Tactical Asset Allocation Strategy Update
Global Core was up 1.66% for July and up 0.15% for the year to date as the Tactical Model shifted from cash in June to fully invested for July. While small and mid caps led gains early in July, big caps picked up strength as the month progressed and ended up contributing the majority of gains. Our Treasury position was down slightly.
A "Correction" is an equity market decline greater than 10% and less than 20%; in short, a significant interruption of a Bull or Bear market trend. Tactical Asset Allocation models are very effective in identifying Bull trends and Bear trends but they are challenged during Corrections when there is no trend. This tends to produce a series of frustratingly small gains and losses until the original trend resumes or a new trend begins.
While equity trends have improved, the S&P 500 has spent 4 months attempting to undo the decline from the January 26 high which took just 10 days. There have been 5 retracements during the 4 months, all of which have been deep and a major change in market character from the 5 month, non-stop rally which preceded the Correction.
Two words: "secondary high", sums up my current equity market outlook. By secondary high, I refer to a high which may be lower or nominally higher than a previous high but one which completes an important market top. A secondary high is also accompanied by lower momentum and lower quality market breadth. I see both in the TAAS Tactical Model and in my weekly market analysis. That said, there are currently few signs that a top is complete and there appears to be an excellent chance that at least some equity indexes will mark new all time highs.
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 and high yield go their own ways. Once the markets stabilize, Treasury rates are going to start rising again as debt, currency, and inflation issues take center stage.
Global Adaptive Strategy
I expected to introduce an improved strategy late this summer or early fall. While I am not finished with my research and development; improvements became significant enough to warrant moving the timeline forward with an interim update to the strategies. Adaptive Dynamic Momentum, which I have spent nearly 5 years developing, played a major role in improving results. The new Global Adaptive Strategy was released to subscribers for the July 31 Rebalance and I have shifted all of our personal TAAS investments to the new strategy. The website will be updated with new information as time permits.
The Tactical Model reports a Compound Annual Growth Rate of 17.5% and a Maximum Monthly Drawdown of 8.8% for the Global Adaptive Strategy across a full market cycle beginning with September 2007. The strategy also produces a much smoother equity curve with a reduction in the Standard Deviation of annual returns from 11.5% to 9.1%:
Note: the table above is produced from backtested results using real closing prices, and Market On Close orders which are filled at closing prices, but do not include trading costs
There are three major improvements: the fund baskets are more diversified, the trend identification is far more robust, and there is no longer a need for internal hedging.
The new Balanced Conditions basket includes 8 funds including US equities, International (Europe, Asia, Emerging) equities, real estate, commodities, precious metals, Investment Grade and Treasury funds. The fixed income funds span a very wide duration of 0.1 to 17+ years. The broader basket is intended to provide the Tactical Model with improved opportunities to adapt to shifts in domestic, international and fixed income markets even if they are unlike anything in recent history.
The new Favorable Conditions basket consists of 14 funds including US index and sector funds, real estate, international (Europe, Asia, Emerging) equities, and longer duration bonds. Exposure to each of the major classes: US equities, International equities, Commodities (including Precious Metals) and Fixed Income can each range as high as 100% broadening exposure to future opportunities.
The new Hostile Conditions basket includes 9 funds, primarily fixed income of intermediate to long duration and includes a couple of equity funds which capture additional gains during equity rallies within hostile markets.
A thorough reading of research papers on Tactical Asset Allocation going back to the 1970's reveals that development of TAA models has been based on using fixed length periods for trend identification. A typical example would be calculating the change in price over a fixed period of 10 months or even a combination of 1, 3, 6, 13, and 26 months (or weeks). The rate of change is then compared for each fund in a basket to select those with the strongest momentum.
While use of fixed length periods has proven robust over many decades of testing; the period(s) selected is either arbitrary and/or optimized to previous history. The use of fixed periods fails to accommodate the many reasons why cycle lengths vary across funds based upon country-specific or global economies, asset classes, and even sectors. Consider the simple fact that fundamental and technical events do not occur on a regular schedule and you begin to understand why predetermined lengths for measuring momentum are less than ideal. It is even less ideal to apply the same predetermined length to each fund in the basket.
I first began working on an alternative approach to trend identification in early 2014 but I was unable to develop it to the level which would make it both practical and competitive with fixed period momentum. I did, however, continue to work on the technology as time permitted. My study of market history back to the early 1900's makes it abundantly clear that we are approaching the end of a major market cycle which began in the early 1980's. It is clear that the markets are changing and shifting. This added urgency to the need for a more dynamic and adaptive technology.
What I now refer to as "Adaptive Dynamic Momentum" (ADM) staunchly resisted initial attempts to "tame" it; however the pieces have now fallen into place and it is proving to be as robust as I envisioned. ADM couples intensive computation with a statistical approach to validating and selecting the momentum look-back period for each fund, each week. ADM not only identifies well-established trends but is quick to adjust when an established trend begins to falter or reverse. In short, ADM handily out-performs single and weighted period momentum across virtually every diversified basket of funds I have tested.
Equities generally carry significantly higher annualized volatilities (18%-35%) than fixed income (1% to 15%). Volatility Weighting is a technique used to reduce portfolio volatility by using the inverse of the fund's volatility in the allocation process by giving higher weights to funds with lower volatility. For example, Funds A, B and C with volatilities of 5%, 10%, and 20%, when allocated in a volatility weighted portfolio would have weights of 57%, 29%, and 14% respectively.
While Volatility Weighting can significantly reduce losses by reducing exposure to high volatility funds, it has the disadvantage of reducing returns. Earlier versions of the Tactical Model incorporated both Equal Weighting and Volatility Weighting capabilities; however it was not until the development of Adaptive Dynamic Momentum that fund selection accuracy increased sufficiently to allow the use of Volatility Weighting without compromising returns. The Volatility Weighting algorithm has been significantly improved and now produces results which out-perform the Equal Weighting which has been used previously.
All equity positions in the original Global Core were combined with intermediate term Treasuries (up to 35%). This was accomplished by blending the equity with the Treasury to target a 12% volatility for the combination. A simple example would be combining 50% of an equity with 20% volatility with 50% of a Treasury with a 6% volatility for an overall 13%+- volatility. The overall volatility of Global Core (as reflected in drawdowns) was roughly half the volatility of an unhedged basket.
Adaptive Dynamic Momentum has increased the accuracy in measuring trends to the point where internal hedging is no longer required to bring volatility and drawdowns within targeted levels. Volatility has been further reduced through the use of Volatility Weighting.
What has not improved?
While the improvements are impressive, they are not a panacea for the doldrums experienced by tactical strategies during periods when markets are shifting trends. These are times which require patience until a fresh trend develops whether that trend be up or down. The true benefits of Tactical Asset Allocation are measured across a full market cycle.
Daily and Weekly Website Updates
The Proforma "Portfolio" page (which now includes both old and new strategies) 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.
Tactical Asset Allocation Strategy Performance
Global Strategy (Conservative)
Year-to-date: 0.15% gain
Full cycle-to-date (Sep 2007): 12.62% CAGR, 6.89% Max Monthly Drawdown
Global Strategy (Aggressive)
Year-to-date: 0.15% gain
Full cycle-to-date (Sep 2007): 15.86% CAGR, 8.22% Max Monthly Drawdown
Global Adaptive Strategy
Month: 1.04% gain
Year-to-date: 3.7% gain
Full cycle-to-date (Sep 2007): 17.5% CAGR, 8.8% Max Monthly Drawdown