Consider this chart showing a 60% stock (SPY) and 40% bond (AGG) mix, rebalanced daily. The theory behind Modern Portfolio Theory is that such a diversified portfolio is supposed to give you growth but protect you on the downside should something go wrong. Simply put, diversifying between stocks and bonds mean that when one thing goes up, the other either stays the same or goes down, and vice versa. That way, you get a much steadier rate of return than by holding one asset class.
Now look what happened during market meltdown in 2008. Diversification didn't help that much because both stocks and bonds fell at the same time. The 60/40 balanced fund portfolio gained a total of 5.8% on an annualized basis from September 2003 to the present and suffered a maximum drawdown of 35% over that period.
The 35% drawdown was particularly surprising given the "diversified" nature of the portfolio. At the same time, I constructed a hypothetical portfolio of what a balanced might have and should have looked like in that market of the Great Bear. I assumed that for the 12-months ending March 2009, the portfolio steadily lost 10% over that time. The rest of the time, it had the same returns as the standard 60/40 benchmark. The modified portfolio returned 7.9% over the same period and saw a maximum drawdown of 15%, which is more in line with the expectations of a diversified balanced fund.
Risk is becoming one-dimensional
The failure of diversification is attributable to the increasingly single dimensional nature of risk. On a daily basis, we see either the "risk on" or "risk off" trade dominating the ticker. When investors buy risk in the "risk on" trade, stocks, commodities, the euro and high-yield bonds generally rise together. In a "risk off" environment, the US Dollar and bond prices rally.
When the prices of different asset classes move together, what was diversifying is diversifying no longer. Foreign stocks and bonds, particularly if they have any form of credit risk aren't diversifying to each other anymore. Neither are commodities, nor emerging markets.
Asset prices either just go up, or go down. We saw a similar investment environment back in the late 1960's and 1970's, when the stock market moved in a broadly sideways pattern with but up and down moves. We also saw a similar pattern in the Japanese stock market in the last two decades.
The Timer Model is a active asset allocation strategy that uses intermediate term trend following techniques to take advantage of those moves up and down, which parallel the patterns of the "risk on" and "risk off" trades of today.
That's why I believe it's the right tool for the current market environment.