Tactical Asset Allocation – February 2022

Tactical Adaptive Strategies Update

Performance

Adaptive Global finished with a gain of 1.33% for the month and loss of 0.20% YTD. The strategy spent the month invested in domestic big caps, commodities, and cash. Adaptive Global is our most broadly diversified “go anywhere” strategy with a 22+ year CAGR of 14.8%, a very modest maximum drawdown of 7.7%, and a low 9.4% standard deviation of monthly returns.

Adaptive Income finished with a loss of 0.69% for the months and loss of 0.98% YTD. It was invested in Senior Loans. With a 22+ year CAGR of 9.6%, this strategy captures nearly $6+ dollars of gain for every $1 in loss. It sports our lowest maximum drawdown of 3.9% and our lowest volatility with a standard deviation of just 4.3%.

Adaptive Innovation finished with a loss of 0.82% for the months and 2.76% YTD. Adaptive Innovation was invested in a combination of Treasuries and cash. This is a niche strategy intended to be used for a very small portion of a diversified portfolio. It sports a 6 year CAGR of 20.%, maximum drawdown of 20.3%, and standard deviation of 17.2%.

The S&P 500 finished with a loss of 2.95% for the month and loss of 8.07% YTD. It has a 22+ year CAGR of 7.0%, maximum drawdown of 50.8%, and standard deviation of 15.0%.

See the strategy descriptions, charts, and tables below or on the Strategies page.

Perspective

The Tactical Model has placed the TAAStrategies at the highest degree of risk aversion with extreme levels of cash. The reason for the shift is easy to understand when looking at the state of our Market Conditions and Tactical Models:

  • The Market Conditions summary provides an overview of current market risk conditions as well as the likelihood of a shift. The current Balanced condition reflects a market still holding onto bullish momentum, unacceptable credit conditions, and the most extreme valuations observed in history.
  • The Tactical Summary provides trend direction and confidence levels for each of the 30+ asset classes and subclasses incorporated across the three strategies. Just two are positive.

While my weekly Market Analysis has zero input into the TAAStrategies Models; my analysis of the Credit Markets suggests a high level of instability.

We can hope that these risks will diminish quickly.

Models

With all that is going on I thought I’d do a quick review of our models and what they are telling us about the markets.

Market Conditions Model

The Market Conditions Model is a multi-factor model that tracks price momentum, credit markets, and valuation; then analyzes the interrelationships of these factors to identify periods of high and low directional probability.

  • Favorable: A strongly trending market with little risk of major decline. Unexpected declines are likely to be temporary and relatively short-lived.
  • Balanced: Risks of market decline and opportunity for advance are roughly equal; however conditions are supportive of increased volatility and uncertainty.
  • Hostile: High risk of sudden declines, extended market corrections (10%+), bear market (20%+) declines, and large equity drawdowns.

The Market Conditions Model measures market conditions in a probabilistic way. For example, it may signal Favorable conditions if there is a high probability of a market rise with low risk. However, a signal of Favorable conditions is not a guarantee of a Bull Market nor does a signal of Hostile conditions presage, with certainty, a Bear Market.

However, the three conditions, when coupled with the appropriate fund baskets, work incredibly well in lowering risk and improving returns across full market cycles (for more information see What Is A Market Conditions Model? How Does It Lower Risk?).

The key takeaway here is that each market condition is linked to a basket of funds from which the Tactical Model makes its selections. Each fund basket consists of a range of asset classes including equities, fixed income, and commodities as well as numerous sub-classes within each asset class.

While the Market Conditions Model continues to signal a Balanced condition, it has been hovering much closer to a Hostile condition. Market condition signals are binary so we don’t anticipate changes until they occur.

Tactical Model

The Adaptive Global and Adaptive Innovation strategies use the Market Conditions Model to select the appropriate basket of eligible funds. Adaptive Income does not use the Market Conditions Model because it works with a fixed basket of financial funds

The Tactical Asset Allocation begins with the basket of funds and ranks them from best to worst. Adaptive Dynamic Momentum is our proprietary algorithm which employs deep computational statistical analysis across a wide range of periods to identify those funds which have the best combination of strength and probability that the trend will continue.

Adaptive Dynamic Momentum is supplemented with volatility management designed to meet the Targeted Volatility for each strategy. Targeted Volatility ranges from Adaptive Income at the low end, Adaptive Global in the middle, and Adaptive Innovation at the high end. The differences can be observed in the Standard Deviation Of Monthly Returns and the Ulcer Index reported in each strategy table.

The Tactical Model can and will reduce risks independently of the Market Conditions Model.

Market

From the February 25th Market Monitor

The broad indexes were generally up, led by small and mid caps (up 0.6%) and trailed by the mega caps (down 0.3%). The Broker Dealer and Banking indexes were down more than 1%. Housing was up 0.6%. Short term momentum for the broad indexes has shifted from bearish to neutral and rising. Intermediate term momentum for most of the broad indexes remains bullish but falling. Price targets continue to point down. The S&P 500 targets 3945 and 3992 after meeting the previous targets at 4133 and 4122. Some momentum measures suggest the price low is already in place.

Cumulative Advancing Declining Volume continues to show intermediate term bullish divergences to price while the short term bullish divergences disappeared this week. The overall picture suggests more corrective action with moderate downside risk.

The Credit Market Index declined again this week. Domestic and Global investment grade, high yield, and junk bond yields and spreads to Treasuries are all rising sharply. This suggests sharply increased downside risk.

High Yield has risen from 3.9% to 5.7% and CCC (junk) has risen from 6.5% to 9.5% during the past 6 months. These are huge increases for businesses reliant on speculative grade credit. Many of these are zombies which survived only because they could get super cheap credit. We can expect problems to show up in small caps and loss producing “growth” companies.

The current watch list :

  • The Speculation Index is trending down as investors reduce risk
  • The Russell 2000 has now broken down from its long consolidation after its breakout rally failed..
  • Apple and Google are the only remaining stocks of the seven mega-cap market leaders which have not turned down.
  • The shift from growth to value has accelerated in both big and small caps.
  • Consumer Staples is much better bid than Discretionary which is risk off
  • Investor inflation expectations are now rising again after falling sharply
  • Overall market breadth is improving across the major equity indexes
  • The VIX levels in the S&P 500 and Russell 2000 are showing bullish divergences to price while VIX in the NASDAQ 100 is confirming the decline.

Last week, I suggested that “The market is likely to retest the low of January 24th. I have targets for the S&P 500 at 4171 and 4133 which would exceed the January low by a 100+- points.” The low came in at 4114 before rallying 6.6%!

The equity market is giving the appearance of correcting. Ordinarily, given the current set of technicals, I would lean toward more correction in time than in price. However, given current conditions in the Credit Market coupled with the possibility of draconian financial sanctions, the downside risk is considerably heightened.

Thank you for reading.

Earl Adamy

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Exceptional results are due entirely to the complementary strengths of our Market Conditions Model and our Tactical Model.