Tactical Asset Allocation Strategy Update
Global Adaptive declined 2.81% for October and has gained 1.89% YTD. All strategy allocations declined: small caps by 10%+, big caps by nearly 7%, corporate bonds by a little over 0.6% and Treasuries by just over 0.3%.
We were fortunate that Adaptive Dynamic Momentum coupled with volatility based allocation kept our portfolio decline relatively modest.
Rebalance comments on last month's allocations
"Our October allocations once again show a bifurcated market with equity strength limited to the domestic market which limits our equity allocation. The Tactical Model likes domestic equities while avoiding all international equities. It is also avoiding commodity related funds. During a bull market, Fixed Income generally carry lower TrendScores than equities so equities get first preference. With international equities sidelined, the Model selected the best performing Fixed Income. On the Treasury side, short and mid-duration are closely competitive for the final allocation with mid-duration winning out."
The S&P 500 closed down 6.9% on the month and tagged a decline of 11.5% from its high. The decline in equities has reached short term extreme levels and is due for a substantial rebound. 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. I did quite a bit of extra review work in preparing this week end's Market Monitor commentary:
"The S&P 500 (SPX) closed the week at 2658 well within my 2640-2665 target; however the price action suggests that the lower end of the range should be expanded to 2585 or 2.7% lower which would put the SPX into Correction (capital C) territory. The SPX also closed just below the close-only trendline for the rally from the important February 2016 low; however it remains well above the weekly close-only trendline from the 2009 bear market low.
Credit spreads to Treasuries have started to widen again; however they remain contained below the highs seen during the February correction. This bears watching because while equity corrections begin in the equity market, recessions and equity bear markets begin in the credit markets.
Housing has broken down through its bull market trendline from 2009. Consumer Staples (usually loaded with value stocks), Energy, Materials, and the new Communications Services sector are all showing accumulation even as prices fall suggesting these may lead the next rally. (The Comm Svcs sector (XLC ETF) is loaded with FANGS.) China also appears to be gaining some strength.
Major indexes are 3 standard deviations below short term average, the put:call ratio is an extremely high 136%, and Cumulative Advancing Declining volume is showing large bullish divergences (selling volume is not keeping up with the price decline). This should power a very sharp rally within the next few trading days.
My overall assessment remains unchanged. “I believe it is increasingly likely that equities have seen their high for this bull market. That said, equities have typically recovered 50% to 78% of their initial decline from the all time high before entering a new bear market so there should be some room overhead for a substantial rally.” What would change my mind? Strong accumulation (CumADVol) during the next rally accompanied by a substantial narrowing of credit spreads. Can it happen? Sure. Probability? Maybe 30%."
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.
There are opposing conditions at work in the fixed income market led by Treasuries. The major trend of yields will be upward from a six year bottoming process; however the rising trend will be periodically interrupted by declines driven by slowing growth and/or rush to safety.
Even with slowing growth, however, the laws of supply and demand can not be ignored. On the supply side, the Treasury must finance a growing pile of debt with the vast majority of that debt of very short duration which requires constant refinancing. On the demand side, both foreign central banks and the Fed are reducing holdings. It is the reduction in foreign purchases which is most concerning because this has been a major factor in demand as well as the means of recycling the trade deficit.
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.
Late week brought a significant widening of credit spreads to which we need to pay close attention.
A Timely Shift
Introduction of the Global Adaptive Strategy in time for the rebalance on July 31 proved its timeliness during October:
- August: Global Adaptive 1.99% gain versus Global Core 1.79%
- September: Global Adaptive (0.78%) versus Global Core (0.59%)
- October: Global Adaptive (2.81%) versus Global Core (5.14%)
For the YTD, Global Tactical is showing a Compound Annual Growth Rate of 2.27% versus (4.56%) for Global Core . Our mix of 7 months of Global Core and 3 months of Global Adaptive shows a CAGR of (1.80%).
While occasional losses are an inevitable part of investing, I remain pleased with the improved trend recognition and classification brought to us by Adaptive Dynamic Momentum. I also remain focused on bringing continued improvements to our investment strategies.
Mauldin, Blumenthal, and TAA
I've been a regular weekly reader of Mauldin's Thoughts From The Frontline for around a decade and Steve Blumenthal's On My Radar for a couple of years now. Mauldin is a prolific writer of books and newsletters and Blumenthal is the head of CMG Wealth Management. While each includes the expected plugs for the writer's products, I generally find the writing to be insightful and charts informative.
The title of last week's letter was "The Real Cost of Low-Fee Funds". Had I written the piece, I would have pointed out that when selecting ETFs, the fees generally matter far less than the index. An excellent example in the mid-cap space is IJH (fee 0.07%) versus MDY (fee 0.24%) where MDY handily outperforms because it tracks the "S&P® MidCap 400 Index" while IJH tracks Blackrock's proprietary "index composed of mid-capitalization U.S. equities".
In any event, the opening paragraphs were a segue for John to promote his new tactical funds. I am always on the lookout for opportunities to invest money with exceptional managers and thought John and Steve might be in that category. I downloaded john's paper "Investing During the Great Reset" and then had a look at the Mauldin/CMG funds on the CMG website. Sure enough, they are tactical funds so I went to Morningstar to have a look at fund performance. I offer the links without comment on the funds.
I will say that I've used Morningstar on many occasions to search for tactical funds and each time have come away disappointed. I just don't understand why these large firms with huge fee income and some of the best computer sciences talent in the world can not produce strategies which outperform many published TAA strategies, much less some of the lesser known proprietary strategies.
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.
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