Tactical Asset Allocation – November 2018

Tactical Asset Allocation Strategy Update

Performance

Global Adaptive declined 1.61% for November while retaining a YTD gain of 0.24%. Our position in commodities, which tends to produce wide swings in performance, turned into a 9%+ free-fall which was a big drag on positive performance from other funds.

Comments accompanying allocations for November

"Our November allocations show all domestic and international equity, fixed income, and commodity markets under duress. Given the absence of strong, high-confidence choices, the Tactical Model settled upon a large allocation to short term Treasuries with the remainder allocated to a mix of domestic equity and commodity funds with slightly positive momentum and low confidence scores."

The Tactical Model had no good choices, just less bad, so it settled for the limited few with positive momentum. The low confidence levels turned out to be prescient.

That leads to a fair question: if the Tactical Model's choices were low confidence, why make the choices?

That was a question which occasioned a great deal of testing during the development of Adaptive Dynamic Momentum. Testing consistently demonstrated that high confidence choices delivered better results than low confidence choices over a full market cycle. It seemed intuitive that cash might be preferable to investing in low confidence choices with positive momentum so I thoroughly explored that option. Surprisingly, returns plummeted over a full market cycle producing a negative trade-off for modestly lower volatility

Market

The S&P 500 is up nearly 2% on the month following the decline of 10.6% from its high. The decline in equities reached short term extreme levels and was due for a substantial rebound. We got a sharp rebound in early November; however it failed to hold leading to a new closing low. A second attempt is now underway.

It is the quality of the rebound which will inform us whether this is a correction in a continued bull market or the top is in with a bear market ahead. While equity markets will likely get a good pop from the tariff “truce” with China, the issues surrounding technology, security, and critical industry targeting are unlikely to be resolved … ever … because they are fundamental to the very power and survival of each country.

The chairman of the Fed was seen to make a major shift in outlook in assessing prospects for future rate increases. Essentially, he retracted his previous "a long way from neutral” comment in favor of “data dependent” because the earlier comment had placed the Fed on the political hot seat. What he did not say was that earlier conditions had changed materially which suggests to me that “dovish” is more likely a perception rather than fact. The Fed failed to raise rates when it could/should and the new Chair is now focused on trying to reload ammunition for the next series of rate cuts.

Cumulative Advancing Declining is not performing as well as price. While we did get one 9:1 up:down volume day in the S&P 1500 Composite; accumulation across indexes and sectors is lagging the sharp price move driven by the allegedly dovish comments from the Fed. Perhaps we’ll get another 9:1 from the “truce” and the market will once again be off to the races.

Credit spreads continued to rise this week. Another week or two will inform us if investors are truly shifting their opinions regarding risk or if all is well now that the Fed is allegedly dovish.

The 10 Year Treasury moved down to what should be strong support at 3%. Again, we need to see if the markets weigh the alleged Fed dovishness more strongly than the coming debt issuance from the Treasury.

We may see part or all of a Santa Claus Rally; however caution is warranted.

Outlook and Strategy

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.

Rising rates always cause dislocation in the credit markets as interest costs rise, profits decline, and the least credit worthy borrowers delay and default. With a historically high 75%+ of new loans being written with "lite" covenants and 45% of Investment Grade bonds carrying the lowest possible IG rating, the next credit contraction is certain to be painful. The next major decline in equities is likely to be driven by events in the credit markets.

TAAS Objectives

There are two factors in tactical portfolio management which work hand-in-hand to grow the portfolio:

  • Improving returns by investing in funds which are rising in value. We begin with a diversified basket of funds and select only the best performing for our portfolio. This takes advantage of what decades of academic research has proven is the most persistent behavior in the markets: price momentum. The details are more fully explained and illustrated in the short whitepaper "What Is Tactical Asset Allocation? How Does It Improve Returns?"
  • Reducing exposure to assets which are falling in value or even just lagging. In short, keep the "holes" shallow so that "recovery" periods are shorter and "growth" periods are longer. The website includes an easy to read whitepaper titled "What Is A Full Market Cycle And Why Should I Care?" which illustrates this using the most recent bear and bull markets.

Tactical Model building requires continuous observation of both factors because risk and return tend to be inversely correlated. Seeking higher returns requires taking more risk which generally leads to deeper "holes". Deep holes lead to long periods spent "filling in the hole" which in turn delays the resumption of portfolio growth.

It was this challenge which led me to study the timing of risk. Are there market periods where risks for the same asset are either higher or lower? The answer is yes. In other words, there are times when a higher risk asset is more risky and times when it is less risky. The Market Conditions Model was the result of identifying and classifying the differing conditions which lead to higher or lower risk for the same asset. The Market Conditions Model plays an important role in increasing returns by shifting into higher risk, higher return assets when market conditions are Favorable. See the whitepaper "What Is A Market Conditions Model? How Does It Lower Risk?" for a more detailed description.

A look ahead

2018 has been a very tough year for investors. In fact, 90% of all asset classes have declined for 2018 which means diversification has offered little shelter. The good news is that a) this condition is rare and b) the condition has historically reversed the following year.

The Tactical Model does a great job of rotating into strength no matter the asset class; however it struggles when the vast majority of asset classes are declining or going sideways. The good news is that Global Adaptive has recovered quickly from a string of poor months, even during corrections and bear markets. The table below shows historical performance for the past 13 years for which we have a full set of ETF data.

Even the simplistic TAAS Momentum Model, used as an illustration in the whitepaper "What Is Tactical Asset Allocation? How Does It Improve Returns?" has not had consecutive negative years since inception in 1993.

In short, history suggests, but does not guarantee, that 2019 should see substantial improvements in trends across asset classes leading to improvements in performance. The Tactical Model will do its job whether bull market or bear as long as it has some positive trends in some asset classes.

Website

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.

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

Tactical Asset Allocation Strategy Performance

Global Adaptive Strategy

Month: 1.61% loss
Year-to-date: 0.24% gain
Full cycle-to-date (Sep 2007): 16.9% CAGR, 8.7% Max Monthly Drawdown

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