Tactical Asset Allocation – March 2018

(Originally published 03/31 but not sent out by the blog RSS feed, republished on 04/02)

Performance

Global Core is down 0.15% for March and down 1.51% for the year to date.

Volatility has picked up and we experienced both a sharp rally and an even sharper decline in the S&P 500 during March. While big-caps were particularly weak, our positions in both mid-cap and emerging markets turned in gains. The biggest gain was in treasuries where yields pulled back from their sharp rise.

Market (from this weekend's Market Monitor)

The equity market continues to weaken with the weakness concentrated in the mega S&P 100 and big cap S&P 500; however the selling has yet to show signs of panic. The S&P 400 mid cap and 600 small cap are faring better. Of our canaries, the Broker Dealer and Banking Indexes are doing poorly while Transport is showing strength. The Intermediate bullish trend remains intact across all indexes while the short term trend shows the indexes are oversold which should be supportive of a bounce. My general expectation is that we see this Correction move somewhat lower in price before attempting a major rally.

My major concern with the market lies with the financial and credit sectors where I track 13 different indexes. 10 of those indexes have progressively turned from Bullish (and extremely extended) to Positive to Neutral to Negative to Bearish. The whole set are intended to serve as an early warning indicator of growing distress in the credit markets before that stress becomes widely evident in the markets. "Early warning" is by intent just that ... a reminder to remain alert and prepared for changes in market conditions.

I am particularly concerned with the credit markets because all sectors of the global economy have been flooded with increasingly cheap money for a decade. Cheap money promotes malspending and malinvestment. As the cost of credit rises, investments and businesses which have been viable for the sole reason that money has been cheap, begin to fail. The detritus from a credit contraction is not pretty.

Equity valuations are stretched to the second highest levels in history. Current extremes continue to suggest holding some cash as a defensive measure. It is questionable whether this Correction will justify returning some of that cash to the market.

Outlook

It is abundantly clear that we are in very late stages of this bull market and it is not uncommon for tactical strategies to lag a bit in late bull markets. However this is more than compensated for by reduced bear market drawdowns and early bull market out-performance.

We have gotten the first quarter Correction I expected. There is no way of knowing whether the Correction will last another month or continue through "sell in May" and into October. My general sense is that the economy is going to see some weakening later this year so it's a toss-up whether or not it takes another run at 3000. Whenever we get the top, I believe it is going to be viscous. That's about as far as my crystal ball takes me.

My crystal ball in fixed income is a bit clearer. I very strongly believe that the next market triggering event is going to come from the credit markets which is why I spend so much time monitoring them. The 10 Year Treasury rose into the 2.9-3% target range and is now correcting some of that rally. Investment Grade and High Yield rates have risen in concert which means that the costs of borrowing money are rising as will the costs of refinancing the large pile of debt coming due this year and next. I think we are going to see continued pressure on interest rates.

Credit spreads are also rising. Strangely the spreads on Investment Grade have risen faster than the spreads on High Yield. The fact that the majority of High Yield debt is being issued (and refinanced) under "Covenant Lite" conditions tells us that the default rate will eventually soar far above historical averages. Overall, the tightening trend signals the very early stages of credit contraction.

My general outlook is that Treasury rates will rise gradually until the markets  blink. We'll know that the markets are blinking because the 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.

Model Upgrades

I have begun working on major upgrades to the Tactical Model to prepare for what I believe will be a return to an investment climate we have not seen in decades: a bear market in bonds, the possibility of rising inflation, a US equity market which likely cycles up and down quite rapidly (see 1966-1980), a declining dollar, and rising dominance of the global economy from Asia. Whether any/all of these things happen is less important than insuring that the Tactical Model is prepared to handle them.

The upgrade process has been proceeding nicely. Early testing with an extremely broad basket of domestic and international funds is showing promise as is a newly developed heuristic technique for trend scoring. I hope to begin publishing the new strategy, concurrently with our existing strategies, late this summer or early in the fall.

During the course of testing, I identified a minor bug which affected historical fund allocations during two months of 2011-2012. The effect of correcting the Model was to slightly reduce Global Core's historical CAGR, slightly increase Global Satellite (Favorable) CAGR@Risk, and very slightly increase CAGR@Term for both Global Conservative and Global Aggressive. Since we did not offer subscription service in 2011-2012, no subscribers were affected; however the March tables and charts include the corrections.

One upgrade which will be getting immediate attention will deal with the Rebalance in months where the last trading day of the month is also the last trading day of the week. When I first started using a subscription TAA service, I was having to do the Rebalance during the open of the following Monday and found it was a major hassle. When I built my own TAA Model, I determined to use Market On Close orders to simplify the Rebalance process and get the same closing prices as the model uses.

The Tactical Model bases allocations on weekly closes so during most months, we have the allocations several days in advance. Not so where the last trading day of the month is also the last trading day of the week … a situation which we faced on Thursday’s close. As of Thursday’s close there was considerable uncertainty whether Thursday’s preliminary allocations would hold into Friday’s close. As it turns out they did but I do not like uncertainty when placing orders.

Daily and Weekly Website Updates

The Proforma "Portfolio" page 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.

Earl Adamy