The Dominant Market Theory is an extension of the work presented in 1997 by Don Beasley, an important mutual fund money manager. The theory supports two basic conclusions about dominant market environments based on the relative strength of the OTC Composite Index to the NYSE Composite Index:
The second conclusion indicates that most diversified funds will do well in a market environment in which the small caps are dominant. Under this theory the bellwether Russell 2000 Index (RUT-I) needs to be in an uptrend for the general investment environment to be considered favorable. The DMT conclusion is that there are identifiable market environments that are highly productive and relatively low in volatility and other environments that are much lower in productivity and much more volatile.
The DMT supports the notion that there are identifiable market environments exhibiting the desirable mutual fund investment characteristics of high productivity and low volatility and often lasting for months at a time.
It can be shown that in a market in which the Russell 2000 is dominant most funds and portfolios will chalk up almost all of their gains for the year. Even the S&P500 is 3 times more productive during such strong small cap markets. Clearly, tracking the trend of the small cap indices has value even if you invest primarily in large cap mutual funds since on average large cap funds are 5 times more productive and less than half as volatile during strong small cap (RUT-I) markets. Nearly all stock funds and sectors are capturing their entire net annual returns or more during the 60% of the time that the small cap markets are in an uptrend.
During the remaining 40% of the time those funds and portfolios will go nowhere or even suffer losses. Since the Russell 2000 is only dominant some 60% of the year, the theory indicates that bond fund positions are often the best choices for the remaining 40% of the time. Since the market cycles in which the Russell 2000 is dominant are interspersed irregularly throughout the year, a number of RUT-I based indicators are often used to make such determinations.
It is through the use of those and similar DMT indicators that TSP Pilot makes many of its Thrift Savings Plan fund allocation decisions. Since the DMT allows portfolios to remain invested in the safer, less volatile bond portfolios, such as the G and F Funds, the total risk exposure of the TSP Pilot Portfolios is reduced substantially while still providing for above market returns.
Since the intent of the TSP Pilot Portfolio is to be invested only during those productive market environments under the DMT, using the Sharpe ratio, NCAlpha, RSI and other risk-adjusted metrics to find the best choices among the Thrift Savings Plan equity funds (C, S, I Funds) will help to ensure that the plan participant remains 100% invested in the strongest funds through the entire market cycle.
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