Tactical Asset Allocation – October 2020

Tactical Adaptive Strategies Update

Performance

All three strategies showed very strong gains into mid-month, then retreated sharply into month end.

Adaptive Global lost 2.04% for the month and is down 1.86% YTD. Adaptive Global was invested in a large allocation to the S&P 500 and smaller allocations to Asia Pacific and commodities.

Adaptive Income lost 0.24% for the month and has gained 5.03% YTD.  Adaptive Income was invested in high yield.

Adaptive Innovation lost 1.85% for the month and gained 5.98% 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

We are just a few days away from what is expected to be a very contentious election and post-election period. However, it was not the election which ended the equity rally into mid-month, but the surging second wave of Covid 19.

The second wave will certainly slow, if not turn back, the recovery. It was the reopening of business coupled with nearly unlimited fiscal stimulus which drove the recovery in GDP. The second wave may have more serious economic repercussions not only for the absence of fiscal stimulus but the fact that many businesses had nearly exhausted financial resources prior to the onset of the second wave. We may see an unrivaled wave of defaults in both bonds and bank loans.

The credit markets are now controlled by the Fed: Treasuries, investment grade, and high yield and the Fed is now the single largest owner of Treasuries. The credit markets are showing a supportive bid and liquidity across the full spectrum of credit spreads and yields in spite of an expected rise in defaults. This should be supportive for equity markets.

The conditions under which our equity and bond markets are operating are clear and unlikely to change in the next few months, likely quite longer:

  • The resurgence of Covid 19 is very likely to drive a second stimulus package following the election. The size, scope and beneficiaries will reflect the outcomes of the Congressional and Executive elections. Whatever the size, it will be a 100% addition to the deficit.
  • The Fed, which has begged for a second stimulus package, will take as much of the resulting Treasury issuance onto its balance sheet as necessary to assure orderly auctions.
  • Treasury rates (e.g. 10 Year at 0.88%) are likely nearing the upper limits of Fed tolerance. The Fed will either cap rates (Yield Curve Control) or purchase enough Treasuries to contain rates and/or drive them lower. This will result in further Fed balance sheet expansion.
  • While election results may or may not offend our personal sensibilities, we have both parties engaged in ever increasing deficits differentiated only by the beneficiaries of the spending and tax cuts. There have been no apparent repercussions so the deficits will not only continue but increase with demands for everything from support payments to infrastructure and lower taxes.
  • Higher Treasury yields will blow out the Federal budget. Most of the US Treasury debt is of short duration which must be constantly refinanced because the market refuses to absorb a greater supply of longer duration at rates acceptable to the Treasury.

All of this boils down to the fact that the Fed will continue to grow its balance sheet in order to absorb the growing supply of Treasury issuance/rollover while suppressing yields by buying whatever the market will not take at the target yield. The Fed will also continue to “manage” yields and spreads across the full spectrum of quality in the credit markets. This should prove supportive for both the bond and equity markets even though the previously “hot stocks” appear to have fallen out of favor.

Ultimately, these policies are likely to yield the Fed’s desired inflation; however the negative effects are likely to be subdued until the economy recovers.

Our tactical adaptive strategies show an ability to weather remarkable and historical shifts in the market during the past two decades. I believe they can weather the next few months. Adaptive Global appears to have sniffed out the fact that SE Asia is getting back to normal while Adaptive Innovation increases its allocation to the ARK funds with volatility capped allocations. Adaptive Income remains invested in High Yield

Market

From the October 30th Market Monitor

"The sharp decline in the indexes last week was not signaled by the technicals nor have the technicals confirmed the decline. The percentage decline was quite similar across mega, large, mid, and small cap and banking indexes. The broker dealer index declined less and the housing index declined more.

The intermediate trend in the big cap indexes remains bullish and declining while the short term trend is neutral and oversold. This is suggestive of a rally within a further decline. I have an unconfirmed downside target in the S&P 500 of 3117.

Cumulative Advancing Declining Volume is showing bullish divergences to price across all indexes and 8 of 12 sectors.

While the Credit Markets Index fell to zero this week, the decline was due to a shift from declining spreads to flattening spreads. There are, as of yet, no signs of distress in credit spreads and yields although defaults can be expected to rise. The dichotomy is likely due to strong Fed support of the credit markets.

The 10 Year Treasury yield rose again this week in spite of the sharp decline in equity prices. This behavior is not normal and is indicative of excess Treasury supply. The Fed has stated clearly that it will maintain low yields so it is clear that the Fed will eventually be forced to step in and mop up the excess supply thereby expanding its balance sheet.

The US$ was up on the week, likely helped by higher Treasury yields. This rally is likely corrective.

Declines in equities are confirmed by sell signals this week in both the Value Line Weekly and VIX Models. These signals are generally good for a minimum of several weeks.

The equity market remains at extreme valuation posing significant downside risk and the decline, while unconfirmed by volume and credit, shows no immediate signs of ending. We can likely expect the equity correction to continue through November. The 10 and 30 year Treasury bonds present an extremely favorable opportunity to rally. Precious metals are likely nearing the end of their correction."

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)