#CrackUpBoom Investment Solution: Adaptive Allocation

November 1, 2014

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Obviously not a bubbleThis week it became clearer where the central banks are taking us all. No matter how much QE has repeatedly failed to produce a sustainable recovery, at least to many, it looks like success if it forces the stock markets higher.

Central banks essentially have 2 modes of behavior, which were both on display this week. First by the Federal Reserve and then by the Bank Of Japan.

The Federal Reserve’s statement on Wednesday was full of praise for the wonderful outcome of their previous QE policy which they claim is now producing a stronger economy. How strong does the Federal Reserve believe the economy will be? The Federal Reserve has consistently overestimated growth for 6 years in a row and their stated long term growth forecast is now barely over 2%, a level far below historically healthy growth levels.

This comes after 6 years of near zero interest rates, and trillions in both debt increases and money printing. Also every time previous QEs have ended it was only a few months away from yet another round of QE. This so far is the track record of the “success” of QE.

Also if the Federal Reserve was really confident why would Federal Reserve Governors rush out immediately the S&P500 falls not even 10%, with promises of yet more QE?

Even Greenspan was this week very candid about the “mixed” results of QE and the very difficult “unwind”:


Then there is the second mode of behavior exhibited by the BOJ. Japan is the leading economy in the extravagant QE experiment, which now appears to be reaching the panic stage. This is best expressed by David Stockman as a measure he calls “Jumping the monetary shark”:

The most disturbing element of all this is that the rest of the world can not ignore these extraordinary measures. If the Yen devalues massively it will just put further deflationary pressure on Europe and other exporting countries. As Richard Duncan’s excellent central bank analysis has argued, other central banks already will need to accelerate their QE programs again, but now the pressure is intensifying.

Just because the Federal Reserve’s QE has just ended, it would be dangerous and even unrealistic to assume that they will not return with some new program before long.

The central banks have become so pervasive in the markets, with their erratic interventions that normal value and economic influences are no longer reflected in prices. As Jim Rickards has said “the Fed is manipulating every market in the world”. The purpose and the dynamic are very clear. Jim Rickards explains this very simply in a recent tweet:

“How can you fight #deflation without inflating asset bubbles? The answer is you can’t. You can only buy time; then it all ends badly.”

This leaves investors with a very challenging and difficult set of circumstances. Price trends are becoming more powerful, and yet future risk is increasing rapidly.

Investment and trading is all about constantly adapting to circumstances, and increasingly I have been adjusting to more systemic adaptive approaches rather than value and economic judgments. Although, the latter never goes away completely, it has become overwhelmed by central bank actions for the time being.

The challenge is to find an asset allocation strategy that can work well however the fallout evolves. Fortunately, the market in portfolio innovation is still very strong. Never more so when the need is at its greatest. There are multiple new products which are becoming available to provide investors with new ways to improve their return to risk outcomes, even when circumstances become increasingly challenging.

One strategy that may be particularly useful in this regard is “Adaptive Allocation”. This approach seeks to resolve the problem of having a highly effective long term static allocation which may become temporarily out of tune with current trends and circumstances. This methodology introduces current trends into the allocation strategy in an adaptive mechanism.

The best way to describe this process is by example. Here is a simple system which shows its very effective results:


Of course this is just the beginning of an endless enquiry into multiple variations that can be considered and tested. New products are now being developed along these lines that provide investors with exceptional opportunities to significantly lower risk, while still participating in the markets currently strongest trends.

This has always been a good basis for allocating capital, but never more so when the trends are strong, but increasingly uncertain. It is time for investors to begin to understand and implement this new approach. It can be produced by a disciplined investment advisor or increasingly there are new ETF products now available that provide very effective solutions.

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