Saturday, April 30, 2011

Changes to the Strategic Growth Model, continued

Managing risk vs. reward...

There are two primary success factors required for the model to profitably align the portfolio's capital in accordance with prevailing market conditions... The model must 1) CONSISTENTLY determine the prevailing market conditions (BUY-NEUTRAL-SELL) and 2) allocate the portfolio's capital (long-short-cash) to take best advantage of the potential rewards while managing the risks associated with the various market conditions.

The Strategic Growth Model relies on the Thrust / Trend Model (TTM) by to signal the various market conditions. The TTM is purely mathematical, which is ideal for our purposes because this removes the possibility that the model's allocations will be affected by human emotions, which tend to be wrong at the most inopportune times.

The table shows the model returns for the 31 TTM signal periods (BUY-NEUTRAL-SELL) since inception in 2003. It also shows the maximum interim loss for each signal period. You'll note that in sixteen "BUY" periods, the maximum interim loss exceeded -4.0% only four times and the maximum interim loss for ANY BUY period was -8.8%. This shows that if the model were to invest 100% of its funds in the selected stocks upon receiving a fresh BUY signal, it's infrequent that the portfolio would weather an intermim loss of even -4% before going on to make a new high water mark, and it would be extremely rare that it will ever see an interim loss worse than -9%. This is well within the system's design limits.

Also note that the benchmark S&P 500 index was down during four of the five "SELL" periods, while the model portfolio was able to show gains during three of these periods.

In summary, the Thrust / Trend Model has demonstrated a CONSISTENT ability to keep the model portfolio on the right side of the market at the most critical turning points.

So... if the SGM is using the same stock selection model and the same Thrust / Trend Model as before, what's changed?

What's changed is the model's allocation strategy.

The specific instrument formerly used to hedge our portfolio (TWM) has been shown to put a drag on the portfolio's performance that far exceeds its value as a hedge against risk. There are multiple factors involved including the specific index being used for the hedge (TWM is linked to the Russell 2000 index of small cap stocks) and the "tracking error" associated with a 2x leveraged fund.

During periods of low risk (BUY) the model portfolio will now allocate 100% of its funds to stock positions. During periods of moderate risk (NEUTRAL) the model portfolio will reduce its exposure to stocks and hold 50% of its funds in cash. During period of heightened risk (SELL) it will allocate 50% of funds to a short position in a non-leveraged INVERSE fund and hold the balance in cash. While this allocation strategy introduces a higher amount of weekly volatility, we've already seen that the model's expected maximum interim loss remains well within acceptable limits.

The model portfolio's allocations are now as follows, in accordance with the Thrust/Trend Model's signals:
BUY - 100% long
NEUTRAL - 50% long / 50% cash
SELL - 50% short / 50% cash

Please note that in my managed accounts, I'm currently maintaining a higher cash position than the model portfolio (approximately 50%), and will continue to do so until the Thrust / Trend Model gives us a fresh "BUY" signal.

I'm doing this because of risk vs. reward. The market trend has become quite extended above its trend line since the current BUY signal was triggered in September, 2010. The risk of a "normal" market sell-off giving us a significant interim loss in our portfolio is much greater now than if the TTM had just thrown us a fresh BUY signal. In my judgement, this is not a good point in the cycle to increase our risk exposure.

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