Tactical Asset Allocation – March 2019

Tactical Asset Allocation Strategy Update

Performance

Global Adaptive gained 2.57% for March and 1.54% YTD. Our positions in global real estate and long bonds did exceptionally well for us while performance in commodities and precious metals were a drag.

Adaptive Income gained 2.12% during March and is up 2.54% YTD. The strategy was invested in investment grade bonds during March.

This is the comment which accompanied the allocations at the end of February: "Our Global Adaptive Strategy for March continues to avoid domestic equities but has low confidence in the negative trend. It sees positive trends in fixed income, international real estate, commodities and precious metals with high confidence in the trend. The Tactical Model selected positions in international real estate, commodities, precious metals and long duration Treasuries.

Our Adaptive Income Strategy for April continues to like high quality bonds. The Tactical Model selected a position in investment grade corporate bonds."

Clobbered By Precious Metals

As if February's 1.23% loss in CEF was not enough, we've been hit with a 3.54% loss in March. Does this mean that this gold and silver fund should be evicted from our basket? I think not.

While an up/down ratio of 147% is not exactly world beating when compared to other funds in our baskets; it does reflect the fact that precious metals contribute meaningfully to performance over a full (bear/bull) market cycle. This is particularly true during periods when market risks are elevated. There have been two periods when the Tactical Model made extensive (and effective) use of CEF: December of 2007 through June of 2009 and February 2016 and July 2017. The earlier period showed a CAGR of 14.6% while the later showed a CAGR of 16.4% (in no way entirely attributable to any one fund).

CEF was chosen because it performed better with less volatility than the very large and more popular gold funds such as GLD. Still, volatility is at the high end of the funds in our basket. Our Tactical Model incorporates volatility into its allocation which is why CEF allocations tend to be smaller than average. Allocations range from extremely low to low depending on how strongly and reliably CEF is trending. CEF's worst loss during the current full cycle  (beginning September 2007) was 18.5% on a very small 8.7% portfolio allocation and best gain was 16.2% on a relatively large (for CEF) 19.7% portfolio allocation.

Finally, it's worth mentioning that each fund in our Balanced, Favorable, and Hostile baskets has been carefully selected and thoroughly tested across a full market cycle. Does that mean we can't improve upon what we have? No. However, I am particularly adverse to performance chasing and therefore avoid frequent changes to the baskets.

The Tactical Model has moved on from CEF for April.

Market

The sharp rally off the Christmas Eve equity lows corrected in early March and then continued upward before running out of steam. Fixed income has soared on the back of the Fed's reversal to dovish

As noted in last weekend's Market Monitor: "The S&P 500 rose this week and appears ready to attempt a breakout higher. While lagging in their recovery, small and mid caps out-performed big caps this week.

Cumulative Advancing Declining Volume continues to support the bullish narrative. CumADVol for the mega cap S&P 100 closed at a new all time high this week and CumADVol on the S&P 500 is very close.

Treasuries soared again this week with the 10 Year Treasury yield declining to the targeted 2.42%. While the 10 Year could drop to 2.24%, long dated Treasuries are extremely overbought and at high risk of correcting.

Credit spreads failed to keep up with the decline in government yields. While somewhat bearish on the surface, this may be attributable to the sheer speed of the decline in government yields.

Overall, not a lot of change from last week."

Although my market work has absolutely no bearing on TAAS mechanical strategy selections and allocations, my current view is that the S&P 500 is very likely to visit 3,000 and, quite possibly, the long standing target at 3047. This is a Fed driven market, not a rational market.

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 Global Adaptive strategy evaluates dozens of possible trend conditions across each of the 24 funds in our basket 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 September 2018 and quite likely has more time to run.

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.
  • 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.

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 undergo a significant shift in risk perception.

Hostile Condition

The Market Conditions Model remained in "Balanced" condition for a record long period of 31 months due to irregular trends and extreme valuations. "Balanced" is a transition between Favorable and Hostile in both directions.

The Market Condition switched to Hostile at the end of January. The Hostile funds basket seeks returns with an increased level of safety. Equity exposure is focused on big cap value and international real estate while fixed income exposure includes a much broader range of longer duration Treasuries and investment grade bonds. It also includes exposure to precious metals and commodities which can be counter-cyclical. As always, the Tactical Model selects the basket's best performing assets each month.

We are faced with two possible outcomes here.

  • A Correction followed by a return to Balanced conditions where the uptrend resumes under extreme valuations, probably for a limited duration.
  • A deeper Bear Market which leads to Favorable conditions after washing out market excesses. The deeper Bear Market would be preferable for two reasons. First it will provide trending conditions which will allow the Tactical Model to maximize returns during the decline. Second, it will setup "risk on" conditions which can produce mouth watering returns.

The Hostile Correction scenario last occurred Sep '15 through Jun '16 (CAGR of 9.9%) and was followed by resumption of the bull market under Balanced conditions and 10.8% CAGR for the strategy. A Hostile Bear Market last occurred Dec '07 through Jun '09 and was followed by 26 months of Favorable conditions and a 29%+ CAGR for the strategy. Clearly, our greatest reward lies in a major decline followed by a new bull market.

Subscriber Portal

The Market Monitor page in the Subscriber Portal 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. I highly recommend checking this page on a weekly basis. While this information has no bearing on the Global Adaptive Strategy, this is where you will see signs of shifts in market conditions which may provide more informed perspective than what is generally available.

Earl Adamy

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