What do you do when everything is overvalued?

US stocks and US bonds are both extremely overvalued according to historical measures. In fact, the US bond market has never been more overvalued, and according to the median price to sales ratio of the S&P 500, neither have stocks. This does not mean that stocks and bonds are going to crash tomorrow. Valuations are not a timing tool, but a key element to a multifaceted portfolio construction method. That being said, the extreme optimism apparent in the drastic departure from fair value in financial assets presents a difficult task for portfolio managers and investors going forward.

Buying and holding a balanced portfolio over the next decade will result in below average returns. We expect that a portfolio of 60% S&P 500 and 40% Barclays Aggregate Bond index will gain an average of only 1% over the next 10 years. So what should a rational investor do? The most obvious suggestion is that investors need to get creative on adding asset classes that may help diversify from the traditional financial assets of stocks and bonds. However, this is behaviorally difficult because finding assets that would help balance a traditional portfolio are largely out of favor. Historically, managed futures have provided a worthwhile hedge against stock and bond market turmoil, but they have underperformed stocks and bonds since the financial crisis.

Managed futures as an asset class rely heavily on volatility to capture large trends in other classes such as currencies, commodities, and financial markets. Global Central Banks have flooded the markets with liquidity in the form of QE programs and equity index purchases. This level of support has squeezed volatility to all time lows and generated new highs for stock markets across the globe. Managed futures and hedge funds, in general, have been some of the casualties during this unprecedented time.

The large scale move to passive strategies is illuminating the herding nature of market participants and forcing us to consider contrarian positioning. We suggest that investors look closely at asset classes that are currently out of favor, yet have historically protected against market downside. Another method for diversifying against market stress is through the incorporation of trend following strategies to traditional asset classes in order to alter their risk/return profile.

Academic evidence suggests that time-series momentum, or trend-following, can add value to a portfolio of stocks and bonds. Trend following systems can drastically reduce drawdown while maintaining significant upside in stocks. This provides a smoother ride for investors and allows for risk reduction during periods of market turmoil. Incorporating a simple trend following system in a traditional portfolio can also allow for a higher overall equity position on average because of the potential risk reduction benefits.

In our overall investment framework, we believe valuations, market trend, economic growth, and Fed policy are imperative to proper portfolio construction. Currently, valuations and Fed policy are extremely bearish for US stocks, while market trend and economic growth are bullish. It is time to re-evaluate portfolios and focus on risk management. Managed futures as an asset class and adding trend following systems to traditional portfolios may provide the potential risk-reduction benefit without sacrificing potential upside.

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