I did a post last October (here) looking at varying allocation between stocks/bonds and at the end I hinted towards a tactical overly between the two asset classes. Six months later, I finally found a decent overlay I feel may hold value.
In a paper called “Principal Components as a Measure of Systemic Risk” (SSRN), Kritzman Et al. presented a method for identifying “fragile” market states. To do this, he constructed the Absorption Ratio. Here is the equation:
The numerator sigma represents the variance of the ith eigenvector, while the denominator one equals the variance of the jth asset. In the paper, n = 1/5 the total number of assets (N). The interpretation is simple, the higher the ratio, the more “fragile” the market state. The intuition behind this ratio is that when its high, it implies that risk is very concentrated. On the other hand, when it is low, risk is dispersed and spread out. Think weak and strong. Following is the raw AR through time of the DJ 30 Components.
As you can see, the ratio spikes during the tech bubble and the recent financial crisis. How would it look like when used as a filter? Below are two pictures comparing the signals generated by 200 day sma and standardized AR.
Pretty good at the timing in my opinion. In line with the paper, I reconstructed the strategy that switches between stocks(DIA) and bonds (VBMFX). When the AR is between 1 and -1, we will split 50/50. When its above 1, we are in love with bonds and when its below -1, we are in love with stocks. Simple. Results:
And here is the code: (I know its messy, didn’t have a lot of time! :)
Note: There is survivorship bias. I used the current day DJ30.
Thanks for reading