Tactical Asset Allocation – May 2021

Tactical Adaptive Strategies Update

Performance

Two of our three strategies were up for the month of May.

Adaptive Global finished with a gain of 1.36% for the month and 11.54% Year To Date. The gain was led by positions in commodities and the Asia Pacific region.

Adaptive Income finished with a gain of 1.03% for the month and 6.37% YTD. Adaptive Income was invested entirely in high yield muni.

Adaptive Innovation finished with a loss of 4.23% for the month and loss of 1.96% YTD.

Perspective

Those who watch financial television or read financial articles will be very much aware that the ARK Funds and founder/CIO Cathy Wood have been getting a lot of bad press. Both received fawning attention during their meteoric rise from upstarts to $80+ billion in Assets Under Managements. Now that the worm has turned, the pundits who forecast the inevitable pullback are celebrating with high fives.

I raised the caution flag for subscribers in December and again in February when I wrote:

The ARK funds “innovation” mandate is a market niche in which there are a limited number of quality companies in which to invest. Investment flows into the ARK funds are now so large that their purchases are driving selected stock prices upward which propels the fund prices higher which begets even more fund purchases which begets higher stock prices. An increasing share of ARK funds are invested in companies where they own 10%+ of the float.

This is a virtuous circle until it isn’t. The day will come when the entire process shifts into reverse.

ARK Innovation (ARKK) lost 34.5% from high to low and 9.2% for 2021 to date. Our Adaptive Innovation is off 2.3% for 2021 to date. Our volatility weighting and risk management algorithms have worked well.

I continue to believe strongly in our Adaptive Innovation strategy; not as a primary investment but as a portfolio niche which provides exposure to the fastest growing segments of our economy.

I also believe that Cathy Wood and the ARK Funds will continue to successfully seek out companies which are our future. Here is a recent quote from Cathy Wood:

“we believe as much as 50% of the companies in the S&P 500 are going to be disintermediated or disrupted by the five innovation platforms around which we have centered our research: DNA sequencing, robotics, energy storage, artificial intelligence, and blockchain technology”

Of course, there will be a good share of duds. And considering the extremely high valuation of the entire equity market, it is quite likely that the ARK Funds may see more downside.

In other words, I expect more volatility. Adaptive Innovation is designed to dampen the volatility; however I continue to recommend a small allocation. Tactical Innovation carries a 5% weight in our family’s tactical portfolio. I expect that 5% will continue to add a small but significant incremental return to our tactical portfolio. When we finally see a major correction in our equity markets, I will consider increasing that 5% to 10%, perhaps a tad higher.

One other point of interest. The ARK Funds have consistently led competitive innovation funds in my testing. An excellent example is the comparison of ARK Innovation (ARKK) versus the Blackrock Science & Technology Trust (BST). For the period October 2015 through April 2021, ARKK produced a significantly higher CAGR (41.0% vs 33.9%) with similar Maximum Monthly Drawdown (22.7% vs 21.2%). While the innovation space will always be volatile, we appear to be riding the right horse.

New Subscription Option

The Adaptive Income strategy is unique among the three strategies in that it includes no equities, does not use the Market Conditions Model and employs a very short duration version of Adaptive Momentum. I have created a new Adaptive Income strategy only subscription option for income focused investors. The Adaptive Income subscription is fully upgradeable to All Strategies at any time.

Market

From the May 28th Market Monitor

"The major indexes were all up on the week led by small caps and the NASDAQ 100. The past six weeks have been far more about sector rotation rather than advancing price. Both Intermediate and short term trends remain bullish and overbought.

The S&P 500 has moved from 2305 in March 2020 to 4204 (weekly closes) with a 7% correction and from 3269 in October to 4204 with little more than small hiccups. To say valuations and momentum are historically stretched is an understatement. That said, targets of 4350 and and a blow-off extreme of 4531 remain in play.

Cumulative Advancing Declining Volume improved this week; however it remains somewhat negative. While the advance from the October lows has been confirmed by CADV; there are signs of distribution beyond the slightly negative CADV. During the past 30 trading days we have seen 9 Distribution Days and 0 Accumulation Days.

As I wrote last week: “Although not quantified in the momentum measures, there is a sense that  upward momentum is stalling. Next week should provide more clues regarding future direction.” We have few new signs of improvement. Perhaps next week.

One item which keeps me somewhat sanguine is the Credit Markets Index. It improved slightly this week due to widening of US and Emerging Market high yield spreads. There are simply no signs of the stress in credit markets which typically precede major shifts in equity investor psychology.

The 10 year Treasury yield appears to be range bound. A break above 1.7% keeps my 2% target in play while a break under 1.5% would signal a reevaluation is due.

We are seeing a problem in the Treasury market. The Fed is being forced to sell short duration Treasuries to sop up excessive bank reserves  (stimulus deposits) while purchasing longer dated Treasuries to contain upward pressure on yields. This is the Fed “twist” to which I have referred in previous weeks. It may be the precursor to Yield Curve Control which will be needed to control yields if the size of the deficits keeps expanding (very likely); especially if the economy begins to show signs of weakness.

Equity market valuations continue their rise into eye popping levels. Market cap to GDP which touched 150%+- at previous peaks has now risen into the 200% range. The reversion, when it occurs, is likely to exceed all modern historical precedent. Markets run on investor psychology and the reversion will not occur until there is a major shift."

Thank you for reading.

Earl Adamy

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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)