Tactical Adaptive Strategies Update
Performance
Adaptive Global spent the month in cash and showed a gain of 0.15% for all of 2022, the 2nd worst showing in 23 years of history. Adaptive Global is our most broadly diversified “go anywhere” strategy with a 22+ year CAGR of 14.2%, a modest maximum drawdown of 7.7%, and a low 9.3% standard deviation of monthly returns.
Adaptive Income finished the month with a loss of 0.37% and a loss of 2.68% for all of 2022, the worst showing in 23 years of history. With a 22+ year CAGR of 9.2%, this strategy captures $5 dollars of gain for every $1 in loss. Adaptive Income sports our lowest maximum drawdown of 4.0% and our lowest volatility with a standard deviation of just 4.3%.
The S&P 500 finished with a loss of 5.76% for the month and a loss of 18.17% for all of 2022, the 3rd worst showing since 1999. It has a 22+ year CAGR of 6.2%, maximum drawdown of 50.8%, and standard deviation of 15.4%.
The Vanguard Total Bond Market Index Fund (entirely investment grade) finished the month with a loss of 0.84% and a loss of 13.45% for all of 2022, the worst showing since 1999. It has a 22+ year CAGR of 3.8%, maximum drawdown of 17.8%, and standard deviation of 3.9%.
For details, see the links below to strategy descriptions, charts, and tables or the Insights page.
Perspective
A Look Back At 2022
The past 12 months have not been kind to the markets. The S&P 500 is down 18% (including 5.5% for December MTD), the Vanguard Total Bond Fund (exclusively investment grade) is down 13% (including 0.5% for December MTD) and the Vanguard Balanced (60/40) Index Fund is down 17%.
Across 22 years of history beginning with 2000 and ending in 2021, Adaptive Global had never spent a month entirely in cash. During 2022, Adaptive Global Strategy has spent 6 months in cash. Of the six months it has been invested, half were up and half were down for a net 0.15% gain.
Across the same 22 years of history ending in 2021, Adaptive Income spent 1 month in cash during each of 3 years: 2004, 2013, and 2015. Adaptive Income has spent 6 months in cash this year and would have avoided a modest 2.52% loss had it spent the other 6 months in cash.
The good news is that we avoided nearly all of what has been the steepest decline in equities since 1932 and the worst decline in the bond market since 1842 (not a typo 1-8-4-2).
A Look Forward To 2023
I update my investment outlook and strategy once or twice a year. Rather than focus on specific outcomes (predictions), I attempt to describe the conditions and constraints which affect each facet of my outlook. My Outlook and Strategy has been refreshed for 2023.
While the detail is reserved for Subscribers, I share some bullet points here:
- Globalization > deglobalization
- Surplus supply > contracting supply
- Cheap energy > expensive energy
- Cheap credit > expensive credit
- Expansive liquidity > tightening liquidity
I expect we are in for a decade of markets which in many ways reprise the challenges of 1965-1982.
Comment on Modern Portfolio Theory
American economist Harry Markowitz pioneered Modern Portfolio Theory in his paper "Portfolio Selection," which was published in the Journal of Finance in 1952.1 He was later awarded a Nobel Prize for his work on modern portfolio theory.
A key component of the MPT theory is diversification. Most investments are either high risk and high return or low risk and low return. Markowitz argued that investors could achieve their best results by choosing an optimal mix of the two based on an assessment of their individual tolerance to risk.
Perhaps the most exceptional characteristic of this year’s bear market has been the total absence of inverse correlation between equities and fixed income which has been the very foundation of portfolios variously referred to as “balanced” or “diversified”. An essential characteristic of these portfolios is the reliance upon rising fixed income prices to offset some or all of the equity losses during a bear market.
Once again, the Modern Portfolio Theory emperor has been revealed without clothes. While this became apparent in 2022 with steep losses in both equities and bonds; the undressing has been going on a good deal longer.
Quite simply, as the cost of money approaches zero, all assets become correlated. The trend toward correlation has been accelerating for the better part of a decade but went unnoticed by most investors and asset managers because nearly all assets, equities and fixed income included, were in a raging bull market which was only briefly interrupted by Covid. Balanced portfolios may have been diversified across asset classes but the asset classes were moving upward together.
The vast majority of investors and asset managers neither noticed nor cared that portfolio holdings were becoming highly correlated in a bull market. Leave it to the bear to reveal the truth.
Unfortunately, one has to go back to the period between 1965 and 1982 to find a period where equities and fixed income were highly uncorrelated for extended periods of time. Prudent investment rewards those with long memories or an appreciation of market history.
What Do Our Models See?
The Market Conditions Model sees declining equity momentum, extended valuations, and significant credit market risk … in sum a market which remains Hostile and is not close to becoming Favorable.
Our two tactical strategies encompass a broad mix of 27 funds including domestic and international equities, fixed income across the gamut from Treasuries to junk, domestic and international real estate, commodities, and precious metals.
The Tactical Model calculates TrendScores for both short and intermediate trends for the funds in each of our fund baskets.
Our broadest strategy with 22 funds is Adaptive Global which shows negative TrendScores across half of all funds (including fixed income) and generally low confidence levels on those which are positive.
Adaptive Income shows positive TrendScores for 5 of the 6 with relatively high confidence levels.
There are strong indications from the Fed that it plans to begin slowing the rate of increase in the Fed Fund rate beginning in December. The last two times the Fed shifted from aggressive rate increases into a final year of measured increases were 2006 and 2018.
During both years, Adaptive Income made excellent use of its ability to switch among the six ETFs representing different sub-classes of domestic fixed income. For 2006, Adaptive Income shows a return of 8.4% with a Maximum Monthly Drawdown of 0.1% and an astounding Up/Down Ratio (gains / losses) of 14194%. 2018 shows a return of 6.6% with a MMD of 0.8% and an extremely high Up/Down Ratio of 655%.
TAAStrategies Website
We have been doing some upgrades and updates to the website. While doing a performance upgrade, we suffered a website and email outage of several hours on Thursday the 29th. I apologize for the inconvenience.
Market Monitor
Note: Market Monitor is a structured weekly process of compiling and analyzing critical information about the health of the markets. I've been doing this for nearly four decades. These are personal observations which have no effect on the TAAStrategies.
From the December 30th Market Monitor
Most major indexes except Housing and the NASDAQ 100, rose slightly in light trading this week. The intermediate trend remains mixed bearish/neutral and falling. The short term trend is neutral with slight bullish divergences; however the bullish divergences may prove unreliable due to the light trading. In broad terms for the S&P 500, the intermediate term is bearish and falling while the short term trend is somewhat oversold.
This is a combination which is likely to see the next week or two in an up/sideways direction before the somewhat stronger intermediate trend reasserts its influence. The market slightly exceeded our short term downside target of 3806 but closed above it. There is no clear short term target. The intermediate downside targets remain in place at 3390, and 2999.
Short term Cumulative Advancing Declining Volume weakened slightly this week (again on light volume) while intermediate term slightly strengthened. What is clearly noticeable is the negative divergence to price action across 9 of 12 sectors. Two defensive sectors, consumer staples and utilities, are the standouts in intermediate term strength.
The Credit Market Index was unchanged for the week at -20%. Although not yet reflected in the Index, I am seeing yields beginning to rise even as spreads remain flattish. I believe we are about to see a shift to rising spreads. A continued rise in yields and shift to rising spreads could be decisively bearish for equities.
The 10 year Treasury rose another 13 basis points this week and has recovered slightly more than half of the decline from its weekly closing high of 4.21%. I continue to believe that there is more near term upside to yields than downside. Volume in the Treasury ETFs did not confirm the rally in prices.
Across other metrics:
- There has been no sign of a critical shift from consumer staples to discretionary (risk off)
- There are some early signs that growth may be getting a bit of a bid (risk on)
- The Speculation Index is falling (risk off)
- 7 of 7 former big tech market leaders continue lagging (risk off)
- The VIX Models are (so far) not confirming the decline.
- Inflation expectations remain elevated and rose again this week (risk off)
- The 10 year/3 month Treasury spread has issued a recession ahead signal
- Small and mid caps appear to be getting the usual seasonal bid
Conditions favor a counter-trend rally which fails into the intermediate down trend. Given strong seasonals, it is quite possible that we will see an extended period of sideways price action until the mix of inflation, GDP growth, and rate hikes shows more clarity.
Shifting from hard evidence to opinion, I believe that the softness in credit spreads is transient. We have seen a taste of this in the housing market but the pain is spreading to autos, credit cards, and business loans. Defaults will begin rising above levels not seen in years. This will not be good for equity markets or businesses which extend credit.
Thank you for reading.
Earl Adamy
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