Preserving Capital (continued)

In my previous Market Observation I opened the door to how capital preservation is viewed from a money manager’s perspective. Clearly one should understand that there are multiple ways individuals will define the objective and that the framework will continue to change in this environment. That being said, last week I focused on the asset classes of a preservation of capital objective, today I am going to focus on how I think an investor should weight equities versus cash at any point in time.

The financial meltdown of 2008 was a nasty lesson to many in adjusting asset class weightings as macro indicators changed. Just the opposite was true in 2003-2004 when at that time you should have been reducing cash and bond positions and increasing equities and tangible assets. As suggested last week, cash is just as important to a portfolio as any other asset class and 2008 solidified this view. In 2009 my colleague, Chris Puplava, began working on several models that assist in the allocation of asset classes and have shown value in being used to determine changes in market trend direction.

On a macro level, the application of these models removes a large amount of personal opinion and ambiguity regarding trends from the decision making process. Lets keep in mind the objective of this portfolio is to preserve capital, the growth comes when the opportunities are available. The models—being a combination of short term, intermediate term and long term indicators—may be a little late removing all of the risk from a portfolio. However, when these models confirm a trend and action is taken, back testing indicates these models can assist in achieving the stated objective.

The Indicators

The longer term objectives of the capital preservation portfolio are dictated by macro economics and some widely recognized technical indicators that are available to just about anyone that has access to the internet. Some examples of what I use:

However, some of the indicators were developed in order to complement widely available data.

Financial Stress Index

Recession Probability Indicator

The Models

I think that each indicator, by itself, provides some insight as to how a preservation of captial account should be allocated over time. However, Chris and I discovered while working with these indicators that combining them with others into a comprehensive model reduced the number of trend change signals, thus avoiding many of the short term whipsaws. The premise behind the analysis was that through the modeling process and back testing, a portfolio would have avoided the majority of the significant bear markets in stocks, and would be better positioned to take part in the following upswing.

These models were back tested extensively before being implemented and thus far have removed much of the market volatility experienced this year. While the model suggested a 50%-60% cash/bond allocation in April of this year it has improved some during the past three months suggesting 30%-40% cash/bond allocation and a 60%-70% equity allocation currently.