Tactical Adaptive Strategies Update
All three strategies posted very strong gains for November. Adaptive Global and Adaptive Innovation posted their largest ever gains.
Adaptive Global gained 11.38% for the month and 9.31% YTD. Adaptive Global was invested in a large allocation to the S&P 500 and allocations to Asia Pacific and commodities.
Adaptive Income gained 2.78% for the month and has gained 7.94% YTD. Adaptive Income was invested in high yield municipals.
Adaptive Innovation gained 19.63% for the month and gained 26.79% YTD. Adaptive Innovation split investments between selected ARK Innovation funds and Treasuries.
All 3 Tactical Adaptive strategies continue to outperform the S&P 500 on a risk adjusted basis.
The equity market is absolutely giddy with optimism and while we have benefited from the run, it is time to take a good look at near-term prospects.
- For months we were informed that a handful of tech stocks were pulling the major indexes higher while the rest of the stocks sagged. That has changed. The rest of the stocks are fully engaged and not just among the big caps but also among the mid and small caps.
- Breadth has been strong and has been confirming the moves in price.
- The credit markets are well supported by the Fed and yields and spreads globally are at or near historical lows.
- Measures of equity volatility have been falling and are beginning to confirm the rally.
- The equity market ratio of capitalization to GDP (aka Buffet Ratio) is now at an eye popping 180% and that includes the full post-Covid recovery in GDP. Previously, levels in the 140% to 150% have turned back every rally.
- The equity market is pushing the statistical limits of standard deviation above its daily, weekly, and monthly averages.
By every possible measure, the market is priced to perfection. It is time to reduce risk and we have a pretty decent track record in that regard. We strongly suggested reducing equity exposure in late 2017 and again in early 2020.
Could the equity market move higher? Absolutely. Will it move higher? Probably another 2 - 3%. What does the downside risk look like? Probably 7% - 20%.
We have stuck with the equity market this time in spite of higher valuation levels due to the Fed having the market’s back. But the risk/reward in equities is now expecting too much of the Fed and it is time to opportunistically rebalance risk. We are going to decrease our equity exposure and increase our fixed income exposure where the Fed is more directly supporting the credit market.
Thoughts on Tactical Adaptive Innovation
Innovation has long been a two-edged sword in the investment world. The challenge of investing at the leading edge has always been in selecting the technologies and companies in which to invest as well as the substantial risk of investing in companies which failed in their quest either through impractical ideas or poor management.
Two years ago, I set out to develop a tactical strategy which would harvest a major portion of the potential gains while significantly reducing the volatility to a level where the risk/reward would be attractive for conservative investors who would otherwise eschew innovation investing.
Tactical Adaptive Innovation, which I introduced 18 months ago, is the result of extentensive research and testing. The major caveat was that I did not have historical data available with which to test it through the 2000 or 2007 bear markets. That changed this spring when we had a 35% decline in the S&P 500.
We now have 4 major declines in the benchmark buy and hold basket of innovation funds (see whitepaper) with which to compare the strategy: -17.4% in benchmark vs +4.22% for strategy in January 2016, -11.2% vs +0.4% in December 2018, -13.3% vs + 4.56% in May 2019, and -14.4% vs -4.9% in March 2020. The Adaptive Innovation strategy appears to be meeting its objective with a very significant reduction in volatility.
The current extreme valuation levels in the major indexes suggests that most, if not all, of the future returns from equities and bonds for the next decade have been pulled forward into current prices. However, the tremendous range of innovation across multiple disciplines which has been driven by Covid-19 informs us that innovation will prosper under any economic scenario.
While Adaptive Innovation can be used to increase equity returns, investors should also consider using the strategy to replace fixed income returns lost to a near zero interest rate environment.
We have been maintaining a 5% portfolio allocation to Adaptive Innovation. We will be increasing that to 10% during the next market correction. Ultimately, I plan on having a 20% weight to Adaptive Innovation.
From the November 27th Market Monitor
"Thanksgiving week was notable for the laggards kicking into gear. While the S&P 500 was up 1.6%, the mid cap 400 rose 2.6%, and the small cap 600 rose 3.7%. Also notable was fresh strength in the broker dealer and banking indexes and the energy sector roared with a 7.9% rally. Participation in the equity market is clearly broadening as the S&P 500 outperformed the 100, the S&P 500 equal weight index outperformed the cap weight index, and the NASDAQ Composite outperformed the NASDAQ 100.
Virtually all of the indexes I track are bullish and overbought on the weekly charts and bullish and overbought on the daily charts. All but a couple of the bearish divergences on the daily charts have been removed.
Cumulative Advancing Declining Volume has been strong across all of the major S&P indexes and most of the S&P sector indexes.
The credit markets index remains bullish at 54%. Every level of risk from high quality corporate to the (CCC rated) dregs of the high yield market is positive. This includes domestic, European, and emerging markets.
Treasury yields are hanging in near the upper end of their recent range.
Gold stocks are showing early signs of strength against the physical which can be a rally precursor.
Were the equity market not so extremely extended on a valuation basis at 180% of GDP, I would expect the rally to easily add 5% to 10% to price. The short and intermediate targets for the S&P 500 are 3690 and 3718 and both are not far away. The bullish overbought conditions in the daily and weekly indexes argue for a modest correction. The extreme valuation conditions, which appear to be similar to late 2017 and early 2020, argue for substantive risk reduction measures either by trimming positions and/or rotating from extended equities into those which are just beginning to participate in the rally."