9/16/2016

CSC

Example:LateExpansionPhase
Inthelateexpansionphaseofthebusinesscycle,corporateprofitsremainstrongalthoughprofitgrowth
slowsandmaybeapproachingitspeakforthecycle.Capitalappreciationanddividenddistributionswould
stillbeattractive.AstheBankofCanadaraisesinterestrates,themarketvalueofmostfixedincome
securitiesshouldbegintofall.Theseoppositetrendsinthefixedincomeandequitypositionsofaportfolio
wouldquicklytriggerrangelimitationsimposedbyadynamicassetallocationstrategy.
Rebalancingwouldineffectsecuregainsfromstrongequityperformancewhileforcingthepurchaseof
fixedincomeassetsatadiscount,thusincreasingthesafetyfactoroftheportfolio.Thetradeoffisthat
overallportfolioreturnishinderedintheshorttermbysellingsomeofthestrongestperformingsecurities
andbuyingcurrentlyunderperformingassets.
Thelongtermreturnshouldbeenhancedwheninterestratesreturntonormallevelsandsubstantial
capitalappreciationisexperiencedonthefixedincomesecuritiespurchasedatadiscount.Dynamicasset
managementinaweakmarket(contractionandtroughphasesofthebusinesscycle)wouldimprovelong
termreturnsasequityholdingsareacquiredatattractivepriceswhenthevalueoffixedincomesecurities
exceededtheirstrategicallocationrange.
Atacticalportfoliostrategywouldsuggestshiftingassetstocashholdingsuntilinterestrateshavepeaked
andthenreturningtothelongtermstrategicmix.Atacticalportfoliostrategywouldsuggestshorteningthe
durationofthefixedincomecomponentoftheportfoliowhiletryingtomaintainthehighestcoupons
(interestrates)possibletheshorterthetermtomaturityandthehigherthecoupon,thelessimpactrising
interestrateshaveondebtsecuritymarketvalues.Tacticalmanagementwouldalsosuggestshiftingequity
holdingstodefensivestocks,whichtendtomaintainmarketvaluewhilecontinuingtoofferattractive
dividendsthatcanbereinvested.Atacticalstrategymayalsoincludetemporarilyshiftingassetclass
weightingsfromfixedincomeandequitytocash.
Itwouldbeextremelyimportantfrombothadynamicandtacticalmanagementperspectivetoproperly
repositiontheportfoliotowardtheendofthecontractionphaseorinthetroughphaseofthebusiness
cycle.Historically,monetarypolicyhashadgreaterimpactthananticipated,resultingintheneedtoreduce
interestratesquicklyandsubstantiallytopreventrecessionaryconditionsoncesupply/demandequilibrium
hasbeenachieved.
Wheninterestratesfall,theytendtofallfast.Stockmarketsareleadingindicatorsbecausecompaniesand
investorsanticipategovernmentpolicyandareturntostrongeconomicconditions.Theendofatrough
phaseandbeginningofanexpansionphasecomesquickly,doesnotlastlong,andthemajorityofthe
returntendstobegeneratedwithinafiveto13monthperiod,eveniftheexpansionphaselastsmany
years.Thesameappliestofixedincomesecurities.Priortointerestratesfalling,theastuteportfolio
managerwouldshiftdebtholdingstoalongdurationwithlowcoupons(interestrates)cashholdingswould
bereducedtoaminimum.

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