The Japan Experience 1988 - 2014:
Improved Investment Outcomes During Deflationary Environments
With the progressive combination of housing and equity bubbles, deflation, aging population demographic, abenomics, and technological shifts, the Japanese economy and financial markets suffered greatly in the decades of the 90’s and 00’s.
For over 25 years, the Nikkei 225 index, the most widely quoted average of Japanese equities, saw a negative compound annual growth rate of -1.2% accompanied by severe volatility .
Similarly, the Government of Japan’s long dated 10 year sovereign bond yield suffered drastic declines and negative “real” interest rates, with the nominal rate many times falling below 1%.
As we empathize with investors who have had exposure in Japanese equities over the last two decades and who have lost their capital and missed opportunities in investments elsewhere, we can look back in retrospect for a quantitative analytical “case study solution” towards improving returns during that time.
Our research has produced a strategy that could have improved investment returns during the Japan experience and can possibly be applied to similar environments going forward.
The initial “basic” strategy employs a conventional moving average rule ( MA rule ) which prescribes buying (moving to cash equivalents) when the 10 month moving average increases (decreases). A price cross of the equity index over the moving average reflects the allocation towards equities and vice versa towards cash. The particular example set in this study is an “all in” and “all out” process.
This has been shown to both enhance returns and reduce risk as compared to a “buy-and-hold”.
The example above shows that in applying the MA rule to the S&P 500 index over the 25 year sample, the performance was enhanced vs. buy & hold, albeit with market “frictions” ( transaction activity costs and some inherent short term taxable events ).
A unique enhancement to the strategy involves the addition of the long dated government treasury bond asset class and the application of the MA rule. This bond allocation would occur only when: 1) the cash allocation is indicated as the S&P500 index crossed / closed below it’s 10 period moving average and 2) if the bond price was > than or moved above it’s 10 month moving average.
This would follow the premise that equities and bonds are “uncorrelated” * asset classes. If the equity market is declining, then bonds will gain in value and this value will be reflected in upward trend trajectory and upward price cross of the moving average .
Chart above shows performance enhancement with inclusion of long dated bond asset class into MOM strategy
MA strategy applied to the Nikkei 225 Index and long dated
Japan Govt bond **….
The addition of the long bond class added value to overall returns.
Additionally, volatility was less than Buy & Hold.
The next chart shows returns for strategy entries into the Japanese equity / bond markets coinciding with three of the highest risk to reward market peaks over the 1990 - 2014 sample.
The chart above shows decent to robust forward performance during highest risk to reward entries
A second solution towards investing in this type of environment could have been a buy & hold portfolio mix of 60% / 40% equities and bonds.
The chart above shows the mixed portfolio performance which produced less than the returns of the MA strategy with somewhat more volatility.
Conclusion
The economic and financial experience of Japan during 1988 - 2010 was epic in scope. Investors lost trillions in yen value in investment market returns.
Using the historical record and quantitative research and insight, we can utilize portfolio management methods and construct portfolios which improve returns and alleviate risk during investment in similar economic situations, if and when they materialize in the future.
* In an equities / bond portfolio allocation mix, performance dynamics occur between the two asset classes. When the equity market falls ( during normal economic and market cycles), the bond allocation will gain value / hold steady and reduce the volatility of the overall portfolio’s decline. When the equity market rises, bond values fall but are offset by the rise in the equity allocation. Hence, the function of bonds in a portfolio mix is to lessen the volatility of the portfolio and equities provide the performance premium / gain. The two asset classes are therefore “uncorrelated” in their movements.
** dividend reinvested not calculated
content is property of Market Map LLC Boulder, CO
past performance does not guarantee future results
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