Tactical Asset Allocation – December 2019

Tactical Adaptive Strategies Update

Performance

Adaptive Global gained 2.83% for the month and 2.81% for 2019.

Adaptive Income lost 0.05% for the month and gained 3.95% for 2019.

Adaptive Innovation gained 1.33%  for the month and 11.64% for 2019.

The Tactical Model jumped on the strong trend in equities for both Adaptive Global and Adaptive Innovation Strategies while Adaptive Income treaded water in Investment Grade bonds.

The allocations for January are notable for shifts to international equities where the Tactical Model is finding stronger trends.

The major concern for January is the extremely high level of equity market valuation coupled with the S&P 500’s move above the 97th percentile of momentum measures. This is a high probability (but not guaranteed) setup for a sharp and fast downside correction of 10% to 15%. The extremely narrow spreads on High Yield raise a similar concern should the equity market decline sharply.

One area I will be monitoring especially closely is the repo market. The Fed has had to purchase (and add to its balance sheet) nearly a half trillion dollars in Federal debt to meet the demand for liquidity. However, the jury is out on whether the problem has been solved or will be exacerbated by continued fresh issuance and rollover of Federal debt.

Position hold algorithm update

While reviewing the proposed allocations for January, I identified an error in the algorithm used to prioritize holding an existing position over trading into a new position. The algorithm was corrected immediately resulting in some small decreases in historical performance.

While  reviewing the code, I observed a potential opportunity for improvement. I expanded the reporting detail covering position holding periods which allowed me to better understand the performance of the algorithm. I then tested and implemented an improved algorithm. The improvements reversed all of the decrease in Adaptive Global and nearly all of the decrease in Adaptive Income. Strategy statistics through November:

  • Adaptive Global: CAGR increased from 14.6% to 14.8%, Ulcer Index increased from 3.6% to 3.7%, MaxDD decreased from 7.9% to 7.6%, and the Up/Dn ratio increased from 226% to 227%.
  • Adaptive Income: CAGR decreased from 10.9% to 10.7%, Ulcer Index decreased from 1.2% to 1.1%, MaxDD decreased from 3.8% to 3.6%, and the Up/Dn ratio decreased from 556% to 531%.
  • Adaptive Innovation: no change.

Deeper historical backtesting

I maintain a database of some 400 Exchange Traded Funds (ETF) and Open End Funds (OEF) categorized by asset class and subclass. The primary use of the funds database is for strategy development. Any fund in the database can be used in the Tactical Model by simply entering its symbol. This not only brings in the quote history but other particulars for the fund which are used by the Model.

However the database is also used to link ETFs for which there is typically only 10-15 years of history with similar OEFs for which there is often 20-30 years of history. The linking process allows us to use the ETF for our portfolio while gaining an improved understanding of how the strategies might have performed over two full market cycles rather than one. For example, VPL (Vanguard Pacific Stock Index Fund ETF), used in our Adaptive Global Strategy, has history back to 2005. VPACX (Vanguard Pacific Stock Index Fund OEF) has history back to 1990. Both use the same management and indexing. In those cases where an ETF does not enjoy a deep fund family; we look for OEFs with the same or very similar indexing and objectives.

Performance tables for Adaptive Global and Adaptive Income cover the most recent full market cycle beginning September 2007. I’ve long wanted to see how these two strategies might have performed during the previous full market cycle beginning with the start of the first of two recent bear markets in March 2000.

I spent some time exploring suitable antecedent funds for the ETFs we use in the two strategies which do not have history back to 1999. Twenty-six OEFs were needed. Vanguard, which has a deep bench of funds with multiple classes and inception dates provided 19 funds which met the necessary criteria. Of the remaining 7 funds, I found 6 OEFs with similar indexing and investment objectives which were suitable for linking. DBC, our commodity ETF, had no suitable antecedent so I ended up linking to the CRB index.

I was able to obtain history back to 1999 which allows the Model to provide results for all of 2000. Both tables include the 2000 bear market (March 2000 through October 2002 @ 42.7% MaxDD in S&P 500) and the 2007 bear market (October 2007 through March 2009 @ 55.2% MaxDD in S&P 500).

Here are the results for Tactical Adaptive Global:

And the results for Tactical Adaptive Income:

I believe the consistency across the earlier full market cycle is remarkable and reassuring. Remarkable because while there will be some fund differences to our ETFs, the fund baskets as well as the methodologies employed by both the Market Conditions and Tactical Models were identical to those we are using now. And reassuring because the first cycle uses an entirely independent dataset from that we have been using for the current market cycle.

Distribution verification

All of our strategy results are based upon Total Return. All calculations are performed using “Adjusted Close” data which includes distributions. The accuracy of the distribution information is therefore critical to the accuracy of both fund selection and monthly reporting.

I downloaded distributions from our quote providers, verified distributions against fund sponsor data, provided corrections where needed, and then verified that corrections were applied correctly. I was pleased to find that the accuracy for our funds was very high with our primary provider. The few corrections resulted in a 0.1% increase in CAGR for Adaptive Global by 0.1%, no change for Adaptive Income, and a 0.1% decrease for Adaptive Innovation. I am working with our backup provider to bring their accuracy to the same level.

Market

From the December 27th Market Monitor

Another strong week for the major equity indexes  The mid and small cap, Broker Dealer, Banking and Housing indexes all lagged with the small cap and Broker Dealer indexes declining. On an intermediate trend basis, there is a clear concentration in mega cap stocks. That said, virtually all indexes are climbing including international developed and emerging markets. Even China’s Shanghai index is nearing a breakout from a six month base.

Cumulative Advancing Declining Volume remains solid on an intermediate term basis but is weakening on short term basis. The Short Term Breadth Model is showing all indexes in bearish divergences.

In the credit markets, global yields and spreads are trending lower and investors are comfortable taking on more risk. Key spreads are returning to historical lows and several of the credit market indexes are at/nearing levels last seen in January 2018.

Although the 10 year Treasury declined a bit this week, it appears headed higher to 2.1%. Wage growth for the bottom 25% of workers has moved up to 4.5% during the past year. 

Market Cap divided by GDP moved up to 153% and prices continue to stretch above 2 standard deviations on daily, weekly, and monthly charts. In short, the trend is very strong with a 3308 target on the SPX accompanied by a very high risk of a very fast 10%+ correction. While the risk of a fast and furious decline is extremely high, this is not a market which should be shorted.

Outlook and Strategy

I believe we have entered a period lasting a decade or more during which the social, political, and economic changes, both domestically and globally, will be profound. Societies and economies have long cycled in both generational (20+- years) and multi-generational (80-100 years) periods. We appear to be entering the terminal phase of a multi-generational cycle. While there is substantial evidence which supports this assertion, I will highlight just a few points:

  • The number one driver of change will be populism which is on the rise globally. Domestic populism is rapidly gaining strength on both sides of the aisle and while the policy prescriptions differ widely, the forces driving populism coupled with demographic shifts will engender massive shifts in financial priorities. This will include more public spending, larger deficits, higher taxes, and growth of the Fed’s balance sheet.
  • Credit is an economic tool which amplifies the contribution of equity to drive economic growth when used wisely and a tool of economic destruction when used to excess. Investment in public infrastructure and corporate capital assets produces benefits/income with which to pay the debt. Spending on wars and stock buybacks produces no long term benefit. Government and private credit in the US and the world has grown to far exceed the income available to fund and repay outstanding credit. Global debt to GDP ratios are far higher today than they were prior to the Great Financial Crisis and ultimately will be proven unsustainable.
  • Global demographics in developed countries (and even China)  no longer favor growth. In fact, the aging societies all favor a spend-down of assets by the baby boomer generation which is deflationary for asset prices.
  • The US has long enjoyed an unrivaled position as military and economic hegemon. That position has imposed costs and obligations on the US which are no longer acceptable to an electorate which has grown tired of global involvement and loss of jobs to global trade.

Similarities to the 1930’s are hard to overlook. In some respects, conditions are more extreme while in other respects less so. But it should be remembered that even at the worst, the economy and markets continued to function and there were opportunities for profit. So what are some of the outcomes we should expect?

  • Lower interest rates will work until lenders lose confidence in the ability of debtors to repay the debt. When that occurs, lenders will prefer to hold cash over making loans. Economic growth will stagnate without credit. The antidote will be rising rates.
  • Modern Monetary Theory (MMT) is seen as the next great panacea as confidence wanes in the ability of Central Bank monetary policies to provide sustained economic growth. Another term for MMT is deficit spending, even during times of economic growth and that’s been the practice since the Great Recession. As deficits expand beyond the ability of the markets to finance them at low rates, the Federal Reserve will step in to expand its balance sheet.
  • Disintegration of the old global order is evident globally. Shifts and realignment of the global order will bring less cooperation, greater conflict, and higher costs. The rapid expansion of global trade is no longer seen favorably in developed economies which have suffered large job losses. Global supply lines are being permanently ruptured and redrawn with costs more likely to rise than continue decreasing.
  • Global credit balances can not be repaid and will eventually require a giant “reset” which will likely require global Central Banks to “write off” the massive government debt held on their balance sheets. This will most likely be accomplished with the printing press.  This will roil the currency markets unless the write offs are coordinated globally.

So what are the investment options in an environment which will prove challenging?

  • Cash is a solid defense against declines in the prices of both equities and fixed income; however the value of cash will decline against price inflation which is likely to be an eventual byproduct of fiscal stimulus and currency printing. Investors will need to be nimble in moving into and out of cash.
  • Precious metals (along with some commodities) are among the very few asset classes where valuations remain well below all time highs. Precious metals generally perform well during times of political and economic risk, when the cost of money is extremely cheap, as a hedge against a weakening currency, and during times of inflation. A sustained period of cheap money and elevated risk are likely to produce above average returns in precious metals.
  • Equities are perilously highly valued; however there are five cases which merit investment consideration. The first is a temporary spike higher driven by a sudden collapse in interest rates and/or expansion in monetary supply. The second is following a major correction or bear market. The third is in non-US developed market equities which carry PEs 25% - 30% lower than US equities. Fourth, GMO, which regularly projects 7 year returns for major asset classes, projects the most significant 7 year returns globally to come from Emerging Market equities. The fifth is innovation (biotech, medical, computer, artificial intelligence, robotics, etc) which will continue to advance no matter the economic and social conditions.
  • Government bonds are also carrying historically low yields. With the effectiveness of monetary policy stimulus now coming into question; the only stimulus which remains untapped is fiscal. (Although the US is currently running a large deficit and engaging in Modern Monetary Theory (MMT) "light", the chorus for full scale MMT is getting louder.) MMT will lead to much larger Treasury issuance and a contest over who (investors or the Fed) will absorb the rising supply. The safest bet is that the Fed will continue to expand its balance sheet to absorb most of the supply. There are two cases which merit investment consideration. The first is continued decline in US interest rates where we could very well see a decline in the 10 Year Treasury to 0.9%. The second is a significant decline in equity markets accompanied by panic in the credit markets which would send "safe" government bonds soaring. While income might be considered a third option, the real (after inflation) yield on the 10 Year Treasury is already negative.
  • The corporate bond market is a disaster in waiting. Record issuance has been devoted to stock buybacks rather than investment in capital assets which would produce income to pay off the debt. The quality of corporate debt, as measured by the quality of the covenants, is historically low. 40% of "Investment Grade" bonds are rated just one notch above junk. With the exception of the highest quality A+ rated bonds, there is one case which merits investment consideration: investment following a major collapse and bottom in high yield debt which should provide stellar performance in high yield. While income might be considered a second option, the risks of principal loss and possible default are simply too high for all but the highest quality bonds.

One might liken the above choices to a game of Dodge ‘Em so the question is how to navigate the process. This is my strategy:

  • Hold a core position in gold with a three to five year (or longer) horizon. The time to exit will be when it is nearly priced to perfection.
  • Hold a position in cash and very short term Treasuries depending upon my overall perception of risks until market conditions turn Favorable.
  • Hold a position in a macro long/short hedge fund we have owned for nearly a decade (since closed to new investors).
  • Hold positions in a diversified group of Tactical Asset Allocation strategies designed to navigate among opportunities presented in domestic and international equities, investment grade and high yield fixed income, precious metals, commodities, and cash.

 

Earl Adamy

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Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

We make extensive use of index funds and most of those have predecessor Open End Funds (OEFs) using the same index,. We use infill from Open End Funds to construct fund "similar" tables for two full market cycles beginning in 2000. In each case where we have used an Open End Fund for infill, we consider the indexing and/or subclass to be substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second cycle, they also offer the advantage of completely out of sample data.

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.

Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

We make extensive use of index funds and most of those have predecessor Open End Funds (OEFs) using the same index,. We use infill from Open End Funds to construct fund "similar" tables for two full market cycles beginning in 2000. In each case where we have used an Open End Fund for infill, we consider the indexing and/or subclass to be substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second cycle, they also offer the advantage of completely out of sample data.

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.

Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

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.