Tactical Asset Allocation – August 2019

Tactical Adaptive Strategies Update

Performance

Adaptive Global lost 1.15% and has gained .61% YTD. Adaptive Global quickly adapted to the strong equity trend into the end of July only to be battered by big negative shift due to the trade war. The position in big caps took a modest loss while both mid-small cap equities and emerging markets took larger losses. The position in precious metals produced a very large gain but not enough to offset the losses in equities.

Adaptive Income lost .49% and has gained 1.95% YTD. Adaptive Income declined on a shift in credit markets which produced weakness in Senior Loans.

Adaptive Innovation lost 6.41% and has gained 1.43% YTD. While Adaptive Innovation produces the highest return, it is also the most volatile. The Strategy was pummeled by a combination of weakness in equities, weakness in mid and small caps, and weakness in technology.

Half A Loaf

As noted above, August has not been a good month for our tactical strategies although the middle of the month was uglier than the finish. (I have my fingers crossed for Friday.) Like most investors, I regularly assess the suitability of our portfolio for our long term goals. It's no secret that Adaptive Global's returns have been lagging the market and I wanted to understand why.

A look at the performance table shows that Adaptive Global performed very well for the full market cycle which began in October 2007 through the end of 2017.

It appears that January of 2018 brought the start of a topping process. If I am correct in that assessment, it is the longest we have experienced since this secular bull market began in 1982. A weekly chart of the S&P 500 shows four topping processes of significance since 1982:

  • August 28, 1987 to October 2, 1987 (6 weeks)
  • July 16, 1999 to September 1, 2000 ( 60 weeks)
  • July 13, 2007 to October 12, 2007 (14 weeks)
  • January 25, 2018 to ?July 26, 2019? (79 weeks ?)

The whitepaper "What Is Tactical Asset Allocation?" illustrates TAA using a very basic tactical strategy which I refer to as "The Switcher". The Switcher, like the Adaptive Global Strategy, uses Adaptive Dynamic Momentum; however its basket is limited to two long-established Open End Funds:

  • Vanguard Total Stock Market Index Fund (VBSMX)
  • Vanguard Total Bond Market Index Fund (VBMFX).

While The Switcher is very simplistic, it's a tool I developed five years ago to validate tactical strategy concepts using out of sample history over longer periods than are available with ETFs.

In this case, I used The Switcher to evaluate performance of the Tactical Model during topping processes. Here is how Compound Annual Growth Rate (CAGR) and Maximum Report Drawdown (MaxRD) performed during each of these periods except 1987 for which I have no data. Note that full months are used rather than weeks:

  • July 16, 1999 to September 1, 2000: 7.6% CAGR and (8.4%) MaxRD. Conditions for the period were Balanced and turned Hostile two months later.
  • July 13, 2007 to October 12, 2007: 7.5% CAGR and (3.4%) MaxRD. Conditions during this period were Favorable and turned Hostile two months later.
  • January 25, 2018 to ?July 26, 2019?: 8.3% CAGR and (7.4%) MaxRD. Conditions were Balanced through January 2019, Hostile during Feb - June 2019, and Balanced since June.

The Switcher shows roughly similar performance across three topping periods. How does this compare to Adaptive Global?

  • Adaptive Global does not fair so well on CAGR: Adaptive Global delivered a GAGR of of 1.8% during this period versus 8.3% for the Switcher and 9.0% for the S&P 500.
  • Adaptive Global does very well on MaxRD: Adaptive Global incurred a MaxRD of (4.0%) during this period versus (7.4%) for the Switcher and (13.5%) for the S&P 500.

And one more comparison for the full cycle:

  • Adaptive Global does very well on CAGR: Adaptive Global delivered a GAGR of of 15.5% during this period versus 9.7% for the Switcher and 8.0% for the S&P 500.
  • Adaptive Global does very well on MaxRD: Adaptive Global incurred a MaxRD of (8.7%) during this period versus (13.2%) for the Switcher and (50.8%) for the S&P 500.

Given identical trend scoring algorithms, the difference between The Switcher and Adaptive Global lies in the composition of the baskets. Switcher's basket is binary: stocks or bonds. Adaptive Global's basket consists of 24 funds selected to provide the Tactical Model with broadly diversified opportunities. The Tactical Model uses this broadly diversified basket to identify the best fund trending opportunities across global markets.

So why is Adaptive Global's return under-performing? There are so many choices in the Adaptive Global fund basket that the funds are thrashing among themselves. A major part of this is the exceptionally high correlations across asset classes. This has temporarily turned a strong advantage into a negative. Fortunately, the Tactical Model has excelled at keeping drawdowns small.

Personal Portfolio Changes

We have made two adjustments to our investments this month. One is to raise some cash in the TAAS portfolio which is our single largest investment and the other is to slightly increase our position in PHYS (gold) from 8% to 10%. These adjustments are precipitated by conditions which have elevated risks on all fronts from equity and bond markets to the economy and global geopolitical.

We are shifting our TAAS allocations effective with the rebalance at the end of August to the following mix:

  • 50% Adaptive Global
  • 25% Adaptive Income
  • 5% Adaptive Innovation
  • 20% cash

Market

From the August 24th Market Monitor

The mid and small cap indexes led this week’s equity decline as they have been doing for weeks which is a sign of market weakness. In healthy markets we generally see the mid and small caps lead with the big caps catching up; or occasionally, the big cap leads off with the mid and small caps catching up within a few weeks. We have seen neither which is a sign of a narrow and unhealthy market.

The big story is in the S&P 500 big cap index not only because it has been a leader but because of where it stands on the daily chart. Here is the evidence:

  • The minimum expected retracement for the rally from the 8/5 low is 2949. I count 3 failed attempts to get there. 2949 to 2984 is range where short sellers would typically hit the offer but they couldn't wait.
  • The index made three attempts to return above the trendline from the December low. All three failed.
  • The structure of the rally from the 8/5 low is an ABC (up/down/up) which is typically found in the first stage of an impulsive decline from a high. An impulsive decline targets 2600, or lower

Volume on Friday’s decline was heavy which tilts the evidence away from a possible triple bottom since the secondary or tertiary low generally occurs on significantly lower volume than the primary low.

We have two very clear lines in the sand for the S&P 500. A rally and close above 2940 would be supportive of further rally or sideways correction. A decline and close below 2820 would be supportive of an impulsive decline.

Cumulative Advancing Declining Volume in the big caps got a bit of repair on Friday. This provides a bit of hope for the bulls.
The Credit Risk Model is unchanged for the week at -12% which is negative but not decisively so. We need to see more change up or down.

The issue of recession, which is keeping all of the major mouths occupied, is irrelevant in my view. It is not the cycling of GDP which keeps markets elevated, but investor confidence. Lose confidence and you'll have a bear market whether preceded or followed by a recession.

My view remains that "The Top" occurred in January of 2018 and we've been going through a year and a half of noise. That said, the noise appears to be getting increasingly negative.

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 Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation strategies evaluate dozens of possible trend conditions across each of the 32 funds in our baskets 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 January 2018 and continues even as the big cap indexes (unaccompanied by the rest of the troops) continue to push slightly higher.

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. Interest rates have plummeted in the expectation of quick Fed easing. Unfortunately, it is the weakening economic conditions which are driving the expectations for Fed easing. The transportation sector provides us with a valuable economic canary and it continues to deteriorate.
  • 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. Credit markets are telling us that investors have reached levels of "concern" but not "fear".

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 reverse their risk perception.

Earl Adamy

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I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

The primary benefit of minor changes to Adaptive Global is reduction in both Standard Deviation of Monthly Returns and the Ulcer Index:.

  • Fund basket and condition eligibility: no change was made to fund baskets or condition eligibility
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Volatility Weighting was replaced with Limited Portfolio Volatility Weighting which is employed to cap the expected total portfolio volatility when high volatility funds (especially equities) are used. This slightly reduces both risk and return.
  • Position Optimization: Upgraded which slightly improves holding periods and performance.

Full cycle: CAGR decreased slightly from 15.0% to 14.6%;  Max Monthly Drawdown declined from 8.7% to 7.9%; and the Up/Down Ratio decreased slightly from 228.7% to 228.4%. The Ulcer Index declined from 3.7% to 3.6% and Standard Deviation of Monthly Returns declined from 9.5% to 9.1% reflecting improved consistency of returns.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

The primary benefit of changes to Adaptive Income is a broadening of the fund basket and reduction in both Standard Deviation of Monthly Returns and the Ulcer Index:

  • Fund basket and condition eligibility: the number of fixed income ETFs was increased from 5 to 6 to broaden the basket to include an investment grade ETF.
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Adaptive Income employed a single selection, 100% weighting to the best performing fund. Limited Portfolio Volatility Weighting is employed to cap the expected total portfolio volatility when higher volatility funds (especially high yield) are used. This forces the allocation across a second, lower volatility fund when the cap is exceeded.
  • Position Optimization: Upgraded which slightly improves holding periods and performance.
  • Full Cycle: CAGR increased slightly from 10.6% to 11.1%; Max Monthly Drawdown increased from 2.9% to 3.8% however Max Daily Drawdown remains unchanged at 7.1%; and the Up/Down Ratio rose from 503.0% to 556.9%. The Ulcer Index declined from 1.3% to 1.2% and Standard Deviation of Monthly Returns declined from 5.6% to 5.1% reflecting improved consistency of returns.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

 

I will be rolling out upgrades to the Tactical Model and Adaptive Strategies beginning with the November 29 rebalance for the month of December. In each case, the focus has been on improving control over the upper bounds of portfolio volatility, improving the consistency of annual returns, and on reducing fund turnover.

In order to provide the fullest possible disclosure, the Chart and Table displays on the website will include tables for both the original (labeled “Repl Dec 2019)” and upgraded Strategy beginning with the next update in early December.

This upgrade to Adaptive Innovation improves performance while significantly reducing volatility.

  • Fund basket and condition eligibility: The existing long duration Treasury ETF was added to the eligible funds for Balanced conditions. This allows strongly performing Treasuries to complete effectively with the Innovation equities for selection. A short duration Treasury ETF was added to provide a higher yielding alternative to cash.
  • Fund selection: no change to fund selection method (Adaptive Dynamic Momentum)
  • Weighting of selected funds: Volatility Weighting was replaced with Limited Portfolio Volatility Weighting which is employed to cap the expected total portfolio volatility when the higher volatility Innovation funds are used. This forces the allocation across a second or third fund when the volatility of the primary fund(s) exceeds the cap.
  • Position Optimization: Upgraded which made no change in holding periods and performance.
  • Partial cycle: CAGR increased slightly from 26.3% to 28.4%,  Max Monthly Drawdown and Maximum Daily Drawdown remained unchanged at 12.2% and 19.2% respectively; and the Up/Down Ratio increased from 280.2% to 336.9%. The Ulcer Index declined from 5.6% to 5.1% and Standard Deviation of Monthly Returns declined from 15.7% to 14.9% reflecting improved consistency of returns.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.