Tactical Asset Allocation – August 2020

Tactical Adaptive Strategies Update

Performance

Adaptive Global gained 0.76% for the month and has gained 2.45% YTD. Adaptive Global was invested in an eclectic mix of precious metals, big cap value, international real estate (all up nicely), and long term Treasuries (down).

Adaptive Income lost 0.23% for the month and has gained 5.18% YTD.  Adaptive Income was invested high yield municipal bonds. The two month OEF reentry limitation prevented the Tactical Model from returning to its preferred selection of the Ivy Fund which turned in a nice gain.

Adaptive Innovation lost 2.60% for the month and gained 7.44% YTD. Adaptive Innovation split investments between intermediate and long term Treasuries.

Perspective

By now, it’s a well known fact that the mega and big cap indexes dominated by a few mega cap tech stocks are making new highs while most other indexes and sectors are showing losses.

Let’s have a look at the CAGR and Max Report Drawdowns (MaxRD) for the major equity indexes for 2020:

  • NASDAQ 100 Cap Weight (QQQ) - 38.12% gain w 12.9% MaxRD
  • S&P 500 Cap Weight    (SPY) - 10.08% gain w 30.6% MaxRD
  • S&P 500 Equal Weight (RSP) - 1.58% loss w 26.7% MaxRD
  • S&P 400 Mid Cap Weight (IJH)  - 4.55% loss w 29.7% MaxRD
  • S&P 600 Small Cap Weight (IJR) - 9.73% loss w 32.8% MaxRD
And the US Treasury market which has outperformed all of the equity indexes on a risk adjusted basis:
  • Treasury 3-7 Year (IEI) - 7.04% w 0.3% MaxRD
  • Treasury 7-10 Year (IEF) - 10.95% w 1.1% MaxRD
  • Treasury 20 Year (TLT) - 20.5% gain w 5.7% MaxRD
Given the right crystal ball we might have picked QQQ or a mix of QQQ and TLT. But we don’t have a crystal ball. We play a middle ground drawing upon a broad base of 30+ funds including domestic and international equities, bonds, and commodities with the dual objectives of maximizing CAGR and minimizing drawdowns. Aside from the broad selection of funds, the strategies incorporate dynamic momentum selection coupled with volatility weighting and volatility targeting to reduce portfolio risk. The strategies have successfully managed to navigate the shortest bear and bull markets in US history.
  • Adaptive Global - 2.45% w 2.8% MaxRD
  • Adaptive Income - 5.18% w 0.5% MaxRD
  • Adaptive Innovation - 7.44% w 4.9% MaxRD

So now we are ⅔ of the way through 2020 and facing an election, civil unrest, historically extreme valuations and an economy which is trying to recover from massive shutdowns and unemployment. Should we abandon all hope and go to cash until sometime in 2021 by which time we hope the storm clouds will have lifted?

Not if we consider the essential backdrop under which our equity and bond markets are operating:

  • The Federal Reserve has assumed absolute control of the credit markets. Neither Treasury auctions nor junk bond issuers will be allowed to fail. Interest rates are at historical lows and the Fed has announced its determination to keep them there for years.
  • While election results may or may not offend our personal sensibilities, we have both parties engaged in ever increasing deficits differentiated only by the beneficiaries of the spending/tax cuts. There have been no apparent repercussions so the deficits will not only continue but increase with demands for everything from support payments to infrastructure.
  • Higher Treasury yields will blow out the Federal budget. Most of the US Treasury debt is of short duration which must be constantly refinanced because the market refuses to absorb a greater supply of longer duration at rates acceptable to the Treasury.

All of this boils down to the fact that the Fed will continue to grow its balance sheet in order to absorb the growing supply of Treasury issuance/rollover while suppressing yields by buying whatever the market will not take at the target yield. The Fed will also continue to “manage” yields and spreads across the full spectrum of quality in the credit markets. This should prove supportive for both the bond and equity markets even if the currently hot stocks fall out of favor.

Ultimately, these policies are likely to yield the Fed’s desired inflation; however the negative effects are likely to be subdued until the economy recovers.

Our tactical adaptive strategies show an ability to weather remarkable and historical shifts in the market during the past two decades. I believe they can weather the next few years.

 

Market

From the August 28th Market Monitor

"The major indexes were up sharply this week except for Housing. Mega and big cap indexes led, mid and small caps lagged. This rally can best be described as “hanging in there” as the intermediate term momentum fails to show true bullish strength while the short term momentum remains bullish. The next short term target for the SPX is 3666 and the next intermediate target is 3718.

Comparative momentum measures across indexes continue to show a loss of momentum in big cap versus mega cap and small cap versus big cap. The equal weighted versus cap weighted S&P 500 is also rolling over. Overall, these represent a significant loss in market breadth.

Cumulative Advancing Declining Volume continued with another week of bearish divergences; however the divergences did not worsen. In other words, the rally keeps chugging along on poor breadth and poor participation whether measured by indexes or sectors.

While the credit markets remain supportive of equities, the declines in both spreads and yields have turned flat leading to a decline in the Credit Market Index. While the Credit Market Index remains positive, it is clear that investors are beginning to shift toward less risk.

The delinquency rates on loans and leases is soaring which argues for a rise in credit spreads. This is coupled with greatly increased caution in commercial, industrial, and personal lending.

The US Dollar declined to support, bounced, and has resumed its decline.

Treasuries are seeing some distribution which is pressuring prices; however the rise in yields is unlikely to progress far.

Precious metals remain in corrective mode; however the major trend remains bullish.

Market Cap divided by GDP notched another historic high of 184% this week. While the sharp decline in GDP was the proximate cause of the sharp rise, the ratio was already sitting in the 150’s which has capped all rallies.

The rally in the equity market appears to be unstoppable; however participation is narrow, sentiment measures are at extremes, and equity volatility indexes are beginning to turn up. In other words, caution flags are flying."

 

Earl Adamy

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Compares performance of the Tactical Adaptive Strategies to the S&P 500 and Vanguard Balanced Index Fund

Supporting tables for Tactical Adaptive Global. S&P 500 (SPY) and Vanguard Balanced Index Fund (VBINX) can be found below

Our backtest results tables are constructed for two full market cycles beginning in January 2000.

The most recent market cycle covers October 2007 to date. The fund baskets for our tactical strategies are constructed from indexed Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history.

The earlier market cycle covers January 2000 through September 2007. A number of the ETFs we use were not created until later in the decade. For those cases, we infill using predecessor Open End Funds (OEFs) for which the indexing and/or subclass is substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second, earlier, cycle, they also offer the advantage of completely out of sample data. The fact that the metrics of both cycles are very comparable appears to validate the process.

We have been asked if it is possible to extend backtests to earlier decades. While this appears to be a common practice with some services; it is not possible to produce credible results for many strategies due to the lack of funds with substantially similar indexing and/or subclass. Doing so would force me to stretch the term "substantial" far beyond my comfort level.

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.

Benchmark S&P 500 (SPY)

Benchmark Vanguard Balanced Index Fund (VBINX)

Compares performance of the Tactical Adaptive Strategies to the S&P 500 and Vanguard Balanced Index Fund

Supporting tables for Tactical Adaptive Income, S&P 500 (SPY) and Vanguard Balanced Index Fund (VBINX) can be found below

Our backtest results tables are constructed for two full market cycles beginning in January 2000.

The most recent market cycle covers October 2007 to date. The fund baskets for our tactical strategies are constructed from indexed Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history.

The earlier market cycle covers January 2000 through September 2007. A number of the ETFs we use were not created until later in the decade. For those cases, we infill using predecessor Open End Funds (OEFs) for which the indexing and/or subclass is substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second, earlier, cycle, they also offer the advantage of completely out of sample data. The fact that the metrics of both cycles are very comparable appears to validate the process.

We have been asked if it is possible to extend backtests to earlier decades. While this appears to be a common practice with some services; it is not possible to produce credible results for many strategies due to the lack of funds with substantially similar indexing and/or subclass. Doing so would force me to stretch the term "substantial" far beyond my comfort level.

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.

Benchmark S&P 500 (SPY)

Benchmark Vanguard Balanced Index Fund (VBINX)

Compares performance of the Tactical Adaptive Strategies to the S&P 500 and Vanguard Balanced Index Fund

Supporting tables for Tactical Adaptive Innovation, S&P 500 (SPY) and Vanguard Balanced Index Fund (VBINX) can be found below

The Innovation ETFs used in the Innovation Strategy were not established until 2014-2015 so our history is limited. There are no predecessor funds which are similar enough to use for infill.

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.

Benchmark S&P 500 (SPY)

Benchmark Vanguard Balanced Index Fund (VBINX)