There’s an old saying that when you put two economists in a room, you get three opinions. In other words, markets are complicated. Something we can all agree on is that the economic cycle repeats itself, and that asset class prices become relatively attractive at different stages in the cycle. CARA attempts to identify the current stage of the cycle and allocate assets according to their relative attractiveness at that time.
To identify the current stage of the economic cycle, CARA first looks at the money supply and its relationship to the Treasury yield curve. Low interest rates, as a result of an increase in monetary supply, make it easier for companies (as well as consumers) to spend and borrow money, hence increasing corporate profits. Increases in corporate profits boost equity prices and perpetuates bullish market conditions.
The reverse of this logic also holds true. Increasing interest rates as a result of the tightening of monetary supply will make it more difficult for consumers to spend and borrow. This weakens corporate profits and is bearish for equity prices.
In addition to these fundamental factors, CARA also considers technical factors by evaluating trends in stock prices. Since CARA believes that markets are efficient, meaning all available information is reflected in a stock’s price, technical trends can account for many other variables that cannot be modeled individually.
Of course, markets have many unknowns, and relationships that have historically occurred in the past may not necessarily play out the same way in the future.
CARA signals rotation between multiple stages, or scenes, when perceived conditions change. When a new scene is identified, assets in the portfolio are reallocated to adjust risk. Assets are chosen in each scene with the understanding that certain asset classes are historically more attractive at different points along the economic cycle.
Risk is removed in layers in an attempt to stay within each portfolio’s predetermined drawdown percentage. More conservative portfolios, with lower drawdown targets, remove risk more quickly than riskier portfolios with higher drawdown targets.
At any given time, some assets are moving up in price while others are moving down, and some assets have no relationship to each other at all.
Each portfolio’s drawdown target is calculated from its highest value. This is known as a ‘high water mark’, which indicates that as a portfolio’s value increases, there is a step-up in the value used to calculate the drawdown percentage.
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