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TACTICAL DILEMMA

DAVID D. MOENNINGChief Investment Officer, Sowell Management Services • November 2016

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THERE CAN BE LITTLE ARGUMENT that tactical management programs, which we define as investment strategies designed to (a) seek opportunities and capture the upside of the market when stocks are moving higher and/or (b) to avoid a large degree (if not all) of the downside seen during major declines, have not fared well in recent years.

In this paper, we review the degree of underperformance the tactical space has experienced, we offer explanations for the underperformance, and provide suggestions for ways advisors can alleviate the tactical drag on portfolios incorporating tactical strategies.

We begin by reviewing the historical performance of tactical funds as well as hedge funds over various time frames, outlining the dramatic underperformance

relative to the S&P 500. We then offer examples of traditional stock market indicators and models that have stopped working in

recent times. We explore the impact global central banks have had on the character of the stock market and how

trading strategies have been affected. We look at the proliferation of technical analysis among advisors.

And we explore the “rise of the machines” and how high speed, millisecond trend following

has wreaked havoc with tradition tactical indicators.

We then provide four possible solutions to the tactical dilemma and discuss the benefits of employing modern portfolio design and diversification techniques.

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THE TACTICAL DILEMMAAdvisors employing tactical investing strategies in client portfolios are likely aware of the fact that flexible investing programs designed to seek opportunities and/or manage exposure to market risk during negative market environments, have not fared well in recent years.

In addition to some very high profile “blow ups” that have occurred in

this industry, it is our view that tactical managers of almost all shapes and sizes have struggled mightily for several years running. And the degree of underperformance experienced by tactical managers may be surprising to many.Exhibit A is the table below, comparing the S&P 500 to the Morningstar Tactical Allocation mutual fund category since 2004.

Source: Morningstar and Standard & Poor’s

Looking at the “bottom line” of this chart makes my point as the cumulative return since 2004 for Morningstar’s Tactical Allocation category is 58% versus the gain of 154% for the S&P 500 total return index (which includes the reinvestment of dividends into the index).

Obviously, this is a large disparity. This means the tactical category captured just 38% of the returns of the S&P over the 12-year, 8-month period.

Most tactical programs/funds tout that capital preservation is the primary focus during big, bad, bear markets. And it is also true that the Morningstar category did just that in 2008 by losing more than a third less than the stock market index.

In addition, many tactical managers don’t claim to be able to keep up with the market during roaring bull market environments such as years like 2009 and 2013.

However, the chart above shows that the last time the tactical allocation fund category appeared to perform well against the S&P was 2008, which is getting to be a long time ago.

For example, if one compounds the returns from the beginning of 2008 through 8/31/16, the disparity is alarming as the tactical category’s cumulative return since 1/1/08 is 18.24% versus 65.68% for the S&P total return.

Looking more closely at the numbers, the real period of underperformance appears to have begun in 2011 when, in my opinion, the impact of high speed trading began to take hold. Doing the math, I find that since the beginning of 2011, the tactical allocation category’s cumulative return is 16.38% versus 94.87% for the S&P.

IT’S NOT JUST THE TACTICAL FUNDSOne argument that can be proffered is tactical strategies have notoriously underwhelmed in what is called a “40 act wrapper” – aka an open ended mutual fund. In my experience, it is true that tactical strategies have had a tendency to underperform once they have been launched in a mutual fund and promoted broadly.

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However, the performance problem of the tactical space isn’t limited to the SMA manager and/or mutual funds. No, hedge fund managers are seeing similar difficulties.

Below is a table comparing the HFRI Equity Hedge Index to the S&P 500.

This is an index compiled by Hedge Fund Research, a hedge fund analysis shop based in the Chicago.

This particular index is comprised of hedge funds whose stated objective is to use both long and short positions in their portfolio - usually in individual equities.

Source: Hedge Fund Research and Standard & Poor’s

Doing the same analysis that we performed on the Morningstar Tactical Allocation category, we find that the cumulative return for the HFRI Equity Hedge index over the last 12.67 years is again quite weak compared to the S&P at 55% vs. 154%.

While the hedge fund index did protect capital during 2008, the index has underperformed since then with 2011, 2013 and 2014 sporting particularly difficult comparisons.

The key takeaway here is this particular investing methodology has struggled during the current market cycle. But it is important to remember that almost all investing methodologies/strategies struggle at times.

Remember the late 1990’s when Warren Buffett, who is viewed as one of the greatest investors of all time, decided to avoid the technology game? The bottom line here is that even the Oracle of Omaha has struggled against the benchmarks at times.

TRADITIONAL INDICATORS STRUGGLINGPart of the problem with the tactical space right now is a great many traditional market indicators have stopped working well. One of my favorite short-term indicators is called a trend-and-breadth confirmation model. The idea here is very simple. If the price trend of the market is up and the trend of the advance/decline line is up, logic suggests that the stock market is in good shape and that the odds of the continued gains are high.

More specifically, this particular indicator uses a 25-day simple moving average of a multi-cap stock universe and a 5-day MA of the universe’s advance/decline line. According to the computers at Ned Davis Research, this indicator would have been VERY useful since 1980. In fact, when both price and breadth were above their respective moving averages (which occurs about 41% of the time), the market has gained ground at an annualized rate of 30.4%.

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Conversely, when both price and breadth were below their respective MAs, stocks have declined at an annualized rate of -22.4% per year.

And when one is above the MA and one is below, the annualized return of the stock market index used has been a respectable 12.7% per year.

From my seat, this rather simple indicator is incredibly intuitive. If the market is “in gear” and the indicator is positive, stocks tend to go up. When the indicator is negative, stocks tend to go down. And when the indicator is neutral, stocks tend to do okay because, well, stocks have historically had an upward bias over time. It is for this reason that versions of this indicator have been in my toolbox since the early 1990’s.

THE PROBLEMThe great thing about using a price-oriented indicator is that unlike so many other models designed to help one figure out what is likely to happen next in the stock market, price cannot deviate from itself. In other words, an indicator based on price isn’t going to suggest one thing while price does another.

But here’s the problem - and the primary reason why I have made a fairly dramatic shift in my thinking about how to analyze the markets in recent years. My trend-and-breadth confirmation model has stopped working.

If you look at this indicator since 2007, the results are very different. Instead of seeing annualized gains in the 30% range when the indicator is positive, the annualized return in what many deem the modern era of the stock market is actually negative.

That’s right. Since 2007, the very same indicator that sported a gain of 30.4% over a 36-year period now produces an annualized LOSS of -12.5% when positive.

Then when the indicator is negative, stocks have actually gained ground at an annualized rate of 10.6% per year.

And when the indicator is neutral, meaning that either price or breadth is below the MA and one is above, stocks have soared at an annualized rate of 32.5% per year.

So, let’s review. Since 2007, when both trend and breadth are positive, stocks have gone down. When both are negative, stocks have gone up. And when they are conflicted, stocks have rocketed higher. I believe this is an important example as to why so many tactical managers have struggled – time-tested indicators suddenly aren’t working.

Next, I’d like to offer Exhibits B, and C, and D in my argument that the character of the stock market changed rather dramatically in the years following the end of the credit crisis.

EXHIBIT B: THE PRICE THRUST INDICATORThis indicator measures what I call the “oomph” behind a move on the Value Line Composite. Historically, when an “upside thrust” signal has been given (which is measured by the distance of 3-day moving average of the Value Line Composite from its 30-day mean), stocks have tended to continue to move higher at a decent clip.

NDR reports that since early 1964 (which is when the data series first became available), when an “upside thrust” signal had been given, the Value Line Comp gained at an annualized rate of nearly 18% a year, which is more than double the buy-and-hold annualized return of 7.6% per year for the index during the same period.

However, if one looks at the results since January 2010, the upside thrust signals would have produced annualized returns of just 4.3%, which is just under one-third of the buy-and-hold returns of 12.2% per year for the period. So again, what was a positive signal that performed well over a long period time is no longer functioning at the same level.

EXHIBIT C: THE BREADTH THRUST INDICATORA similar approach can be used to identify a “breadth thrust” in the stock market. This particular indicator uses the totals of 10-day advancing issues versus declining issues on the NASDAQ Composite. Again, historically, when an “upside thrust” has occurred, the historical test of this indicator shows that stocks moved significantly higher.

According to NDR, from August 1980 (when the data series began) through September 9, 2016, when an upside thrust signal was given, the NASDAQ gained ground at an annualized rate of 20.8% per year. And when a downside thrust occurred, the NASDAQ lost ground at a rate of -6.22% per year. As such, this indicator would have been a very valuable tool.

But the story changes rather dramatically when the indicator is viewed from a more recent time frame. Since the end of 2007, an upside thrust buy signal would have produced annualized returns of -5.8% per year while the downside thrusts would have seen annualized gains of +5.0% per year. And when compared to the annualized buy-and-hold gain of 8.4% per year, this once-trusty indicator now appears to have a problem.

EXHIBIT D: SENTIMENT COMPOSITE INDICATORSo far, we’ve reviewed indicators that focus on price, price and breadth, and volume. Often referred to as market’s internals, variations of these indicators have been the bread and butter of tactical managers looking to time the trends of the stock market for decades.

Now let’s turn to something a bit more esoteric; a composite model of sentiment indicators. Sentiment is a tricky business and I’d be willing to bet that most investors (a) may not understand how such indicators truly work or (b) use them effectively.

This particular NDR Model is a sentiment indicator designed to highlight short-term swings in investor psychology. It combines a number of individual indicators in order to represent the psychology of a broad array of investors. The goal is to identify extremes in sentiment that can be used for “going the other way” when sentiment reaches an extreme.

From the beginning of 1995 (the date of the model inception) through September 8, 2016, NDR data shows that when investor sentiment has been extremely pessimistic, the S&P 500 rose at an annualized rate of 32.7% per year.

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And when the readings of the sentiment model were deemed extremely optimistic levels, the S&P fell at an annualized rate of -10.72%. So again, from my seat, this type of model would appear to be exceptionally valuable.

But when I shortened the time frame to reflect my view that the character of the market changed somewhere in 2010/11, the results are once again, very different.

Telling NDR’s computers to start the indicator history in December 2009, I found that while an extreme pessimism scenario still produced strong annualized gains for the S&P (33.9% per year to be exact), the extreme optimism readings, which over the preceding 20-year time frame would have been very useful signals, no longer signaled that stock market weakness was likely.

In fact, since the end of 2009, the overly optimistic readings (considered to be a “sell signal” for this model) would have produced annualized gains of 3.6% per year for the S&P (compare this to the -10.7% rate for “sell signals” for the entire data series). And with the buy-and-hold return of the S&P 500 sitting at 10.6% per year during this time frame, well, the sentiment “sell signals” don’t appear to be effective.

I’m of the mind that this helps explain why a great many tactical investing strategies have struggled for several years. I’ve talked to scores of financial advisors as well as fellow money management professional on the subject and the sentiment is usually the same. Although I am indeed generalizing here, the common theme has been that tactical strategies have failed to deliver and/or seriously disappointed.

THE QUESTION IS WHY?The key question, of course, is why have indicators/models/systems that worked well for literally decades suddenly go out of favor – or worse?

I believe there are three primary reasons that the tactical/technical approach has struggled. Here’s the executive summary:1. Everybody’s Doin’ It 2. Global QE 3. The Rise of the Machines

EVERYBODY’S DOIN’ ITWhen I began doing technical analysis in the early 1980’s a 30-day moving average of a stock market index worked very well. As did a 50-day and the media’s favorite indicator, the 200-day moving average. I believe one of the reasons these simple indicators worked is the indicators were hard to produce and only a small percentage of investors utilized what was once deemed the dark art of technical analysis.

Remember, this was before personal computers. Trendlines and support/resistance zones were drawn with a pencil on the Wall Street Journal or what is now Investor’s Business Daily. The calculation of moving averages involved a legal pad, a pen and a calculator.

The key is that when the S&P 500 crossed a moving average – or a band set at a certain percentage above and below said moving average (which was considered sophisticated stuff at the time) – only a handful of folks knew about it. As such, the signal given didn’t move the market – it allowed those following the signal to easily make moves in and out.

At that time, fundamental analysis was all the rage and indicators using charts and math were viewed as something akin to witchcraft.

However, generally speaking, those practicing “market timing” (a term sullied by the mutual fund industry during the secular bull market of the 1990’s) actually fared pretty well. You bought when the index moved above your moving average and you sold when it dropped below. And if memory serves, up until the turn of the century, such an approach worked pretty well!

In fact, using a technical approach involving moving averages would have kept investors out of harm’s way during the fall of 1987. As such, I’m of the opinion that “The Crash of ‘87” was responsible for moving technical analysis out of the shadows and into the mainstream. And in fact, it was the monumental computer foul-up that occurred on October 19, 1987 that helped launch my career.

Over time though, technical analysis became easier and easier to use. The PC made it much easier and significantly faster to calculate moving averages. Next, the computer allowed one to place an indicator on a chart. Soon thereafter that same chart could be updated during the day. The advancement of technology in the early years of the PC was amazing!

As computers became a prominent part of our lives, technical analysis gained respect and more and more technical indicators were dreamed up.

Fast-forward to today. Now we have charts with all the various moving averages and all kinds of technical indicators – on our phones. Technical levels are talked about all day long on television. And today, just about everybody, everywhere knows when an important trend or support zone has been broken.

Why does this matter, you ask? As the saying goes, something that everyone knows isn’t worth knowing.

The bottom line is, in the stock market, when something becomes too popular, it tends to become less effective. This is due to the fact that (a) a great many investors using a particular approach try to make the same move at the same time and (b) folks try to front-run the move by making their move before the signal is given.

THE ROLE OF QUANTITATIVE EASINGTo be clear, what I’m about to present is an oversimplification of a very complex issue. But the premise is fairly straightforward. When global central bankers buy bonds on the open markets (a tactic called “quantitative easing” or “QE” for short), they are doing two things. First, they are trying to push bond yields lower. And second, they are “expanding their balance sheet” in the process. This means that the central bank is basically printing money (a term I’m using loosely here) in order to make the purchase of the bond on the open market.

Why would a central banker employ such a strategy, you ask? The thinking is that if the markets know a central bank is going to buy bonds each and every month over an extended period of time, traders will join in the game and rates will move lower during the QE period. And a primary theme in the world of central banking is that low interest rates help stimulate a country’s economy.

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S&P 500WEEKLY

The QE game has been going on for many years and analysts continue to debate the effectiveness of the plan. Many will argue that QE has not been effective way in terms of stimulating economic growth. However, it is fairly clear that QE has caused interest rates around the world to fall as something on the order of one-third of all government bonds in the world traded with a negative yield during 2016.

In terms of being a stimulative measure from an economic standpoint though, the reviews are definitely mixed.

MONEY GOES WHERE IT IS TREATED BESTThe key is QE schemes effectively wind up creating new capital in the markets. The central bank buys a bond on the open market. The seller of the bond (primarily big banks), receives money from the sale that needs to be reinvested. In other words, this fresh capital created by QE has to go somewhere.

And this is the really important part. While the jury is still out on whether or not QE really works from an economic standpoint, it DOES create capital. And a fundamental rule of markets is that “money goes where it is treated best.”

One thing traders have learned since the credit crisis ended is that a fair amount of the fresh capital created by QE programs winds up in the U.S. stock and bond markets. And it really doesn’t matter what the color, shape, or size of the currency is that is being “printed.” The important thing is that a great deal of that new money apparently winds up in the U.S. markets.

BUY THE DIPS!It is debatable as to whether or not the actual seller of the bond a central bank is buying turns around and invests the proceeds directly in the stock market. However, traders do know that when central banks create capital, it eventually has to go somewhere. And since the U.S. tends to be the place where money is “treated best,” traders have learned that the U.S. markets wind up being supported by global QE programs.

The central bankers also know this. So, every time there is a new crisis or threat to the economy, the bankers tend to flock to the microphone and start talking about all the additional stimulus they “can” provide if the instability in the markets were to continue.

Thus, each and every decline seen in the U.S. stock market over the past several years has been reversed in relatively short order. Why? In my opinion, it is because traders know that the QE money will be coming. And just like the potential crossing of a once-important moving average, traders want to get in front of this event. As such, a buy-the-dip mentality has become the norm in the stock market.

This means that declines of 5% to 10% can now be erased in a matter of days. And reversals of what were once deemed meaningful declines (10% to 20%) can now occur within a month or so.

From my vantage point, this is another reason why tactical management techniques such as moving to cash when prices start to head south, have proved largely ineffective since 2010. Because declines are reversed very quickly whenever the central banks start talking about saving the day again.

BOTTOMS ARE NO LONGER A PROCESSI believe it is important to recognize that markets today are not following the traditional patterns often seen during a corrective phase. Typically, a correction in the stock market plays out as follows. Stocks decline in response to some event or fear. Then they bounce off the bottom on a “sigh of relief.” But then the reason for the decline usually reappears and the indices “retest the lows” in some fashion. And finally, as things settle down over time, the markets experience a basing period before beginning the next leg higher.

This is why technical analysts contend that bottoms in the market are a “process” and not an event. However, this has definitely not been the case during the QE era. Instead of a bottoming process occurring over a period of weeks or months, central bankers start talking to the press and BAM – traders start buying.

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Because of this, fast-paced “V-Bottoms” have become the norm. And cutting to the chase, a V-Bottom that is triggered by a headline is very difficult to anticipate. Thus, tactical systems wind up being caught off guard and whipsawed as traders fall all over each other buying the dips at the speed of light.

THE RISE OF THE MACHINESFor years now, I have suggested that the character of the way the markets trade on a daily basis has changed due to the proliferation of algorithmic trading strategies on the exchanges. It started with computers “mining” the headlines for key words and automatically trading on them at the speed of light. From there, programmers worked with traders to code up just about every trading strategy known to man.

The key is that today’s stock market isn’t controlled by the market makers, the institutions, mutual funds, or even the hedge funds. No, according to the stats I’ve seen, the vast majority of trading done on the stock exchanges today, which these days are also electronic, is done by computerized algorithms.

From my seat, this is the reason why volatility spikes have become the norm. This is why the “V-Bottom” has become so prevalent. And this is why so many indicators/models that were once a reliable indication of the stock market’s internal health – as well as a being a good harbinger of things to come – have simply stopped working.

It is important to understand that the machines don’t care about the trendline that may look important to you. They aren’t really concerned about the support zones on the charts. And unless we are talking about the all-important 200-day (which is important, because, well, because the media says it is), the algos don’t seem to give a hoot if a moving average or trading band is violated – in either direction.

No, the computers simply execute their trading strategies over and over again until the end of the day. Thus, when a trend in the markets starts to roll, everybody playing what I call the “millisecond trend-following game” piles on until the closing bell rings.

While it may be just one man’s opinion, I believe THIS is one of the primary reasons that intraday volatility has increased in the past few years. This can also help explain why there are so many big reversals in the market from one day to the next. Remember, if you trade on a millisecond basis, you don’t need to concern yourself with the major trend because today is the only time frame that matters.

HOW MANY MILLISECONDS ARE THERE IN A TRADING DAY?I keep a sticky note on my desk that reminds me there are 23,400,000 milliseconds in a full trading day. This means that there are 23.4 million data points for the trend-following algos to work with. And if my spreadsheet is correct, this means that the millisecond trading crew has the equivalent of 92,857 years of daily bars available to trade on during each and every trading day.

In other words, the algos don’t need to worry about tomorrow, the next week, or the next month. They have PLENTY of price points to work from every single day. The trend of the next 10 minutes is the key here. And from my perch, this would appear to be the reason that high-speed trading now dominates the markets.

So, with so many folks using sophisticated algos and co-located computers to automatically trade at the speed of light, intraday moves have become increasingly exaggerated. While I’m just spitballin’ here, my estimation is that big intraday moves that tend to be driven by news, are now much, much larger than they were just a few years ago.

And as a trader, what do you do when a move becomes “overdone” in one direction? That’s right, you go the other way. And yes, this too is programmed into the machines. So, once a move “goes too far” the mean reversion algos tend to kick in and voila, yesterday’s big, bad decline can be reversed very quickly.

WHAT IS REAL?Another problem is that it has become very difficult to determine what moves in the market are “real.” And again, in my opinion, this is the reason that so many trend and momentum indicators have simply stopped working. In short, nearly every move can look like an “important move” from a technical standpoint.

This helps explain why tried and true indicators such as “thrust signals” in price or internal momentum (which were once strong buy/sell signals) have become commonplace and in turn, much less valuable.

THE BOTTOM LINEIf you are a tactical manager using traditional indicators/models, chances are pretty good that you’ve been struggling with underperformance lately. And the reason is simple as the traditional signals and models you are using to guide your buy and sell decisions in the market are being consistently fooled by the exaggerated intraday moves caused by “the rise of the machines.”

For example, Ned Davis, a 40-year stock market veteran and founder of Ned Davis Research (and one of my early heroes in the game), recently told his clients, “This is not the stock market I grew up with.” And while one of Ned’s claims to fame is that he has never had a losing year in his portfolio, his key point here is that you have to adapt to the game when it changes.

For example, one of Ned’s key tenets to managing money over the years has been to “trust the thrust.” The thinking here is that when the market experiences a “thrust” – meaning that either price, breadth, or volume is completely lopsided for an extended period of time – it is an indication that the market has experienced a sea change and that the trend of the market will now be in direction of the thrust signal.

However, given that many thrust signals, especially price thrusts, now occur much, much more frequently than in the past, Ned has changed his tune from “trust the thrust,” to “trust, but verify.” In short, one of the game’s best known tactical managers says you have to change the way you play the game these days.

Which brings us to the next part of this paper: what managers and investors using a tactical/technical approach can do about the changes to the market’s character.

SOME POSSIBLE ANSWERSBefore we proceed, let me make a couple points clear. First, there is rarely a single answer to any market dilemma. And this one is no exception.

Second, what follows is one man’s opinion regarding the potential solutions to the problems that tactical/technical managers have encountered in recent years.

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But, I can also say that I have been working on this very dilemma since the end of 2011. And while I don’t proclaim to have a silver bullet solution, I would like to offer some of my thoughts and findings on the topic.

What follows are a handful of ideas relating to adjustments that investors/advisors/managers may want to consider in order to lessen the impact of the market’s increased intraday volatility and change of character.

RELY LESS ON PURE TREND/MO-MENTUM INDICATORSOne of the big problems tactical managers have faced since the high-speed trading era began is it has become increasingly difficult to identify when a trend is meaningful. In the “old days,” managers would look for a surge in price that was accompanied by strong momentum. If there was some “oomph” along with a big move in price, it was a sign that buyers were anxious to get in and that there was strong demand for stocks. As such, the move was likely to continue.

However, in today’s game, it seems that all the moves are accompanied by “oomph.” This is due to the fact that the majority of trading today is done by computers and not people. As a result, there is no emotion involved. There is no rush to get “in” or “out.” No, algorithms simply implement their millisecond trading schemes over and over again until the closing bell rings.

The bottom line is that traditional trend indicators such as moving averages, crossovers, support/resistance zones etc., wind up getting fooled by the “mindless” computer moves. And because of this, tactical managers may want to consider placing less emphasis on price trend indicators – especially from a short-term perspective.

EXTEND THE TIME-FRAMEIn my humble opinion, the short-term action in the market has become less and less indicative of what may transpire next. Look at the number of sideways trading ranges and “V-Bottoms” that have occurred since 2011. Short-term trends get reversed at the drop of a hat – often without any obvious catalyst. Then once a trading range is established, the indices have tended to move violently up and down within the range.

In essence, stocks move hard in one direction one day and then often reverse course and go the other way the next. A downtrend can morph into an uptrend in short order and vice versa. Thus, you may want to start looking at the shorter-term movement as “noise” instead of an important “signal” to make a move.

For this reason, I have all but eliminated the use of shorter-term trend indicators in my work. These indicators have become unreliable and the whipsaws have become more severe (which, unfortunately is a recipe for losses). And since, from my seat, the ultimate goal is to stay on the right side of the market’s big, important moves, I now spend more of my time looking at weekly charts and longer-term indicators/models.

MAKE INCREMENTAL MOVESOne of the oldest rules in the trading game is to “do less” and/or “trade smaller” when things aren’t going your way. This is the premise for the next big adjustment to consider.

Given that a great many indicators have either ceased working altogether or are far less effective in today’s market, the idea here is to implement the “do less/trade smaller” rule. Instead of bombing into the market with everything you’ve got when a signal is given, it makes more sense to make a smaller move.

For me, this has meant creating an exposure-based, incremental approach. Instead of relying on a single model or indicator, I prefer to use 10-15 models/indicators, with each indicator controlling a set percentage of the portfolio’s exposure to the market. For example, if there are 10 indicators, each time an indicator flashes a signal, the exposure is increased/decreased by 10%.

To be sure, this will increase the amount of trading one does. And there will be a bunch of little moves that don’t really amount to much. But since the goal is to be mostly long when the bulls are running and then try to preserve capital when the bears are in control, using an array of indicators and an incremental approach makes sense.

LEARN TO IDENTIFY TRENDING/MEAN-REVERTING ENVIRONMENTSMake no mistake about it; trying to define the type of “trading environment” or “mode” of the market can be very tricky. But the basic idea here is to try and use the right tool for the job.

The premise is when the market is in a “trending” mode, it makes sense to (a) employ trend-following indicators and (b) lengthen your time-frame. And then, when the market finds itself in a sideways, back-and-forth, “mean-reverting” mode, using mean reversion indicators, swing trading techniques, oscillators, channels, and sentiment indicators would appear to be a better way to go.

While this seem to be an exceptionally sensible approach to the market – and one that just might make work in today’s world – there is a rather large fly in the ointment.

The problem is that when employing such an approach, it is possible to be wrong on two fronts. First, you can get the trading environment wrong. This means you will likely be using the wrong indicators for the environment. This brings us to the second problem. As you might suspect, if you get the environment wrong, there is also a good chance that the effectiveness of the indicators used will be reduced.

For this reason, I believe it is a good idea to use a confirmation approach when trying to determine the trading environment. For example, I employ three different models – each designed to indicate whether the market is in a trending or mean-reverting mode. And I require two out of three agree in order to make a call.

MODERNIZE DIVERSIFICATION TECHNIQUESFinally, we come to what I believe is perhaps the best solution to what I call the “tactical dilemma.”

Instead of putting all of your investing eggs in the tactical methodology basket, I believe it makes sense to utilize what I will deem a modern approach to portfolio diversification.

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There are many different investing methodologies such as passive allocation, strategic investing, tactical management, equity/bond selection, liquid alternatives, etc. The problem is that many advisors and investors “take a stand” on a single methodology and espouse why the XYZ approach is the BEST way to invest.

But what I’ve learned in my nearly 30-year career as a money manager is (a) THERE IS NO ONE SINGLE BEST WAY TO INVEST! and (b) most every methodology/strategy/manager WILL UNDERPERFORM or be out of favor (or worse) at times.

So, I believe the key here is to plan for this reality. Instead of trying to figure out the BEST way to invest, why not utilize multiple investing methodologies, multiple strategies, and multiple managers?

The crux of such an approach is to try and limit the damage done to one’s

overall portfolio when a particular methodology/strategy/manager falls out of favor or underperforms for a couple years. For example, while tactical strategies designed to “time the market” have indeed struggled since 2008, a longer-term strategic approach has performed well at times. Thus, doesn’t it make sense to use more than one methodology in your portfolio?

IN CONCLUSIONSo, what’s the best way to solve the tactical dilemma these days? For me, the answer is to employ a more modern approach to both tactical management AND to portfolio diversification.

Instead of putting all your eggs in the tactical basket, the idea is to incorporate several methodologies/strategies/managers in your portfolio. And in my humble opinion, this represents the best solution I can come up with to try and combat changing market environments over time.

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