Tactical Asset Allocation – February 2024

Tactical Adaptive Strategies Update

Performance

Strategy: Adaptive Global finished the month with a gain of 2.70% and a gain of 2.98% YTD.  Adaptive Global is our most broadly diversified “go anywhere” strategy with a 24 year CAGR of 13.8%, a low maximum monthly drawdown of 7.7%, and a low 9.3% standard deviation of monthly returns.

Comment: Adaptive Global’s equity positions in S&P 500 Growth, S&P 500, and Asia Pacific performed strongly while Treasuries declined.

Benchmarks: Adaptive Global is a broad strategy that invests in global equities and averages a 36% position in fixed income.

  • The Vanguard World Stock Fund (VT) finished the month with a gain of 4.49% and a gain of 4.49% YTD. It has a 24 year CAGR of 9.0%, maximum monthly drawdown of 49.2%, and monthly standard deviation of 18.2%.
  • The Vanguard Balanced Index Fund (VBINX) finished the month with a gain of 2.72% and a gain of 3.34% YTD. It has a 24 year CAGR of 6.2%, maximum monthly drawdown of 32.6%, and monthly standard deviation of 9.8%.

Strategy: Adaptive Income finished the month with a gain of 0.59%% and a gain of 0.96% YTD. With a 24 year CAGR of 9.2%, this strategy captures $6 dollars of gain for every $1 in loss. Adaptive Income sports our lowest maximum monthly drawdown of 3.9% and our lowest volatility with a monthly standard deviation of just 4.2%.

Comment: High Yield and Senior Loans were both up for the month.

Benchmark: The iShares Aggregate US Bond Fund  (entirely investment grade) finished the month with a loss of 1.77% and a loss of 1.91% YTD. It has a 24 year CAGR of 3.7%, maximum monthly drawdown of 17.1%, and monthly standard deviation of 4.4%.

For details, see the links below to strategy descriptions, charts, and tables or the Insights page.

Financial Conditions

The Fed has reduced its balance sheet by $2.4 Trillion (25%+) during the past year; has ratcheted the effective Fed Funds rate from 0.08% in early 2022 to 5.33% in mid-2023; and has held firm against rate cuts for 9 months.

Shouldn’t financial conditions be relatively tight? Yes. Are they? No.

I watch 14 global measures of financial conditions. Here is how some of the key measures look:

  • The Chicago Fed National Financial Conditions Index “provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.” The NFCI shows the loosest financial conditions since the beginning of 2022. That’s when the Fed began reducing its balance sheet and raising Fed Funds.
  • US High Yield spreads to Treasuries provide an excellent indication of how risk is perceived in the vast middle market between highly rated mega borrowers and junk. They are also a useful leading indicator for equity risk. They have only been lower for 3+ years out of the past 24, primarily the 3 years preceding the Great Financial Crisis.
  • Even the risk of true junk is perceived as relatively low. US CCC and below spreads at 9%+- sit 20% below the 24 year average of 11.5%+-.
  • Emerging markets have historically been extremely sensitive to rising US interest rates since much of their debt is denominated in US dollars. Not so this time. In fact, spreads on emerging markets high yield bonds have only been lower for 4 years out of the past 24: mid-2004 thru mid-2007 and mid-2017 thru mid-2018.

Overall, credit is more expensive; however credit markets are not pricing in additional risk. The reduced risk premiums in the emerging markets is likely a combination of shifting trade/US dollar patterns and further maturing in their economies.

The Fed appears to consider current rates and credit conditions are somewhat normalized. The economy appears to be humming along. The Fed has established new lines of credit access for banks which it believes will allow it to respond to sector issues (think CRE). As long as nothing is breaking, the Fed is unlikely to lower rates.

AI Mania

We are caught in an AI mania which has taken the valuations of just a handful of stocks to the moon.

NVDA appears to be the shovel maker for this gold rush while others are buying shovels hand over fist. Does AI have great promise? Yes? Is there compelling evidence that these hundreds of billions worth of shovels are going to earn vast sums of money? Not yet. Have the shovel users pre-ordered more shovels than they need in order to assure their places in line? Probably. Will new shovel makers emerge? Yes. Will the market for shovels shift into balance? Yes. Will the shovel buyers find gobs and gobs of gold? Probably not. Has this scene played out previously? Yes, in the late 1990’s.

Full Cycles

Our website is chock full of performance charts and tables; however the two most valuable charts cover our returns and drawdowns across four market cycles. They should not be missed:

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 February 23rd Market Monitor

The major indexes rose strongly (1%+) this week except for small caps which fell sharply (-2%). Intermediate term momentum is bullish and overbought while short term momentum is bullish and overbought with numerous bearish divergences. Both the S&P 500 and the Nasdaq 100 have broken cleanly out of a 2+ year consolidation. While their respective major minimum targets lie at 5177 and 18472, there is a reasonable expectation of them reaching their major typical targets at 5638 and 20873 before the rally ends.

Short term Cumulative Advancing Declining Volume weakened  this week while the intermediate term is running sideways at very negative levels. Even Info Tech lost the baton of sole sector with positive intermediate term CADV to Utilities. This means that advancing volume is severely lagging price. The divergences are historic.

Market Breadth Ratios (SPX equal weight vs cap Weight , S&P 500 vs S&P 100, Ru2000 vs S&P 500, Nasdaq Comp vs Nasdaq 100, Nasdaq 100 equal weight vs cap weight) are all giving up their improvement with the exception of the Nasdaq. Breadth is very concentrated.

Market Cap to GDP is now at 183%. While valuations provide no measure of timing, they do provide a measure of risk. MC/GDP was 134% at the 2000 high and 209% at the 2021 high. In short, valuation risk is very high.

The Credit Market Index improved to 43% on the back of several tightening spreads including US High Yield and CCC junk. This means that monetary conditions are quite loose and favorable for equities. The Credit Market Index however, is not confirming the most recent (January) leg of this rally.

The 10 year Treasury moved down 3 basis points to 4.26%. The previous low was retested and rejected during the week ending Feb 2nd. Last week’s rally has provided a target at 4.42% which would represent an upside breakout from the recent range between 3.87% and 4.21% and a retracement of half the decline from the 5% high. A weekly close below 4.20% would be suggestive of further weakness.

Across other metrics

  • One VIX Model remains on a buy signal while the second remains on a  sell signal (neutral)
  • The Short Term Breadth Model is failing to confirm the later stages of this rally (risk off)
  • My Offense Defense Indicator has turned down to defense (risk off)
  • The growth/value ratios have shifted back from value to growth  (risk on)
  • The Speculation Index is turning up (risk on)
  • Big 8 “tech” stocks: 4 are bearish, 4 are bullish (neutral)
  • Inflation expectations are basing (neutral)
  • The 10 year/3 month Treasury spread widened to  -0.98% and is above its -1.63% low.
  • Industrial metals are flattening, petroleum is rising, and precious metals are falling
  • The US Dollar has completed a higher weekly high and higher weekly low and appears poised to move higher to its next target at 105.25 which lies at trendline resistance. A further rally in the 10 year Treasury would be supportive of a dollar rally.

Generally, any index with a heavy weight in technology is moving up while others lag on a relative basis; however technology appears to be losing some momentum. The S&P 500 hit its extended target this week at 5103. The structure of the breakout above a 2+ year base provides a minimum target of 5177 (+89 points) and a typical target of 5638 (+550 points).

A rising 10 year yield and dollar is likely to present some drag to equities and the big cap indexes are extremely overbought; however, there is little to suggest that the rally is in immediate danger of a major decline. This is a rally built on psychology, not fundamentals and the market is likely to power higher with brief corrections until there is a meaningful shift in psychology.

Given an upside probability of 10% in the S&P 500, there are huge downside risks in the market including concentration, valuations, breadth, and significant divergences. Ultimately, there will be a major reversal in passive fund flows which brings a 30%-50%+ decline; however that risk does not appear to be immediate.

Overall, for investors with a multi-year horizon, chasing this market offers downside risks which far outweigh the possible upside returns.

Thank you for reading.

Earl Adamy

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