Tactical Asset Allocation – April 2019

Tactical Asset Allocation Strategy Update

Performance

Global Adaptive gained 0.04% for April and 1.58% YTD. Our position in commodities turned in another good month for us as did our new position in big cap value. Our positions in global real estate and long dated Treasuries underwent correction following two strong months.

Adaptive Income gained 0.99% during April and is up 3.55% YTD. The strategy was invested in high yield bonds during April.

This is the comment which accompanied the allocations at the end of March: "The Tactical Model finds positive trends in all 24 funds with improved levels of confidence across most. (This is a rare occurrence.) Global Strategy selections for April, constrained by Hostile market conditions, continues to include commodities, international real estate, and long dated Treasuries while substituting big cap value equities for precious metals.

The Tactical Model finds positive trends in all 3 fixed income funds which represent the spectrum of risk from Treasuries to high yield. The Adaptive Income selection for April takes both yield and risk up a notch in shifting from investment grade bonds to high yield bonds."

Market

The sharp rally off the Christmas Eve equity lows has quite likely run its course for now. While the market shows relatively few signs of weakness (although breadth has narrowed), it appears to have exhausted much of its strength and needs time to recharge. Fixed income has soared on the back of the Fed's reversal to dovish

As noted in last weekend's Market Monitor:

"The S&P 500 has slightly exceeded the all time weekly closing high of September; however the indexes appear to be suffering from exhaustion. The small and mid cap indexes continue to lag their larger cap brethren. While the market continues to target higher, any move higher is very likely to be preceded by consolidation with support at 2820.

Cumulative Advancing Declining Volume has confirmed the highs in the big caps; however it is not only failing to confirm the rally in small and mid caps, but turning negative.

Credit spreads remain supportive of risk taking; however there is a bit more caution in the high yield space than in investment grade.

While prospects for further advances in the large cap indexes remain constructive, investors should not lose sight of the fact that the ratio of market cap to GDP (AKA Buffet Indicator) has reached levels which have previously proven unsustainable. The entire structure is increasingly reminiscent of the 1998-2000 blow-off.

Although my market work has absolutely no bearing on TAAS mechanical strategy selections and allocations, my current view is that the S&P 500 is very likely to visit 3,000 and, quite possibly, the long standing target at 3047. This is a Fed driven market, not a rational market.

Outlook and Strategy

The great advantage of employing Tactical Asset Allocation to manage our portfolios is that we don't have to figure out where the market is going. Our Global Adaptive strategy evaluates dozens of possible trend conditions across each of the 24 funds in our basket and picks the best combination of direction, strength and confidence. Across a full market cycle, it gets far more fund selections right than wrong and when it does get one wrong, it corrects the problem.

But that doesn't mean we shouldn't pay attention to what is going on in the markets. Tops in equity markets are processes, not events. From all appearances the topping process began in September 2018 and quite likely has more time to run.

I don't need to recapitulate the long lists of reasons provided by financial analysts and commentators to explain why the equity market should rise or fall. There are two basic facts at play:

  • The economic cycle is long in the tooth and losing steam from the 2017 fiscal stimulus while equity market valuations are extreme even as corporate earnings appear to be slowing.
  • Equity prices are based on the multiple of earnings which investors are willing to accept for the perceived risk. A bear market can not begin in earnest until investors shift their risk perception from positive to negative leading to significant reductions in market multiples.

The first fact tells us that we are somewhere near a top while the second tells us that we should remain constructive (but careful) on equities until investors undergo a significant shift in risk perception.

Peak To Peak, A Road Less Traveled

On April 23, the S&P 500 closed at a new all-time closing high of 2933.68 surpassing the prior high close of 2929.67 on September 21. While I generally eschew strategy comparisons across short periods of time; it is instructive to compare the performance of the S&P 500 against the performance of the Global Adaptive Strategy for the seven month period September 1 through April 26 when this article was written.

On the basis of return, the S&P 500 with a negative Compound Annual Growth Rate (CAGR) of 2.12% outperforms Global Adaptive with a negative CAGR of 5.45%. On the basis of safety, Global Adaptive with a Maximum Daily Drawdown (MDD) of 6.6% outperforms the S&P 500 with a MDD of 19.3%.

In my capacity as our family's investment manager, I wear two hats: create wealth and preserve capital. Under my wealth hat, the negative CAGR of 2.12% looks more attractive. But under my preserve capital hat, the MaxDD of 6.6% looks far better. After all, there was no guarantee that the market would rebound rather than continue south.

Obviously, I expect positive long term returns; however capital preservation is an essential part of my responsibility and one I have always taken seriously. This is why I started my journey into TAA in 2012 and why I believe the long term results justify my confidence in using it as my primary investment management tool.

Examining another, longer duration, peak to peak structure also proves instructive. The S&P 500 peaked in September 2007 and returned to its September 2007 peak in April of 2013. For that period, Global Adaptive shows a CAGR of 20.15% with an 8.7% Max Monthly Drawdown (MMD) while the S&P 500 shows a CAGR of 2.77% and a MMD of 50.8%.

A few other comparisons of Global Adaptive versus the S&P 500:

  • Last 5 years: 9.47% and (6.0%) versus 11.36% and (13.5%)
  • Last 10 years: 16.04% and (8.7%) versus 15.11% and (16.2%)
  • Full cycle Oct 2007-current: 15.29% and  (8.7%) versus 7.89% and  (50.8%)

Hostile Condition

The Market Conditions Model remained in "Balanced" condition for a record long period of 31 months due to irregular trends and extreme valuations. "Balanced" is a transition between Favorable and Hostile in both directions.

The Market Condition switched to Hostile at the end of January. The Hostile funds basket seeks returns with an increased level of safety. Equity exposure is focused on big cap value and international real estate while fixed income exposure includes a much broader range of longer duration Treasuries and investment grade bonds. It also includes exposure to precious metals and commodities which can be counter-cyclical. As always, the Tactical Model selects the basket's best performing assets each month.

We are faced with two possible outcomes here.

  • A Correction followed by a return to Balanced conditions where the uptrend resumes under extreme valuations, probably for a limited duration.
  • A deeper Bear Market which leads to Favorable conditions after washing out market excesses. The deeper Bear Market would be preferable for two reasons. First it will provide trending conditions which will allow the Tactical Model to maximize returns during the decline. Second, it will setup "risk on" conditions which can produce mouth watering returns.

The Hostile Correction scenario last occurred Sep '15 through Jun '16 (CAGR of 9.9%) and was followed by resumption of the bull market under Balanced conditions and 10.8% CAGR for the strategy. A Hostile Bear Market last occurred Dec '07 through Jun '09 and was followed by 26 months of Favorable conditions and a 29%+ CAGR for the strategy. Clearly, our greatest reward lies in a major decline followed by a new bull market.

Subscriber Portal

The Market Monitor page in the Subscriber Portal is updated each weekend. It provides an updated assessment on the health of the equity market as well as interest rates, commodities, and precious metals. I highly recommend checking this page on a weekly basis. While this information has no bearing on the Global Adaptive Strategy, this is where you will see signs of shifts in market conditions which may provide more informed perspective than what is generally available.

Earl Adamy

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