Featured Image Detroit Jazz Festival

I spent part of the Labor Day weekend at the venerable Detroit Jazz Festival, held here since 1980. The world’s biggest free jazz festival takes over the Detroit downtown scene for four days. It seems to get bigger and better every year, drawing over 100,000 jazz fans from around the globe. With Detroit’s resurgence, it was energizing being downtown on a sunny day in the 70s with the streets full of enthusiastic people.

Jazz has been a part of my life since the 1960s. I’ve always loved the combination of individuality and collaboration that is specifically a part of the modal, hard bop version of traditional jazz.

The focus is on snatches of a song’s melody captured by the various members of the trio, quartet, or quintet playing. The instruments are separately featured as each musician has their own individual take on the tune within a limited chord structure. However, no matter what musical heights the individual takes us to, at the end of their part, it is back to the group as a whole.

Investment portfolios are often compared to music. I’ve even heard portfolios referred to as a symphony. This may be apt. Yet, while traditional asset allocation may be analogous to a symphony, modern portfolios need to be closer to jazz.

Classical music focuses on accurately playing the composition as it is written. It is judged by the degree to which the orchestra members adhere to the musical score. Similarly, traditional asset allocation focuses on how closely each element (asset class) adheres to its assigned benchmark.

In contrast, jazz is all about the individual performer’s interpretation of the music and his or her ability to ultimately integrate that with the other members of the group. Both the symphony and the jazz group are judged by how the whole work sounds, yet they differ in how they reach that end.

Just as jazz differs from the symphony, portfolio construction using strategies instead of asset classes is different. Like the jazz performers, the individual strategies reflect their own personalities. They may use one asset class, like in a stock strategy, but they do not perform in the same manner as an asset-class benchmark.

Like a talented jazz musician, the strategy picks up the theme of the asset class. But it also drifts away from it in asserting its personality.

If it is a trend-following strategy, it will stick with the trend while it predominates but then move to an alternative defensive asset class when the trend wanes. If it is a contrarian strategy, like the short notes played as counterpoints to the overall melody in a jazz performance, it will zig when the asset class zags, seeking profits in quick bursts of activity from countermoves in the price of the asset class.

Whether that is a good strategy is determined by its profitability at the end of a complete market cycle and how it works with the other strategies in the portfolio. This collaborative interaction element, which is so important to traditional jazz, is essential to portfolios of strategies, even more so than portfolios of asset classes.

Like performers in a jazz quintet, different strategies will perform at different times. And just as you would not want to listen to a piece played with a single note from a solo instrument, the beauty of jazz and of a portfolio of strategies comes from the combination of each musician’s performance.

This is combining uncorrelated strategies in a portfolio is important. They must act differently from one another to ensure that one musician (strategy) keeps performing when all of the other performers (strategies) have ceased playing (stopped performing).

If all of the strategies in your portfolio are moving higher or lower together, that portfolio is not uncorrelated. You must cultivate the outliers, the unique individual performances, to end up with a portfolio that can deliver virtuoso performances on any stage.

Again, the asset class just has to stick to the benchmark, often simply by buying the benchmark. In contrast, like a jazz musician, each strategy must individually wend its way in and out of the benchmark, and then finally find its way home to profits at the end of the cycle (five to seven years on average, encompassing, at the very least, a 20% move up and down).

Why take this circuitous route if you could just buy the benchmark and, in effect, stick to the musical score? Risk is the primary reason. The strategies seek to get the same return or better than the asset benchmarks over an entire market cycle. But they are designed to do so while incurring less risk along the way.

I’m fortunate. I’ve always loved both symphonies and jazz performances. I’d hate to not have either one in my life.

It’s strange that most investors seem to stick only with the “symphony”—the portfolio of asset classes. They are missing out on all that jazz—the collaborative portfolios of unique strategies that when blended together seek lower risk and higher risk-adjusted returns in an entire market cycle.

Market update

It was another great week for the stock market. The S&P finished about 1.4% higher after rising six straight days, and the NASDAQ 100 hit a new all-time high! While I would feel better if the S&P 500 had hit a new high also (see last week’s article), the NASDAQ often leads the S&P, so its new high can often lead the S&P to its own new high.

S&P 500: Last Year

NASDAQ 100: Last Year

Volatility retreated again last week. The VIX (“fear index”) fell back toward its all-time low, settling around 10. While the North Korea bombasts of the weekend are sure to unsettle investors (and everyone else for that matter), the market approached it at one of its lowest levels ever.

I am concerned that the market is overbought after last week’s daily run-up. Yet, Rob Hanna of Quantifiable Edges points out that when the week after Labor Day is preceded by a downtrend, it ends the week higher about 70% of the time.

Rob even seeks to assuage my fear of the current overbought conditions with a study of market action since 1980. It suggests that when such conditions occur (five up days in a row), the outlook is bright as long as the overbought conditions have not taken the market over its highest level in the last 50 days. Again, there is about a 70% chance that the market will be higher 15 trading days later, he says.

Still, unpredictable events on the world stage can disrupt all of this statistical evidence. Like a jazz musician performing a solo who can’t seem to find a way back to the group’s thread, today’s market action certainly doesn’t look like stocks are going to continue the uptrend. Stock indexes are down more than 1%, and the VIX is now soaring almost 30% higher (indicating a substantial increase in volatility).

This is not the case for gold and bonds, however. After breaking out of a downtrend a week ago, gold continued to advance last week and, in a flight to safety, is up strongly again today.

Similarly, bonds rose last week. Incredibly, the 10-year bond yield finished the week near its lowest level this year. So much for fears of Fed tightening! Yields fell even more today, to a new low, sending bonds higher still.

Both stock and bond returns last week rose on the economic reports of the week. The employment report was weaker than expected. Although, as if to prove my belief that experts are right less than half of the time, I would note that economists have overestimated August job growth 16 out of the last 20 times.

The weaker jobs report led to conjecture that the Fed would delay any further tightening this year, helping stocks and bonds move higher. The fact that manufacturing job growth was a bright spot in the jobs report, and that the ISM Manufacturing Index Report was also very favorable, led stocks higher last week as well.

Remember the advantage of a band versus a solo performance. Although one of the members of a jazz band may not be performing up to his or her abilities, the rest of the group can overcome that poor performance.

So it is with a portfolio of strategies. While an investor following a single strategy can stumble, a portfolio of strategies can have one or more uncorrelated strategies that have standout performances that save the show.

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