Tactical Asset Allocation – May 2018

Performance

Global Core was up 0.20% for May and down 1.47% for the year to date. The Strategy was 75% cash during May while small positions in domestic big cap and treasuries advanced and precious metals retreated.

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.

Market

The often cited rationale (low interest rates and low inflation) for the historically extreme valuations has been kicked out from under the market during the past year (Wile E. Coyote anyone?):

• The 10 Year Treasury declined sharply from 2.48% to 1.37% between mid-2015 and mid-2016 while more recently we have seen a sharp rise from 1.37% in mid-2016 to 3% last week.
• The CPI for All Items was at 0.84% in mid 2016 while it has since risen to 2.5%

While Earnings Per Share have risen considerably, fueled by stock buy-backs, total Corporate Profits as compiled by the Saint Louis Fed are just 4.9% above Q1 2012 when the S&P 500 closed at 1326 which is roughly half of where it is now. This includes just reported earnings for Q1 2018 which were sharply boosted by a combination of one time and continuing tax cuts.

(partial comment from this weekend's Market Monitor): "I’ve been doing weekly market reviews for 35 years now and every once in a while I have an “ah ha” moment. I had one this morning. Early signs of a market top are falling into place: the weekly price structure in many of the major indexes suggests that a final rally is underway and there is growing weakness in the Broker Dealer, Banking, and Housing indexes. These early signs are reversible; however they should not be lightly dismissed in a late cycle market."

Outlook

Corrections can be slow tortuous affairs which are very unpleasant for those of us who are accustomed to earning steady returns on our portfolios. In the years during which I traded actively, I enjoyed corrections: wait for the market to become short term overbought and sell, wait for the market to become short term oversold and buy. Wash, rinse, repeat.

Having discarded my trading hat some years ago, I find myself becoming impatient for the market to "get on with it". If our Tactical Model could speak, I imagine it would be telling the market something along the lines of "find an investable trend, any trend, up or down but find an investible trend".

If the past 20 years is any kind of prologue, our need for patience should be coming to an end soon as we have begun the 5th full month of Correction:

• The 1998 Correction which preceded the final blow-off to the 2000 high lasted just 3 months.
• The 2000 correction which preceded the final retest of the highs lasted 4 months.
• The 2007 correction which preceded the final retest of the highs lasted 3 months.
• The 2011 Correction which preceded a 3 year rally lasted 5 months
• The 2015 Correction which preceded the most recent rally lasted 6 months.

The behavior of the equity market suggests that it wants to return to its former highs but is having trouble finding enough gas in the tank to get there. While investors have remained relatively loyal to equities, the markets are seeing headwinds which were not so apparent last January.

While the rise in the 10 Year Treasury is likely to take a temporary respite, we have the near certainty of another Fed rate hike in two weeks. As pointed out by the article linked from this weekend's Market Monitor, opposition to the dollar as “the” global reserve currency is organizing and growing. Credit spreads, which remain at historically low levels, have clearly bottomed and are trending upward. The Treasury must issue more debt at the same time that the Fed is pursuing Quantitative Tightening by reducing its bond holdings and some of the foreigners who purchase Treasuries would prefer (to the extent possible) to reduce purchases of US debt.

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 finished a month long correction and crossed above 3% for the first time in 4+ years. 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.

Ventures which may have looked attractive under Zero Interest Rate Policies look far less attractive as rates increase. Interest costs rise for both floating rate loans and for fixed rate loans which must be refinanced.

The fact that the majority of High Yield debt (bonds and bank loans) is being issued (and reissued) 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 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.

Tactical Model Upgrade

Why upgrade our Tactical Model?

It is becoming increasingly clear that major changes are afoot both domestically and globally which are likely to drive an entirely new investment paradigm. My study of market history strongly suggests that we should prepare to navigate market conditions which we have not seen in 35+ years; namely a bear market in both bonds and equities. That will likely be accompanied by the requirement to become much more adept at investing internationally to find faster growth and hedge against dollar weakness. Finally, there may be increased opportunities in physical assets as compared to paper assets. Some of this conditions would bear far more resemblance to the the 1966-1980 period.

The current crop of Tactical Models (ours included) is largely based market history since the early 1980's which marked the beginning of the current, secular equity and bond bull markets. Rather than risk running into the proverbial brick wall at some point in the future, I decided to design and construct an upgraded Tactical Model which will dynamically adapt to a far wider range of conditions including those experienced during recent history as well as those we may experience in the future.

I have already completed work on a preliminary basket of funds which emphasizes increased domestic and international diversification across equities, fixed income, and commodities.

My current efforts are focused on Improving trend identification. A thorough reading of research papers on TAA going back to the 1970's reveals that development of TAA models has been based on using fixed length periods for trend identification. (A simple example would be calculating the change in price over a fixed period of 10 months.) While use of fixed length periods has proven robust over many decades of testing; the period selected is either arbitrary and/or optimized to previous history. I believe that I have the technology required to intelligently and dynamically adapt momentum period lengths to current market conditions.

I am in the process of writing and testing the code required to implement dynamically adaptive momentum.

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