"If you don't know where you are going, any road will get you there."

- Lewis Carroll

Unless you take a completely passive approach with your investments, it's important to maintain a sense of direction.

The primary goal of tactical asset allocation is to stay on the right side of major market trends. That means diagnosing the most probable path ahead, using a mix of empiricism and common sense.

The two biggest opportunities I see for U.S. investors over the next 5 years are: (i) protecting capital ahead of the next bear market, and (ii) subsequently overweighting international assets.

1. The Stock Market Cycle

Throughout history, there are multi-year cycles in which stocks have seesawed between two basic environments:

• high return/low volatility
• low return/high volatility

The table below depicts these cycles, using the S&P 500 Index as a proxy.

You don't have to be a financial professional to see the recurring pattern and diagnose what type of regime likely comes next. At some point, probably not in the too distant future, we’re going to see a flip back to lower returns and higher volatility.

Hedge fund heavyweight, Ray Dalio, drove home this point last week in an interview with CNBC. He said the economic cycle is probably in the "seventh inning," implying there is less remaining upside relative to downside risk.  “Whatever your strategic risk is ... I’d be more defensive rather than more aggressive,” Dalio said.

When it comes to multi-year cycles, Dalio is one of the market's brightest minds.

I follow Hedgeye Research for quarter to quarter guidance. They maintain a predictive tracking algorithm which measures and maps the trajectory for growth and inflation. In recent years, they've been spot on.

Next quarter, Hedgeye is calling for both growth and inflation to slow. They call this macro setup "Quad 4." Historically, it's an environment which favors defensive plays (i.e. bonds and defensive sectors).

Things that normally don't perform well in Quad 4? Pretty much everything that has worked well over the last two years. Namely momentum, technology, and high-beta. These factors may see a bearish rotation in upcoming months.

Even if Dalio and Hedgeye's forecasts don't materialize right away, I'm perfectly comfortable trimming risk.

For most people, money management is a long-term compounding game. Viewed through that prism, it's not how much you make during a bull market that counts, but how much you keep and roll into the next cycle. The average bear market wipes out over half of a prior bull market's gains. That makes preserving capital paramount in a late-cycle environment.

2. The Global Leadership Cycle

Imagine being a Japanese investor with all your money tied up in domestic stocks. That market peaked in 1989, and still has not recovered. This illustrates why foreign diversification is important.

Canterbury Consulting advises institutions and high net worth investors on asset allocation. I recently caught up with Matthew Lui, Canterbury's Global Equity Research Committee chair. He said, "Investors who ignore international stocks due to 'home country bias' are missing out on growth opportunities in other parts of the world."

Case in point: After adjusting for purchasing power parity, China became the world's largest economy in 2014. China is growing  GDP four times faster than the U.S.

Nonetheless, the U.S. has significantly outperformed this cycle. This year is a continuation of that trend. The S&P 500 is up about 10%, while foreign markets like the German DAX (-7%) and China's Shanghai Index (-22%) have faltered.

But if you're a long-term investor, Mr. Lui would recommend maintaining at least some foreign diversification. "Including both U.S. and non-U.S. stocks can result in a smoother overall performance pattern," he says.

Here's a table that demonstrates why that's the case. Similar to how return and volatility regimes mean revert, so do global leadership cycles.

No single region always outperforms. If that were the case, everyone would overweight the best market, and it would become prohibitively expensive.

So, it's not surprising that developed countries in the MSCI EAFE Index performed similar to the S&P 500 from 1970-2017.  Within that long span, however, there have been multi-year periods of high dispersion.

Since 2008, foreign stocks have lagged U.S. stocks. That's made developed and emerging markets cheaper versus U.S. stocks, prompting many on Wall Street to recommend going overweight foreign stocks. So far, that recommendation has been early.

Investors often confuse valuation as a catalyst. It's not. Foreign stocks will not lead just because they're cheaper than U.S. stocks.

The spark for a rotation is usually a mix of buyer/seller exhaustion, combined with a fundamental catalyst that reverses sentiment. Flows follow.

That's when valuation starts to matter. The cheaper an asset or market is at the turn, the longer its runway for potential excess return.

Studying the above table, there's another subtle pattern, which I think provides a valuable timing clue. That is: global leadership pivots occur during bear markets. 

The MSCI World Index includes both U.S. and foreign markets. If you track that index's return history, you can see it was engulfed in bear market drawdowns (declines over 20%) during key years when global leadership cycles reversed, i.e. 1970, 1990, 2002 and 2008.

Europe and China's economies began slowing early this year, and their markets have followed.

The U.S. economy is still riding high on fiscal stimulus. But as those effects fade, my guess is the U.S. will follow the trend taking shape in the rest of the world.

Will this be enough to push the MSCI World into a bear market? Hard to know.

But whenever that time arrives, chances are foreign markets will bottom first, because they're already further along in their economic downshifting.

However, I'm not aggressively buying foreign stocks yet. Reason: sequencing matters.

For now, I'm still overweight the U.S., because when tremors hit capital markets, the U.S. is normally a safe haven destination. I think tremors come first, then a big leadership rotation. Probably one of the best chances to overweight foreign stocks I'll see in my career.

 

Originally published by Forbes. Reprinted with permission. 

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This material is not intended to be relied upon as a forecast, research or investment advice. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.​