Correlation-Based Allocation, January 2013
- We propose a model that is designed to identify bull-market and bear-market regimes. We examine correlation between stocks and bonds as a signal. Our hypothesis is that negative correlation between long bonds and stocks represents a bear-market regime, and a positive, or non-existent correlation, reflects a bull market regime.
- Correlation-Based Allocation (CBA) is a one-signal model that is simple-to-implement, robust, and historically generates a favorable risk/reward return profile.
- The model calculates rolling 90-day correlation estimates between the S&P 500 and long-bonds. At each month end, the model computes the 60-day MA of the correlation against the 600-day MA of the correlation. If positive, the model invests in risk; if negative, the model invests in riskless.
- Over the March 1, 1985 to December 31, 2012 period, CBA generates a CAGR of 10.77% and a maximum drawdown of 18.35% when applied to our 5 core assets classes: domestic equity, developed equity, emerging equity, real estate, and long-term government bonds.
- CBA performs similarly to MA-based trading systems. The two systems can be combined to lower standard deviation risk and total drawdown risk.
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