Tactical Asset Allocation – October 2019

Tactical Adaptive Strategies Update


Adaptive Global gained 0.98% and 0.36% YTD.  Positions in precious metals and equities were standout gainers while Treasuries and investment grade bonds produced small gains.

Adaptive Income lost 0.61% and gained 0.95% YTD. Adaptive Income declined on weakness in high yield. (Note: the Tactical Model's selection of mortgage bonds was overridden following completion of the rebalance - see below. Those who remained invested in mortgage bonds saw a gain of 0.32%.)

Adaptive Innovation gained 2.41% and 1.80% YTD. The Web Innovation position produced a large gain while the Treasury position produced a slight gain.

Dividend confusion with WHIYX

Open End Funds (OEFs) are an entirely different animal from Exchange Traded Funds (ETFs). WHIYX is included in our Tactical Adaptive Income basket because it significantly outperforms every alternative ETF candidate.

I added code to the Tactical Model to handle the 60 day trading limitation imposed on some OEFs including WHIYX.

Then I learned that most OEFs report dividends well after the ex-dividend date rather than on or before as is the case with ETFs. I added code to the Tactical Model to allow the latest dividend to be entered manually.

During the rebalance at the end of September, I found a new wrinkle. The WHIYX dividend was omitted from the quote stream, subsequently added, subsequently removed, and finally, permanently added.

The Tactical Model selected MBB for October on September 29 when the Subscriber Letter was prepared. On the morning of October 1, changes in dividend reporting caused the Tactical Model to show WHIYX was the correct selection. I sent out a Correction reporting the change to WHIYX, my view of the choices between continuing to hold the just purchased MBB or switching to WHIYX, and my decision to continue holding MBB.

I have added code which will automatically detect the presence/absence of the dividend in the quote stream and prevent duplicate posting. I trust that this will bring the WHIYX dividend issues to an end. The ex-date for October was the 25th, the dividend has not appeared in the quote stream so it is has been manually entered. I will be actively monitoring the accuracy of the automatic detection algorithm prior to the rebalance.

Bull or Bear … we’re agnostic

Are the bulls correct that the Millennials are now established and about to unleash a torrent of consumer spending which will keep the economy out of recession? Are the bears correct that consumers and corporations are so extended that the credit market is about to implode? Are the bulls correct that a recession is several years away? Are the bears correct that the US economy has either entered recession or is on the cusp of one?

I swore off financial TV many, many years ago which has benefited my psyche. I still read a wide variety of financial and economic material and that can set my head to spinning as I attempt to make sense of the conflicting information. When that happens, I attempt to sit back and “sort it” as the Brits say. That consists of categorizing information in two buckets: long term and short term.

The long term information is checked against my Outlook and Strategy to see if adjustments are required.

The short term is simple since the bulk of our investments are managed using tactical (or quantitative) strategies. Bull market? The strategies will take on more risk in equities and higher yield fixed income. Bear market? The strategies will hunker down in high quality fixed income, precious metals, and/or cash. Inflation? The strategies will shift to equities, real estate, and precious metals. Deflation? The strategies will shift to fixed income and value stocks.

In other words, my short term view is agnostic … as long as we have a sustainable trend.

Tactical Model upgrades pending for 2020

I have upgraded the algorithm which prioritizes holding existing funds over rebalancing into different funds which may have slightly higher TrendScores. This has slightly increased the average fund holding period in both Adaptive Global and Adaptive Income resulting in increased opportunity for LTCG treatment.

Both Adaptive Global and Adaptive Innovation employ volatility based allocation algorithms which work to moderate portfolio volatility. I am completing work on a a new Volatility with Limit allocation algorithm which permits capping the expected portfolio volatility. I expect that this will prove useful in further moderating portfolio volatility with little or no reduction in return.

I am also testing the addition of a third Treasury ETF to the Adaptive Innovation basket which I expect will capture some additional return during Balanced and Hostile periods while reducing volatility.

We will continue with the existing Tactical Model through the allocation for December 2019. Final Tactical Model upgrades will be used beginning with the rebalance for January 2020.

Tidbits from work on the Market Conditions Model

The Market Conditions Model sets the stage for the Tactical Model. It identifies the current market condition (Balanced, Favorable, Hostile) and provides that information to the Tactical Model. The Tactical Model uses the condition to select a fund basket and identify the funds within the basket which have the best momentum characteristics. So getting the market condition right is a very important part of the process.

I’ve been actively working on an upgrade to the Market Conditions Model for over a year now. I started with some pretty ambitious ideas for improvement including both weekly and monthly level signals. While I’m very proud of the full cycle CAGR and Max Drawdown of the TAAS Strategies, I’ve long wanted to even out the hills and valleys in performance. It’s frustrating to sit through years like 2015, 2018, and 2019 with low single digit gains or losses when the majority of years show strong double digit gains.

The development process has been iterative with the focus shifting among coding ideas and testing the ideas, refining the coding, and more testing. I’ve completed the process of testing the various Model components and have started integrated testing of the Market Conditions Model with the Tactical Model.

The first thing I learned is that the current Market Conditions Model is pretty darn good and sets a very high bar. I’ve also learned that perfect does not exist. There is simply no way to avoid the frustrating performance when the market is whipsawing, short of rebalancing on demand, multiple times per month.

Inverse Funds

I always appreciate comments and suggestions which might lead to improving our strategies. Our Tactical Model includes capabilities and sophistication far beyond the usual tactical strategy testing tools so testing subscriber suggestions is usually a pretty simple process.

One recent note suggested that bonds, which carry extreme valuations, might not provide a safe haven/hedge during the next bear market. I generally share this view although I see a two-stage process:

  • I expect early stages to exhibit a flight to government bonds no matter how highly valued, to escape rampant downgrades in junk, near-junk, and lower rated investment grade bonds.

  • Once the credit markets have stabilized, I expect investors will begin to examine and reject extreme valuations in government bonds leading to carnage in higher quality bonds.

So where to invest when most of the securities in our baskets are going down? We have a wide enough assortment that at least one or two are likely to be going up. And then there is cash.

But what about inverse equity funds which go up when equities are going down and inverse bond funds which go up when bonds are going down? That sounds like a no-brainer that I’ve performed numerous tests with inverse funds over the years. They have not worked out.

Few inverse funds existed until the late great bear market when demand for these products surged. However, there were a few. Both SH (inverse S&P 500) and RWM (inverse Russell 2000) have sufficient history to permit running a full market cycle test.

Here is what happens when the two inverse funds are added to our Adaptive Global Strategy:

  • SH yields a full cycle gain of $476

  • RWM yields a full cycle loss of $1,474

  • Adaptive Global’s results suffer as well: CAGR drops from 15.1% to 14.5%, Ulcer Index rises from 3.7% to 4.4%, Max Monthly Drawdown rises from 8.7% to 13.8%, and Up/Down Ratio drops from 227.2% to 207.8%

The result of limiting use of inverse funds to Hostile market condition is even more surprising:

  • SH yields a full cycle loss of $8,461

  • RWM yields a full cycle loss of $12,569

  • Adaptive Global’s results are even worse

One experiment with a basket consisting of 4 pairs of long/short equity and bond index funds (example SPY and SH), yielded positive portfolio results: CAGR of 8.1%, Ulcer Index of 8.0, Maximum Monthly Drawdown of 17.7%, and Up/Down Ratio of 143.1. All 4 of the regular ETFs returned substantial gains. 3 of the 4 inverse funds returned losses while the 4th inverse fund returned a small gain. So virtually the entire gain was derived from the long funds.

While I never say “never” when it comes to the markets; I’ve not been able to find a way to make inverse funds work for us as hedging vehicles. I will continue to keep my eyes peeled for opportunities to increase our exposure to non-correlated funds.


I began building a significant portfolio allocation to gold in late 2017 as it showed signs of nearing the end of what turned out to be a six year base. The roughly 10% portfolio allocation, which dovetails with my outlook, has a 3 to 5 year horizon during which I expect to see the price exceed $2500.

It peaked at the beginning of September and has been consolidating rather tightly since. I think we could see a resumption of the move upward in the near future.

Outlook and Strategy update

The Outlook and Strategy will be updated when a change or correction in course is needed. A minor update has been posted to the investment options for bonds.


From the October 25th Market Monitor

All major indexes are up again this week led by the Banking Index. Many of the weekly indexes are overbought and all daily indexes are overbought. This suggests a pullback.

Strength in the Banking Index may be smelling out flattening or even rising yields which is positive for banks. This would be consistent with what appears to be at least a short term bottom in the 10 year Treasury.

Cumulative Advancing Declining Volume is mixed but more positive than negative. Certainly no sign of major distribution.

The Credit Market spreads improved again this week with many Index components “Historically low, turning down”. A sign that investor risk tolerance is increasing which is bullish for equities.

Repeating from last week: “odds would slightly favor a modest move upward in view of the seasonally strong bias.”

The energy sector has been severely beaten up between lower oil prices and with higher risk financing drying up in the shale fields. Although still early, a move upward could be explosive.

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 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. 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. 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. 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. At least until investors abandon the greater fool theory where bonds are owned in expectation of selling at a higher price. 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