would happen, so the government and the citizens ignored the warnings. PRI and many others have been warning that downside risks are higher than upside potentials for the last year. Once again we say, just because you got away with it so far, doesn’t mean you didn’t take any risk and it doesn’t mean the old buy & hold strategy of the past will work in this new age we live in.
Nothing works forever and nothing works all the time!