[this is the content of our letter to clients today]

Discussed in this letter:

UTILITY

What use is close monitoring of stock market condition?

For an investor who is determined to hold a static portfolio through good times and bad, the answer is not very much.

For a young people executing a regular weekly or monthly investment accumulation program with many years ahead, bad news is good news, because they purchase more shares per Dollar of investment when the market is down than when it is up. In the long-term market downturns help them accumulate wealth. So they can ignore all this, unless they want to increase their periodic investments during market downturns.

For investors in retirement who are not overfunded and who must sell assets for their standard of living, it is important to be aware or stock market conditions to decide which assets to sell to minimize the risk of rapid portfolio depletion, or to know when to minimize withdrawals to the extent possible.

Then for others who wish to tactically modulate their asset allocation in response to and to potentially profit from changing stock market conditions, this stuff is very important. For those of our clients, this market condition information is useful.

For example, an investor with a long-term 50/50 stock/bond policy allocation, but with a collar around that policy level of say a more defensive 40/60 to a more aggressive 60/40 allocation, this information could be used to decide when and how to modulate. Let’s call that allocation shifting, where the allocation revolves around the target level based on market conditions.

It could apply to any target policy allocation with collars; such as an aggressive 80/20 stock/bond long-term target with a 70/30 to 90/10 range; or a 30/70 with a 20/80 to 40/60 range.

This first chart is our monthly “Allocation Shifting Indicator” (the bond black line in the top panel) which rates a market from 0 to 100 for condition where 0 is very weak and 100 very strong.

A hypothetical investor with a target policy 50/50 stock/bond allocation, and with 40/60 to 60/40 collars, might use the data this way:

When the indicator is at zero, a more defensive posture is suggested, which for that investor would be 40/60 stock/bond. At an indicator reading of 25, a less defensive posture of 45/55 might be appropriate. When the indicator is at 75, a more aggressive 55/45 stock/bond allocation is suggested by the indicator. Then when the indicator is at 100, the maximum risk level within that particular investors investment policy would be called for at 60/40 stock/bond.

The same logic would apply to any investment policy target allocation, and to any magnitude of more defensive and more aggressive range endpoints.

ALLOCATION SHIFTING INDICATOR

With all that said, let’s dive into the allocation shifting indicator.

With this indicator we focus on monthly data, which is not so volatile as weekly or daily data to avoid a lot of “whipsaw” risk — the indicator is not constantly switching back and forth between aggressive and defensive signals. We use four different criteria that are minimally overlapping in what they measure: