Tactical Asset Allocation – September 2019

Tactical Adaptive Strategies Update

Performance

Adaptive Global lost 1.22% and lost .62% YTD.  The position in big caps took a modest loss, the position in precious metals took a large loss as they pulled back from the recent sharp run-up, the large position in high quality bonds suffered a small loss on the pullback from the recent sharp drop in yields.

Adaptive Income lost .46% and has gained 1.57% YTD. Adaptive Income declined on a shift in credit markets which produced weakness in muni bonds.

Adaptive Innovation lost 2.0% and has lost .60% YTD. While Adaptive Innovation produces the highest return, it is also the most volatile. The Strategy, which straddled investments in both technology and Treasuries, suffered from declines in both.

Trend Between Tweets!

The equity and fixed income markets have reached the point where trends are measured in time between Tweets. I spent some years successfully trading index and commodity futures using intraday charts as short as 1 and 5 minutes but it is an exhausting process and a younger man’s game requiring years of practice and full-time focus.

I constantly review the performance of the Tactical Model to insure that its performance is consistent with its design which is to identify and hold intermediate trends in asset classes and ETFs. While we could tweak the Tactical Model to prioritize shorter term trends, doing so would fail to meet our goal of delivering lower investment risk and improved returns over a full market cycle. Testing has consistently shown that chasing short term trends frustrates that objective. I won’t tweak the model to address a short term issue which results in sacrificing the longer term.

While this may be the longest, this is not the first time the Adaptive Global Strategy has experienced extended sideways action while waiting for a true trend to develop. Have a look at the Tactical Adaptive Strategies page in the Subscriber area or the Strategy Results on the Strategies page and you’ll see similar periods beginning in May of 2011 and in May of 2015. This too shall pass.

New Outlook and Strategy

I have spent a good deal of time this month pulling together my big picture thoughts on what lies ahead. Much of this has been culled and distilled from many months of reading and thinking about an incredibly wide variety of material.

New Rebalance Calculator

The Portfolio Manager tab on the Subscriber menu has been renamed “Rebalance Tools”. I have added a link to a new Rebalance Calculator.

"The Rebalance Calculator is a simple spreadsheet which simplifies the calculation of new position percentages and buy orders (no sell orders) when performing a rebalance. It is ideally suited for use with the Interactive Brokers TraderWorkstation (TWS) Rebalance Tool. It generates the percentages for direct entry into the Rebalance Tool. A future version will generate a file which can be imported directly into the Rebalance Tool."

Market Conditions Model

The planned upgrade to the Market Conditions Model has been my primary focus for many months now. While the development appears to be complete, a great deal of testing remains ahead. The original Market Conditions Model has proven to be a capable contender during comparisons so the improvements will be incremental. One major focus in development and testing of the upgrade has been extending historical capabilities back to the 1970’s.

Market

From the September 28th Market Monitor

The major indexes, except housing, were down this week. Even small caps, which have been showing some signs of relative strength, were down this week.

Cumulative Advancing Declining Volume has improved just enough during the past several weeks to turn neutral instead of declining.

The credit market index has also turned neutral at -4%. While one can make the argument that the credit index at neutral, fails to confirm the near all time highs in the S&P 500, the fact is that neutral means that credit spreads are not that far off their historical lows and there is no discernable trend in direction.

The 10 Year Treasury yield has retreated back toward the low; however it too may simply go sideways.

Gold and silver are also correcting with some large moves up and down but sideways overall.

The equity and bond markets remind me of the old clocks which one wound with a clock key. Winding it too tightly would inevitably launch the spring into an instant unwind. The equity market has been winding since January of 2018 seemingly unable to complete a move downward or make real upward progress. The next sustained move could be breathtaking but we’ll likely get some clues from the market before it gets well underway.

Most directional and leading technical indicators are dead neutral. At low valuations, this would be extremely bullish with strong odds of a sharp and sustained trend upward. With all major asset classes (ex precious metals) so extended, the odds of a sustained trend upward are pretty low. The bear case carries higher odds due to excessive valuations; however the market internals provide little evidence of the loss of confidence which is required to collapse earnings multiples.
 

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.
  • Bonds are also extremely highly valued and the most worrisome fixed income sector is high yield where quality has declined dramatically along with yields. 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 following a major collapse and bottom in high yield debt which should provide stellar performance in high yield. While income might be considered a third option, the real (after inflation) yield on the 10 Year Treasury is already negative.

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

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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.

 

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.

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.