Tactical Asset Allocation – January 2020

Tactical Adaptive Strategies Update

Performance

Adaptive Global lost 2.23% for January.

Adaptive Income gained 0.76% for January

Adaptive Innovation gained 6.60% for January.

All three strategies were headed for exceptionally strong months through the first three weeks of January. The markets began taking the Wuhan coronavirus seriously coming out of the MLK weekend. It was our positions in emerging markets and Asia which sent Global Adaptive strongly into the minus column.

The problem with overvalued, extended markets is that they do not handle bad news well.

By all reports, Wuhan coronavirus can be transmitted during the incubation period during which there are no symptoms. This is a significant departure from previous viruses which have come out of the Chinese meat markets.

Moody’s was out late Thursday afternoon with a special alert and warning regarding the potential impact on the global economy and the credit markets. The warning leads off with:  “A coronavirus pandemic would be even more of a “black swan” than the global financial crisis and Great Recession of 2008-2009. Unlike the U.S. home mortgage meltdown, no one predicted the early 2020 arrival of a potentially devastating pandemic. And unlike the financial crisis, public-health and economic policymakers may be limited regarding their ability to remedy or offset a 1918 (or Spanish flu) type pandemic.”

Federal Reserve

I included a comment about the Fed In the year-end rebalance.

One area I will be monitoring especially closely is the repo market. The Fed has had to purchase (and add to its balance sheet) a half trillion dollars in Federal debt to meet the demand for liquidity. However, the jury is out on whether the problem has been solved or will be exacerbated by continued fresh issuance and rollover of Federal debt.

January is just about complete.

  • The Fed announced Wednesday that its “temporary” repo operations will continue through April. It has become clear that these “repo operations” are in fact QE #4 which is absolutely necessary to find a home for deficit-funding TBills while holding hold short term rates low. The Fed’s balance sheet is now $4.2 trillion and approaching its all time high $4.5 trillion of January 2015.
  • The Fed has proposed to remove the 2% inflation cap on inflation targeting and replace that with “average” inflation. I believe this is a clue that the Fed expects inflation to accelerate.
  • The Fed has proposed to “cap” yields. The Fed last did this between 1941 and 1951 with a ⅜% rate on bills, ⅞% on 1 year, 2% for 7 - 9 year, and 2-½% on long term.

The Fed’s cap program is discussed in a 2003 Fed paper1 which was held from publication until 2016. Here is the interesting part: “The recognition that the caps could not be maintained without exacerbating inflationary pressures eventually led to the Treasury-Federal Reserve Accord of 1951, which (among other things) discontinued the interest rate ceilings.” Note that between 1942 and 1951, inflation averaged 5.5% with a post-war peak of 18% and a rate of 8% on 01/01/1951 just before the cap was abandoned2.

1Targeting the Yield Curve: The Experience of the Federal Reserve, 1942-51
2Inflation Table By Year

I have seen estimates that the Fed’s balance sheet will expand to $10 trillion in order to finance current and future Treasury deficits through the next recession while capping the yield curve. This would be QE on a scale not yet seen.

Market

From the January 31st Market Monitor

All major indexes declined this week led by small caps, mid caps, and banking. Both intermediate and short term trends remain bullish and declines have reached a point which could support a rally.

Both the VIX and ValueLine Weekly Models triggered Sell signals on Friday. On a combined basis, these are often a good intermediate term indicator with signals lasting at least a month, often longer.

Cumulative Advancing Declining Volume shows a slight bullish divergence to the price declines in big caps and confirmation of the decline in small and mid caps. Sector CADV is mixed.

The Credit Risk Model index fell strongly to +27%. This means that the credit markets remain supportive but are deteriorating. Spreads, which had been declining have flattened but have not risen enough to change trend to rising.

Market Cap divided by GDP pulled back from a high of 157% to 151% which is still extreme. We generally see equities decline when this ratio gets into/above the high 140’s. Part of the decline is attributable to price and part is attributable to a just-reported increase in GDP.

We’ve gotten the expected “fast and furious” decline. Now we wait to see how the Wuhan virus progresses. While the developed countries may be spared the contagion seen in China, the global markets are far too intertwined not to suffer when China closes cities, factories, and transportation. This includes the emerging markets in SE Asia which have benefited from factory relocation from China yet have similarly poor social and health infrastructures. Economies on a global basis will minimally see a 3 - 6 month hit to GDP … at best.

For the time being, with no signs that a bear market has begun, I rate this as a correction with more downside risk than upside potential. The upside target at 3535 remains on the table.

Earl Adamy

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The table below shows performance for the Adaptive Global strategy through May.

Effective with the May 29 monthly rebalance, several of the ETFs have been shifted among the Favorable, Balanced, and Hostile market conditions. The strategy continues to use the same basket of ETFs, the same Adaptive Dynamic Momentum algorithm, the same selection algorithm, and the same weighting algorithm..The chart and table below reflect the changes.

Compares performance of the Tactical Adaptive Strategies to the S&P 500 and Vanguard Balanced Index Fund

Supporting tables for Tactical Adaptive Global. S&P 500 (SPY) and Vanguard Balanced Index Fund (VBINX) can be found below

Our backtest results tables are constructed for two full market cycles beginning in January 2000.

The most recent market cycle covers October 2007 to date. The fund baskets for our tactical strategies are constructed from indexed Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history.

The earlier market cycle covers January 2000 through September 2007. A number of the ETFs we use were not created until later in the decade. For those cases, we infill using predecessor Open End Funds (OEFs) for which the indexing and/or subclass is substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second, earlier, cycle, they also offer the advantage of completely out of sample data. The fact that the metrics of both cycles are very comparable appears to validate the process.

We have been asked if it is possible to extend backtests to earlier decades. While this appears to be a common practice with some services; it is not possible to produce credible results for many strategies due to the lack of funds with substantially similar indexing and/or subclass. Doing so would force me to stretch the term "substantial" far beyond my comfort level.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

Benchmark S&P 500 (SPY)

Benchmark Vanguard Balanced Index Fund (VBINX)

Compares performance of the Tactical Adaptive Strategies to the S&P 500 and Vanguard Balanced Index Fund

Supporting tables for Tactical Adaptive Income, S&P 500 (SPY) and Vanguard Balanced Index Fund (VBINX) can be found below

Our backtest results tables are constructed for two full market cycles beginning in January 2000.

The most recent market cycle covers October 2007 to date. The fund baskets for our tactical strategies are constructed from indexed Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history.

The earlier market cycle covers January 2000 through September 2007. A number of the ETFs we use were not created until later in the decade. For those cases, we infill using predecessor Open End Funds (OEFs) for which the indexing and/or subclass is substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second, earlier, cycle, they also offer the advantage of completely out of sample data. The fact that the metrics of both cycles are very comparable appears to validate the process.

We have been asked if it is possible to extend backtests to earlier decades. While this appears to be a common practice with some services; it is not possible to produce credible results for many strategies due to the lack of funds with substantially similar indexing and/or subclass. Doing so would force me to stretch the term "substantial" far beyond my comfort level.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

Benchmark S&P 500 (SPY)

Benchmark Vanguard Balanced Index Fund (VBINX)

Compares performance of the Tactical Adaptive Strategies to the S&P 500 and Vanguard Balanced Index Fund

Supporting tables for Tactical Adaptive Innovation, S&P 500 (SPY) and Vanguard Balanced Index Fund (VBINX) can be found below

The Innovation ETFs used in the Innovation Strategy were not established until 2014-2015 so our history is limited. There are no predecessor funds which are similar enough to use for infill.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

Benchmark S&P 500 (SPY)

Benchmark Vanguard Balanced Index Fund (VBINX)