Looking beyond 60/40 again, use momentum and value

With value at extreme and rates at low levels, it is again worth discussing alternatives to 60/40 stock bond portfolios. While I will not currently advocate the set and leave 60/40 mix, it has served as a very good core benchmark. If you are going to suggest an alternative, you better show that you can beat the passive 60/40 allocation. 

The two current 60/40 problems:

1. The rising correlation between stocks and bonds

2. The high equity and bond valuations 

3. The low rate growing inflation expectations

Looking for some simple alternatives, a three step process makes sense.

1. Make sure that the equity and bond allocations are diversified. Add other equity markets to the mix (international and EM). That diversification was a drag during the last few years of superior US performance, but it may serve investors well on a relative basis going forward given the higher valuations in the US.

2. Use momentum to change the exposure against the base. This can be done easily through a number of look-back alternatives and can be employed to cut and raise asset allocations.

3. Use value metrics to change weights to asset class exposures. High valuations do not mean an immediate decline, but the threat of revision to the mean is real. 

The benefit from using a combination of diversification, value, and momentum was well-researched a view years ago in "A Case Study for Using Value and Momentum at the Asset Class Level" by Victor Haghani and Richard Dewey in the Journal of Portfolio Management. The authors show that simple value and momentum signals applied to well-accepted benchmarks create improved Sharpe ratios. The benefit of using both value and momentum is through their negative correlation. The combination of both will add more value that using each signal separately. There are higher costs from turnover, but the benefits are still significant.

Using strategy enhancements is the most effective way of beating the potential negative effects of a static 60/40 portfolio in a world where asset classes may be overvalued.

 

The term machine learning is overused - Have to get specific with what techniques are used

 

The term "machine learning" is being overused by many investment managers. It is being bantered about by some as a special technique or sauce that will magically liven returns for any portfolio. Sorry, there is no special magic, but there is a broad set of technique that can help analyze data. The magic is still connecting data with analysis in different ways to provide new insights.

Better analysis can lead to better returns. (The detailed mind map graphic on different machine learning techniques is from machinelearningmastery.com.) It does a good job of breaking down the wide variety of tools within machine learning and data science. If some portfolio manager says he uses machine learning, ask two simple questions: What techniques do they use? Why are these techniques better than a simpler analysis?

I wish there was greater use and explanation of these tools when in economic graduate school, but the focus of the times was different. The emphasis was on building models based on theory with the hope of testing hypotheses and making predictions. The new emphasis on a very simple level is on letting the data speak and then determining what it says that can be meaningful.

Data science today does not eschew theory, but places emphasis on prediction and extracting information. Theory is not thrown out, rather the focus is on extracting relationships from data suspected to be relevant. For the theorist, the key component for developing a machine learning solution is the feature engineering which determines what data are used. When discussing machine learning, focus on the feature engineering.

Using machine learning can be very attractive, but any expected results should be tempered by the fact that it does not automatically leads to excess returns.

China and stopping the upward pressure on copper

Governments do not like to be ruled by markets. Markets force prices higher or lower based on supply and demand and not the desires of policy-makers. There are overshoots and bubbles, but these are usually only determined after the fact and can be a matter of opinion. 

We have seen copper prices move off their highs coincident with discussions between Chinese companies and  policy-makers who want market prices to be kept in order. What this means is not exactly clear, but there have been issues of excess borrowing against copper stocks by Chinese firms. Additionally, softening in the Chinese economy has reduced pressure on copper after strong imports over the last year.

If global demand increases as the world economy reflates, it will determine price; not the desire of policy-makers. This current price reversal will only be temporary, and the longer-term trend will remain in place.

"The NDRC, China's top economic planner, along with the industry ministry, the state-owned assets regulator, the State Administration of Market Regulation, and the China Securities Regulatory Commission, reminded companies with market influence in sectors such as iron ore, steel, copper and aluminum at a Sunday meeting to run in accordance with laws and regulations and keep the market prices in order.

Industry associations such as the China Iron and Steel Association and the China Nonferrous Metals Industry Association also attended the meeting"  news on May 25th.  - Shine 

 

Lumber bubble and imposition of tariffs for anti-dumping - you cannot make this stuff up

The price of lumber has exploded over the last year and is considered by many as a bubble even with the increased demand for housing. It is expensive and new housing prices will reflect this cost. 

Lumber prices have fallen from market highs in May, but now there is the report that the Biden Administration's Commerce Department will raise tariffs on Canadian lumber imports as an anti-dumping response. This should help consumers? The tariff would move to 18.29 percent for 2019 and would apply retroactively. Granted prices were lower in 2019 but the cost will apply to the market today. The anti-dumping tariffs decisions are not supposed to take into account the impact on consumers, yet we already see the impact on housing prices. 

The increase in housing prices and shortages of lumber is having an impact on housing permits and starts. The feedbacks are not always clear, but high price will turn-away some buyers and builder activity will reflect declining consumer behavior.