Does Rotation Work in Global Markets?

Earlier posts this week compared rebalancing and rotation across time in a single country: 100 years in U.S. markets. Today's post takes a turn, pivoting to hold time steady while examining a varied set of countries. Time is constrained to the last 25 years; the countries are Germany, Japan, and Australia. While not having the last word, recent experience in these global markets closes one important chapter in the story that began on June 3 when I asked, What Now: Sell, Rebalance, or Rotate?

At first glance, the averages over the three countries seem familiar. The biggest drawdowns were for large-cap stocks; the smallest ones, for local 10-year Treasuries. Smoother results came from rebalancing 60% in stocks and 40% in Treasury bonds, while tempered drawdowns and the best inflation-adjusted returns were definitive for 100-or-0 Rotation. Underneath the averages, however, investors in the three countries had very different experiences in the last quarter-century.

Of the three, Germany most closely resembled the U.S. from 1994 to early this year. Stocks rose overall, though the German DAX had a deeper drawdown (-68%) than did the American S&P 500 (-51%). Bonds were more competitive with stocks in Germany, enabling a portfolio that rebalanced 40% local Treasuries against 60% local stocks, all in local currency, to keep pace with an all-stocks portfolio. While these strategies took their different paths to similar destinations, 100-or-0 Rotation ultimately found a way to take investors even farther in Germany (8.7% annualized, adjusted for local inflation) than did the same strategey in the U.S. over the same years (7.4%).

Japan's experience was sadly unique. Stocks were mostly underwater for the last 25 years. Though inflation was low, the Nikkei 225 barely kept up with it, even with dividends reinvested. Bonds and the 60-40 portfolio managed to finish about 3% and 2% above inflation, respectively, in their characteristic ways:  paddle-boarding with local Treasuries behind the harbor breakwall; and boogie-boarding to catch big surf the 60-40 way, not quite so daring as air-freaking stocks. Outmanuvering all others, once again, was 100-or-zero Rotation, which rode the good waves and avoided the rest.

Yet another distinctive pattern transpired in Australia. Nominal interest rates for local 10-year Treasuries were higher in Australia (averaging 5.7% from 1994 to 2019) than in the other countries (3.9% in Germany, 1.9% in Japan, and 4.4% in the U.S.). Had Australian investors appreciated that local inflation was tepid (2.5%), they would have been wise to prefer their Treasuries, whose 25-year run exceeded both the AX 200 index of stocks, with reinvested dividends, and a 60-40 rebalanced portfolio. The strategy of 100-or-0 Rotation was sometimes the worst, though not by much. In the end it eaked out a small victory.

Good as it was overall, 100-or-0 Rotation exhibited at least one consistent vulnerability. For the worst-month metric, it always finished in third place, better by far than stocks, but outdone both by bonds and by rebalancing. There's a simple explanation, and it has a clear message. If a strategy is 100% invested in stocks when stocks fall suddenly and dramatically in a very short period, as on Black Monday in October 1987 and in the flash-crash of 2010, then the portfolio gets the full effect. However, a portfolio invested partly or completely in Treasuries will partly or completely escape the damage. Furthermore, Treasuries will very likely rise in value at such times.

The natural question to ask is whether a better rotation would stay below some ceiling, never going to 100% in stocks. A related question might be whether 0% is, in fact, the best floor. Happily, the data of the last 100 years in U.S. markets and the last 25 internationally have clear answers for both questions. Next week's posts will show how the answers are derived.