Tactical Asset Allocation – May 2019

Tactical Asset Allocation Strategy Update

Performance

Global Adaptive lost 2.17% for May and 0.63% YTD. Our position in long Treasuries did extremely well while positions in both equities and commodities did poorly. The decline in Global Adaptive was 1/3 of the decline in the S&P 500.

Adaptive Income lost 1.93% during May and is up 1.55% YTD. Our position in high yield bonds suffered from widening spreads to Treasuries.

This is the comment which accompanied the allocations at the end of April: ""The Tactical Model finds positive trends in all 24 funds with improved levels of confidence across most for a second month in a row. (This is a rare occurrence.)  Global Strategy selections for May, constrained by Hostile market conditions, continues to include commodities, international real estate, long dated Treasuries and big cap value equities.

The Tactical Model finds positive trends and high confidence in all 3 fixed income funds which represent the spectrum of risk from Treasuries to high yield. The Adaptive Income selection for May continues its preference for higher risk and return with high yield bonds.""

Market

Evidence is accumulating that the S&P 500 (SPX) has entered Neverland. Not unlike the fictional island where Peter Pan, its best known resident, refused to grow up, the bull market in this major equity index refuses to fully mature.

Consider that weekly closes for the SPX peaked at 2873 on January 26, 2018; 2930 on September 21, 2018 and 2945 on May 3, 2019. With a 2.5% spread across the three peaks, and intervening declines of 10% and 18% respectively, it would not be unreasonable to consider that a triple top.

The SPX has since declined from it's all time high by 6.8%. Other bellwether indexes tied to key economic sectors which I watch closely are recording significant declines from their highs:

  • S&P 400 Mid Cap 12%
  • S&P 600 Small Cap 19%
  • Russell 2000 Small Cap 16%
  • Broker Dealer Index 17%
  • Banking Index 22%
  • Housing Index 20%
  • S&P Transport Index 13%

The combination of a possible triple top in the SPX and several key indexes at or nearing bear market (20%) declines could make a reasonable case that a bear market in equities is probably underway.

But wait! Investor psychology (fear and greed) drives market multiples (PE ratios) in huge swings in either direction around "fair value". It is the huge swings in multiples which drive bull and bear markets to their extremes. I track two measures which very effectively directly monitor investor psychology.

  • Cumulative Advancing Declining Volume (CumADVol)  measures whether investors (including machines) are accumulating or distributing shares. CumAdVol remains balanced and shows little evidence that investors are distributing their shares.
  • Credit spreads measure the premium over (safe) Treasury rates required by lenders and fixed income investors. Of particular value are the spreads for high yield (aka “junk”) bonds which are first to exhibit signs of stress and fear. Domestic, European, and Emerging Market credit spreads have risen enough to spell “concern” but show no signs of spiking to “fear” levels.

While poor breadth in the broad market indexes is sounding a warning; it looks like the SPX will be stuck in Neverland until investors (and machines) feel considerably more fear. That could happen quite soon, or not. “One way to tell the time is to find the crocodile, and wait until the clock inside it strikes the hour.”

Outlook and Strategy

The great advantage of employing Tactical Asset Allocation to manage our portfolios is that we don't have to figure out where the market is going. Our Global Adaptive strategy evaluates dozens of possible trend conditions across each of the 24 funds in our basket and picks the best combination of direction, strength and confidence. Across a full market cycle, it gets far more fund selections right than wrong and when it does get one wrong, it corrects the problem.

But that doesn't mean we shouldn't pay attention to what is going on in the markets. Tops in equity markets are processes, not events. From all appearances the topping process began in January 2018.

I don't need to recapitulate the long lists of reasons provided by financial analysts and commentators to explain why the equity market should rise or fall. There are two basic facts at play:

  • The economic cycle is long in the tooth and losing steam from the 2017 fiscal stimulus while equity market valuations are extreme even as corporate earnings appear to be slowing.
  • Equity prices are based on the multiple of earnings which investors are willing to accept for the perceived risk. A bear market can not begin in earnest until investors shift their risk perception from positive to negative leading to significant reductions in market multiples. Credit markets are telling us that investors have reached levels of "concern" but not "fear".

The first fact tells us that we are somewhere near a top while the second tells us that we should remain constructive (but careful) on equities until investors reverse their risk perception.

Patience Tested

I wish we were making money! That sentence pretty much sums up my personal frustration with the market and with our tactical asset allocation portfolio which comprises roughly 60% of our investments (roughly 40% in Global Adaptive and Adaptive Income). We have two primary investment objectives.

  • Protect our principal. We are retired, both have a life expectancy of 20+ years, and rely upon our investments to provide a comfortable lifestyle. We are not in a position to “start over”.
  • Earn returns which are commensurate with moderate risk. We employ a limited number of investment strategies, each of which must pull its own weight on a long term basis.

Successful tactical strategies are generally focused on identifying and holding intermediate to long term trends. Extensive testing has demonstrated that focusing on shorter term swings results in small decreases in portfolio volatility at the cost of much lower full cycle returns. Global Adaptive constantly seeks to identify the strongest trend for each fund in our basket of global equities, fixed income, commodities, and precious metals. To do so, we calculate trend direction. trend strength and confidence levels across a wide range of different periods for each fund; a process which involves millions of calculations.

A review of Tactical Model outputs shows that trends within individual funds have been getting shorter and shorter since the first peak in January 2018. This means that holding periods have deteriorated to the point where we are often holding a fund position for just 1 to 3 months. This leaves us with a lot of chop after allowing for the fact that the fund’s final month return is generally negative (the reason for exit).

The Market Conditions Model moved to a “Hostile” condition at the end of January which limits equity exposure. This explains why Global Adaptive lagged the post-December rally in the large cap (S&P 500 and DJIA)  indexes.

While my (and your) patience is being tested, the weight of evidence over the preponderance of tactical asset allocation studies dating back to the 1970’s favors focus on full cycle returns as long as principal is protected during corrections and bear markets.

Subscriber Portal

The Market Monitor page in the Subscriber Portal 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. I highly recommend checking this page on a weekly basis. While this information has no bearing on the Global Adaptive Strategy, this is where you will see signs of shifts in market conditions which may provide more informed perspective than what is generally available.

Earl Adamy

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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.

 

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.

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.