Did Modern Portfolio Theory Survive the Bear Market?

The following in an excerpt from an article by Arijit Dutta, associate director of mutual fund analysis with Morningstar.

 Two bear markets in one decade have shaken investors' faith in the tenets of Modern Portfolio Theory and the asset-allocation strategies the theory spawned. Critics say that blind faith in MPT led to lopsided asset allocation. The theory did not properly account for systemic risk, which caused investors to allocate too heavily in stocks, and now their portfolios will need years to get even.

Useful but Not Guaranteed

 Some investors leaned too heavily on MPT models as though they were all they needed, but those models still serve a purpose. Diversification is still a great way to reduce risk and earn a higher level of return in the long run. Studies show that asset allocation is still of tremendous importance, even after last year's meltdown.

In fact, most constructive ideas about improving asset allocation retain the basic framework of MPT. These ideas suggest practical tweaks to the theory, rather than any radical remedies. For example, one idea is to improve risk measurement. This means less reliance on the normal distribution and more on other distributions or approaches that entertain the possibility of extreme losses. A combination of lower allocation to especially risky assets and hedging tools can then be used to protect the portfolio. Another suggestion is to engage more in tactical or dynamic asset allocation. Rather than stay with a static allocation to equities, say, this approach involves shifting the mix based on macro views or valuation analysis.

By Arijit Dutta, associate director of mutual fund analysis with Morningstar.

11 06 09 Market Comment

The stock market experienced a mild correction in the last half of October. It has rallied back to recapture roughly half that decline. We will watch the market closely in the next few days. If the market can shrug off this morning’s disappointing economic news (10.2% October unemployment report) and continue to rally, the major indexes could challenge the recent uptrend highs within a week or two setting the stage for an important end-of year rally. If the market sells off from its current level, however, we could quickly retest the recent lows. Penetration of those lows would send a powerful signal to many portfolio managers that it is time to lock in gains for the year.


High yield bond and other low-volatility uptrending bond/income funds have weakened. Some have declined a little, but few have declined enough to trigger reasonable sell stops. For the moment we will not be adding new positions to any high yield bond funds or stock funds. We will wait to see how the market behaves for now.

October Market Scorecard

Monthly Market Performance Report

High Yield Bonds (aka: Junk Bonds) are the best performers for the month as well as for the year.

10 30 09 Market Comment

 Yesterday the market reversed its recent downtrend and was up sharply. The trough formed by that advance is now important support. As long as the major indexes hold above that level, the decline from the mid-September highs will be properly viewed as just another typical bull market correction. If yesterday’s trough is decisively penetrated however, the odds favor a much deeper decline. It is probably going to take a few days for the market to give us enough information on which to make a reasonable guess about the near-term direction of stock prices.

 Many junk bond funds were flat or down – even though the stock market was broadly up. That is a normal delay function that we frequently see expressed in the junk bond market. The mutual funds got hit with redemptions on Wednesday and had to sell bonds yesterday. Hopefully, they were able to get all the selling to cover redemptions completed yesterday. If so, junk bond funds may resume their uptrend and move higher today.

09 29 09 Market Comment

The stock market accelerated its downside move yesterday and is now deeply oversold. Such oversold conditions usually trigger some type of a bounce – and we’re getting a big bounce today. The nature of this bounce will give us some clues about the market environment, but it is what follows that bounce that will really be important.


Downtrends are made up of strong down-legs interrupted by weaker up-legs. When the next up-leg in the stock market develops, it will establish a trough that will mark the bottom of a strong down-leg. It is highly unlikely that the first up-leg following that trough will erase all the drawdown of the current down-leg. That means we will likely end up with a weaker up-leg following the current strong down-leg. What happens after that will determine if the current correction morphs into a significant downtrend.

The trough formed by the next up-leg is the key. That will be very important support. If it is subsequently penetrated in a decisive manner, we can logically conclude that the stock market has completed a significant topping pattern and established a downtrend. If the stock market holds above that trough, we will have to watch and see if a pattern of stronger up-legs interrupted by weaker down-legs (an uptrend) reemerges.

Most junk bond funds declined modestly yesterday. That is not surprising since junk bond funds typically follow the major trend of the stock market, but with a lag and with little of the day-to-day volatility. These funds may move lower again today – even if the stock market rallies. That is the lagged effect that helps make these funds so easy to time. We shouldn't worry about a small decline. I have moving average stops in place to protect us from the downside. With junk bond funds the day-to-day volatility in the stock market can be ignored in the short term. If stocks have topped and entered a significant downtrend, we may start to hit some sell stops in junk bond mutual funds in a week or two. If the correction in stocks is about over, junk bond mutual funds will likely turn higher following a modest decline.

We can’t control what the market does, but we can control how we react to what the market does. Being invested in junk bond and similar mutual funds, there is nothing to do at this point except to make sure you have stops set.

Las Vegas meeting with Michael Price

On Oct 17th Christopher and I spent a day with Michael Price and about 70 other investors and advisors. It was a great opportunity to learn from the master. As you know Michael is someone I admire very much. He is most generous when it comes to sharing his insights as well as his superb money management techniques and strategies. He personally manages over $200,000,000.  He works out of his house in Florida and has just two employees; his daughter and son-in -law.

Steve Gerritz, Michael Price, Chris Gerritz


The meeting was held at the Venetian on the Vegas strip. It is a beautiful hotel. Chris said  "I have been to Venice and parts of this hotel looks just like the real thing."

In the upcoming November issue of The Gerritz Letter, I will  share the highlights of my meeting with Michael.

10 26 09 Market Comment

The market appears to have entered a period of consolidation following a strong uptrend that peaked Oct. 15th. This correction does not look any different from the others that have occurred since the market bottomed in March. Moreover, our more conservative investors are invested in Bond/Income funds, most of which remain in a very low volatility uptrend.

More aggressive clients have a relatively small exposure to stock funds at this point and should not be overly concerned with what appears to be a garden variety correction. If it turns out to be worse than expected, we are protected by our trailing stop strategy. Sector fund trailing stops set at 12% and diversified stock fund trailing stops set at 8%.