Tactical Asset Allocation – February 2018

Performance

Global Core is down 3.17% for February and down 1.36% for the year to date.

Domestic Big Cap, Domestic Mid Cap, and Treasuries all gave up ground for February which broke the string of 15 consecutive months of gains ... an extraordinarily long time to go without a portfolio pullback. The TAA Model continues to find more opportunity in equities than in fixed income.

Market

The S&P 500 gave up 11.8% at its low on February 8 before recovering a little over half of its decline from the late January high. Subscribers who have been following the Market Monitor page know that I've seen no evidence to suggest that "the top" is in. While this weekend's update is yet to be performed, I found this week's market action constructive in the context of a Correction. By that I mean that while Corrections are not pleasant events, it is proceeding in a manner which favors a correction in time over a correction in price and leaves the possibility of new highs still on the table.

As I wrote last month: "While I still see so no immediate signs of a major market correction, the entire feeling is akin to being in the Twilight Zone. I've been actively investing and trading equity, bond, and commodity markets since the mid-1980's and I've never seen anything quite like this. I know this is not going to end well but I'll be darned if I can see when."

As expected, the 10 Year Treasury Yield, which closed the week at 2.86%, appears to be consolidating in the 2.9%-3.0% range. Absent a big kick from inflation, I expect that the 10 Year will remain range-bound for another month or two before moving higher. That could give equities a breather if the US does not launch a trade war. The market has a history of tolerating yield increases as long as GDP is growing and then reacting badly when rates appear to be climbing faster than GDP. While we've seen some interest rate driven volatility, I suspect we could see another 1% (10 Year @ 4%+-) before the credit markets start to react badly and bleed into equities.

Too much analogue has been made to Bush's 2002 steel tariffs which were followed by a 30% plunge in the S&P 500. The S&P 500 was already in an established Bear Market precipitated by the Tech Bull and Bust which started in March of 2000. That said, winners are more likely to emerge from negotiations than from a trade war. During the 1980's Walmart attempted to help stem the loss of jobs with a Buy American campaign; however consumers preferred the cheap imported goods. Reducing the trade deficit is going to require more domestic production and those higher costs will bleed into inflation.

Equity valuations are stretched to the second highest levels in history. Current extremes continue to suggest holding some cash as a defensive measure. It is questionable whether this Correction will justify returning some of that cash to the market.

Outlook

It is abundantly clear that we are in very late stages of this bull market and it is not uncommon for tactical strategies to lag a bit in late bull markets. However this is more than compensated for by reduced bear market drawdowns and early bull market out-performance.

I expected a "minimum 5%-10% pullback during the first quarter of 2018"; however we've gotten 11.8%. From here we could see a rally which fails ("the top") or we could see a run to SPX 3000+. General market conditions suggest the later; however it will not be a big challenge for policy mistakes to take us the other way. Whenever we get the top, I believe it is going to be viscous. That's about as far as my crystal ball takes me.

Bond investors (as a group) are generally smarter than equity investors so the degree to which the corporate and high yield markets are extended is rather surprising. DoubleLine (Gundlach) is out with charts showing both corporate and high yield are two standard deviations above trend when compared to Treasuries ... the first time in over 30 years. Still, credit spreads continue to remain fairly stable.

I very strongly believe that the next market triggering event is going to come from the credit markets which is why I spend so much time monitoring them. My general outlook is that Treasury rates will rise gradually until the markets blink.  We'll know that the markets are blinking because the credit spreads will tell us. The Fed will blink afterward. A crash will see a flight to safety in Treasuries (lower yields again) while corporate will take a small hit and high yield will take a big hit. Once the markets stabilize, Treasury rates are going to start rising again as the government's debt financing needs continue to increase. Moody's and Fitch have both warned of a possible downgrade of US credit which will be noticed in the credit markets. Ultimately, we are going to be faced with a bear market in bonds which was confirmed by weekly and monthly closes above 2.6% in the 10 Year Treasury.

Global Core is perfectly capable of switching from Equities to Fixed Income (cash and/or Investment Grade Bonds and Treasuries) on a timely basis; however it is not going to "nail" the exact top in Equities.

New TAA Strategy Coming

The equity and bond markets are my hobby and my passion. Although nominally "retired", I would quickly  vegetate without the challenge of continuing to improve my understanding of the markets and therefore the performance of our investments. I read prodigious amounts of financial material and spend many enjoyable hours working with my Market Analysis, Market Conditions, and Tactical Asset Allocation Models. (I also play lots of pickleball, travel, and play a bit of golf so I do have a life.)

I believe our current tools have served us well and provide the tools we need to navigate the final stages of this Bull Market as well as the next Bear Market. Lurking just beyond lies what promises to be a whole new investment paradigm including a bear market in bonds, the possibility of rising inflation, pension issues, a US equity market which likely cycles up and down quite rapidly (see 1966-1980), rising importance of investment in Asia, and a declining dollar.

This investment paradigm will require a new generation of Models which are capable of managing a much broader basket of assets and evaluating a wider set of market conditions.

Our management of volatility is cutting edge but the next generation will represent a major leap. Currently, our portfolio volatility level is targeted based on historical volatility. One of the major features of the new model will be the ability to target volatility to market conditions while dynamically adjusting portfolio positions based on current levels of volatility. This would mean, for example, that exposure to each asset will not only rise and fall with momentum but will rise and fall with changes in the volatility of that asset as well as general market conditions.

Fortunately, I built a great deal of modularity into the existing Tactical Model which makes it possible to upgrade rather than start from scratch. The specifications are pretty well defined and I started the development work late this week. I hope to begin publishing the new strategies, concurrently with our existing strategies, late this summer or early fall.

Daily and Weekly Website Updates

The Proforma "Portfolio" page is updated in near real-time with daily and month-to-date performance. I generally get dividends posted within a day or two of x-date. This page now includes the date of the next Rebalance Notice as well as the next Rebalance Date.

The "Market Monitor" page 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.

Earl Adamy