Tactical Asset Allocation – November 2020

Tactical Adaptive Strategies Update

Performance

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.

Perspective

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.

The Good

  • 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 Worrisome

  • 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.

Market

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."

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)

This strategy is intended to capitalize on trending moves in both precious metals and bitcoin if and when they occur while managing volatility to reduce risk. The strategy, which uses a basket of precious metals, bitcoin, and Treasury funds, selects the single best fund each month although it provides blended allocations when necessary to manage volatility.

Bitcoin is a relative newcomer to investable assets and we take no position as to whether bitcoin is or is not a sustainable asset class. The Grayscale Bitcoin Trust used in this strategy was not established until 2015 so our history is limited. There are no predecessor funds which are similar enough to use for infill.

The CAGR in 2017 is extraordinary; however the bitcoin trust rose 1893% from $1.17 to $22.15 during this period. While the strategy remained invested in bitcoin for 10 of the 12 months, volatility weighting significantly reduced the weighting to bitcoin from a low of 14.6% to a high of 68.0%. The use of Treasuries to manage bitcoin volatility accounts for the high percentage invested in fixed income assets.

Volatility weighting has little effect on precious metals which typically receive a 100% weight when selected.