Tactical Asset Allocation – November 2019

Tactical Adaptive Strategies Update

Performance

Adaptive Global lost 0.38% and 0.02% YTD. Gains in big cap equities were offset by the continuing correction in precious metals and a decline in mid-duration Treasuries.

Adaptive Income gained 0.01% and gained 0.96% YTD. The position in mortgage bonds gained slighlty.

Adaptive Innovation lost 0.24% and gained 1.45% YTD. The position in mid-duration Treasuries declined.

Our Tactical Model, which seeks to identify intermediate and long term trends, has been buffeted by a steady stream of sharp and short term changes in market direction among equities, bonds, and precious metals which has persisted since January 2018. While this has had a negative effect on returns, the Model has performed very well in minimizing drawdowns.

Tactical Model and Strategy Upgrades

Details of the upgrades to the Tactical Model and Tactical Adaptive Strategies are covered in the article I posted last week on the blog.

Please note that the performance reported above represents actual performance for November. Allocations based on the upgrades went into effect for December.

Outlook and Strategy Updates

The Outlook and Strategy presented below represents a comprehensive long term view. It will be updated from time to time when a change or correction in course is indicated.

This is a very worthwhile video for anyone who might entertain the possibility that the dollar might be in trouble, the Treasury has too much debt to sell, that rates might go up if the Fed doesn't monetize the growing debt (and maybe in spite of monetization), and that the "repo problem" was temporary.

https://www.youtube.com/watch?v=Ij9HFiCcy_g

Market

From the November 22nd Market Monitor

Indexes remain solidly overbought on weekly basis while they are bullish and falling on a daily basis. This suggests that the correction now underway will be followed by another rally. The big cap indexes continue to dominate price advances which means the market remains narrow rather than broad and healthy.

The bearish divergences in longer term Cumulative Advancing Declining Volume are growing. Small and mid cap CumADVol are especially negative. Again, this means the market is concentrated in big caps which is not healthy. All S&P cap indexes continue to show short term bearish divergences to price action.

Of the 12 sector indexes, 8 are showing intermediate term bearish divergences. The only sectors performing well are Consumer (Discretionary and Staples), Finance, and Healthcare.

The volatility of VIX is the lowest it's been since October 2017. We are due for a sharp rise in VIX.

The credit markets are generally treading water while leaning toward deterioration with the index having fallen to -31%. The spread on CCC bonds (junk of the junk) is now the highest it’s been since Nov 2017 and HY spreads are showing signs of turning up.

This still looks like a blow-off rally in seasonally strong period which could run to SPX 3308.

Outlook and Strategy

I believe we have entered a period lasting a decade or more during which the social, political, and economic changes, both domestically and globally, will be profound. Societies and economies have long cycled in both generational (20+- years) and multi-generational (80-100 years) periods. We appear to be entering the terminal phase of a multi-generational cycle. While there is substantial evidence which supports this assertion, I will highlight just a few points:

  • The number one driver of change will be populism which is on the rise globally. Domestic populism is rapidly gaining strength on both sides of the aisle and while the policy prescriptions differ widely, the forces driving populism coupled with demographic shifts will engender massive shifts in financial priorities. This will include more public spending, larger deficits, higher taxes, and growth of the Fed’s balance sheet.
  • Credit is an economic tool which amplifies the contribution of equity to drive economic growth when used wisely and a tool of economic destruction when used to excess. Government and private credit in the US and the world has grown to far exceed the income available to fund and repay outstanding credit. Global debt to GDP ratios are far higher today than they were prior to the Great Financial Crisis and ultimately will be proven unsustainable.
  • Global demographics in developed countries (and even China)  no longer favor growth. In fact, the aging societies all favor a spend-down of assets by the baby boomer generation which is deflationary for asset prices.The US has long enjoyed an unrivaled position as military and economic hegemon. That position has imposed costs and obligations on the US which are no longer acceptable to an electorate which has grown tired of global involvement and loss of jobs to global trade.

Similarities to the 1930’s are hard to overlook. In some respects, conditions are more extreme while in other respects less so. But it should be remembered that even at the worst, the economy and markets continued to function and there were opportunities for profit. So what are some of the outcomes we should expect?

  • Lower interest rates will work until lenders lose confidence in the ability of debtors to repay the debt. When that occurs, lenders will prefer to hold cash over making loans. Economic growth will stagnate without credit. The antidote will be rising rates.
  • Modern Monetary Theory (MMT) is seen as the next great panacea as confidence wanes in the ability of Central Bank monetary policies to provide sustained economic growth. Another term for MMT is deficit spending, even during times of economic growth and that’s been the practice since the Great Recession. As deficits expand beyond the ability of the markets to finance them at low rates, the Federal Reserve will step in to expand its balance sheet.
  • Disintegration of the old global order is evident globally. Shifts and realignment of the global order will bring less cooperation, greater conflict, and higher costs. The rapid expansion of global trade is no longer seen favorably in developed economies which have suffered large job losses. Global supply lines are being permanently ruptured and redrawn with costs more likely to rise than continue decreasing.
  • Global credit balances will eventually require a giant “reset” which will likely require global Central Banks to “write off” the massive government debt held on their balance sheets. This will most likely be accomplished with the printing press.  This will roil the currency markets unless the write offs are coordinated globally.
So what are the investment options in an environment which will prove challenging?
  • Cash is a solid defense against declines in the prices of both equities and fixed income; however the value of cash will decline against price inflation which is likely to be an eventual byproduct of fiscal stimulus and currency printing. Investors will need to be nimble in moving into and out of cash.
  • Precious metals (along with some commodities) are among the very few asset classes where valuations remain well below all time highs. Precious metals generally perform well during times of political and economic risk, when the cost of money is extremely cheap, as a hedge against a weakening currency, and during times of inflation. A sustained period of cheap money and elevated risk are likely to produce above average returns in precious metals.
  • Equities are perilously highly valued; however there are five cases which merit investment consideration. The first is a temporary spike higher driven by a sudden collapse in interest rates and/or expansion in monetary supply. The second is following a major correction or bear market. The third is in non-US developed market equities which carry PEs 25% - 30% lower than US equities. Fourth, GMO, which regularly projects 7 year returns for major asset classes, projects the most significant 7 year returns globally to come from Emerging Market equities. The fifth is innovation (biotech, medical, computer, artificial intelligence, robotics, etc) which will continue to advance no matter the economic and social conditions.
  • Government bonds are also carrying historically low yields. With the effectiveness of monetary policy stimulus now coming into question; the only stimulus which remains untapped is fiscal. (Although the US is currently running a large deficit and engaging in Modern Monetary Theory (MMT) "light", the chorus for full scale MMT is getting louder.) MMT will lead to much larger Treasury issuance and a contest over who (investors or the Fed) will absorb the rising supply. The safest bet is that the Fed will continue to expand its balance sheet to absorb most of the supply. There are two cases which merit investment consideration. The first is continued decline in US interest rates where we could very well see a decline in the 10 Year Treasury to 0.9%. The second is a significant decline in equity markets accompanied by panic in the credit markets which would send "safe" government bonds soaring. While income might be considered a third option, the real (after inflation) yield on the 10 Year Treasury is already negative.
  • The corporate bond market is a disaster in waiting. Corporate debt is at a record high and the quality of the debt is historically low. 40% of "Investment Grade" bonds are rated just one notch above junk. With the exception of the highest quality A+ rated bonds, there is one case which merits investment consideration: investment following a major collapse and bottom in high yield debt which should provide stellar performance in high yield. While income might be considered a second option, the risks of principal loss and possible default are simply too high for all but the highest quality bonds.
One might liken the above choices to a game of Dodge ‘Em so the question is how to navigate the process. This is my strategy:
  • Hold a core position in gold with a three to five year (or longer) horizon. The time to exit will be when it is nearly priced to perfection.
  • Hold a position in cash and very short term Treasuries depending upon my overall perception of risks until market conditions turn Favorable.
  • Hold a position in a macro long/short hedge fund we have owned for nearly a decade (since closed to new investors).
  • Hold positions in a diversified group of Tactical Asset Allocation strategies designed to navigate among opportunities presented in domestic and international equities, investment grade and high yield fixed income, precious metals, commodities, and cash.

 

Earl Adamy

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Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

We make extensive use of index funds and most of those have predecessor Open End Funds (OEFs) using the same index,. We use infill from Open End Funds to construct fund "similar" tables for two full market cycles beginning in 2000. In each case where we have used an Open End Fund for infill, we consider the indexing and/or subclass to be substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second cycle, they also offer the advantage of completely out of sample data.

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.

Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

We make extensive use of index funds and most of those have predecessor Open End Funds (OEFs) using the same index,. We use infill from Open End Funds to construct fund "similar" tables for two full market cycles beginning in 2000. In each case where we have used an Open End Fund for infill, we consider the indexing and/or subclass to be substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second cycle, they also offer the advantage of completely out of sample data.

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.

Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

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.