This significant divergence has had a powerful impact on markets.
1. The US dollar strengthened considerably in Q2 2018 and the US dollar uptrend remains in place.
2. The degree of overseas earnings exposure has determined relative equity performance. Overseas equity funds are now in major downtrends, while US equities have held up but internationally exposed indexes, DIA and SPY have struggled and failed to make new highs above the January 2018 highs.
3. Commodities, have also broadly continued to trade lower overall, with the notable exception of energy commodities, where there may be temporary supply factors involved. This also is confirming the global slowdown.
The chart below shows how combined central bank buying also peaked in the first half of 2018. Now the ECB has just announced that it plans to reduce its Quantitative Easing program from €30 billion per month now to €15 billion per month in October; and then to end QE altogether in December.
This takes away one of the significant props for the equity markets over recent years. The global economy and the financial markets have grown accustomed to ample liquidity and very low interest rates. Now that liquidity is drying up, the markets will need to adjust if past tight correlations continue.
A Stronger Dollar leads to weaker US earnings growth
The chart below shows that a stronger dollar correlates closely with a decline in earnings per share growth for S&P 500 stocks as a whole. The dollar rally has not yet shown up in lower earnings per share growth.
Here is a summary of the 10 models used for client portfolios.
LOW RISK Initiated Allocation Guide
Cycle Dynamics Passive 1/1/17 12.5%
Cycle Dynamics Bond 1/1/17 12.5%
Tactical Diversified High Income 2/1/17 15%
Cycle Dynamics Asset 1/1/17 15%
Cycle Dynamics Commodities 7/1/18 5%
TSP.GOV Models 1/1/17
Quant Agora 6/1/17 15%
Equity Aristocrats 1/1/17 15%
Venture Tech 3/9/17 5%
Precious metals 12/6/17 5%
Model activity in 2018
Cycle Dynamics Passive
This model is a variation on the All Weather system designed by Bridgewater in the 1970s. Over 40 years of data shows that this static allocation has lower long term volatility and higher return to risk than almost any other static asset allocation model. The performance of PRPFX shows similar results since 1981.
CD Passive takes this a step further by adjusting the allocation to only holding the All Weather assets when they are in long term uptrends. This is a similar but different version with a performance bias.
At the end of 2017 International equites positions AAXJ and VXUS were closed as the international cycle had peaked. Then in February a core US equity position in NOBL was closed when a long term trailing stop was triggered. Later our position in convertibles CWB was also halved, reducing equity exposure to very low levels. In the main the cash raised was switched in to TIP. http://chrisbelchamber.com/tipsallocation/
Cycle Dynamics Bond
This model rotates through different ETFs through the whole economic cycle. No matter which phase of the economic cycle there are good choices for different types of bonds. This approach could solve the asset allocation problem of investing in bonds at the lowest interest rate levels in history, with little upside potential. Investors can have greater peace of mind about what could happen if a bond bear market could materialize. This model has in the main been invested in VTIP and occasionally in CWB, when US equities were in an uptrend.
Tactical Diversified High Income
This model looks at the whole universe of high income assets, from corporate bonds, high income stocks, and fixed income products. As the outlook for growth and Corporate bond debt ratings has clouded the model has shifted to TIP, and only a low allocation to short maturity corporate debt.
Cycle Dynamics Asset
The design for this model has similarities to CD Bond, except this model addresses asset allocation. Investors who are concerned about the possibility of a bear market in equities, but want to benefit from any remaining upside could benefit from this approach, which switches between stocks, bonds, commodities, real estate, and gold based on relative strength among other factors. As discussed in the note a week ago trends have been erratic across asset classes in 2018. This is currently invested 50% in REITs through VNQ.
Cycle Dynamics Commodities
The design for this model has similarities to CD Bond, except this model addresses commodities. This is a new option but so far has not been allocated to any client account. It provides a great way to focus on commodities when they are on the move
This model combination addresses the significant problem of efficiently allocating the Thrift funds available in the Federal Government’s IRA plan. There are major challenges in the limited fund choice, and the Lifecycle funds have very significant issues that investors need to be aware of. This model provides clarity, a clear decision structure, and an extensive history on which to test the models. Trend following worked well in 2017, but has been more challenging in 2018. The focus has been on avoiding the S fund and gradually shifting towards the F and G funds.
Quant Agora, Equity Aristocrats, Venture Tech
These models are based on different sets of mainly individual equities and uses a filter called “Pure Quant” described here, http://chrisbelchamber.com/launching-quant-agora/. This is a tactical and money management system for selecting and allocating stocks. In addition, research and cyclical factors are considered. This provides a very wide selection basis and allocation tool for equity exposure.
Quant Agora applies “Pure Quant” to all the research families of Agora Inc.. of which I am a lifetime subscriber as well as some others. A wide selection of stocks have been traded this year and more recently DOG has been added as a hedge.
Equity Aristocrats applies “Pure Quant” to Global Elite stocks. A full fact sheet is available on application for Equity Aristocrats, showing results back to the beginning of 2017. The focus has shifted in favor of tech stocks and starting in Q2 equity hedges using DOG and SH. The Dow Jones and S&P 500 indexes.
Venture Tech uses a similar approach to small cap stocks and technology stocks. However, this model takes smaller positions but has many more selections. Money management has been adjusted to handle higher individual stock volatility. This model also incorporates additional strategies and so although it involves higher risk equities, they are all position sized and there is some additional model diversity.
Positions have shrunk with the narrowing of performance, and PSQ is used opportunistically as a hedge.
Precious Metals takes a “Pure Quant” approach to precious metals and related stocks. Precious metals are often excluded from asset allocations, but I believe they significantly improve long term RVAR, when applied appropriately. It is very valuable to have a separate tactical model that can be incorporated into client accounts.
A strong dollar and rising interest have been a challenge for precious metals as a whole. Fortunately, the allocation has been much wider than GLD, which has traded down this year. The cash position has increased this year as trends have been unfavorable, but many positions have held up well, SPOXF and RGLD were stand outs.
The chart above shows that the US economy is on a record run of consecutive quarters of accelerating YOY growth. Likely it will be eight when Q2 2018 GDP is reported in July. Inflation also is likely to peak around the same time around 3%.
Importantly, it is the second derivative of growth that impacts markets the most. So in the second half it is likely that the US will go from great to merely good. Although still “good” this would be a cyclical downturn in the second half of 2018.
Hedgeye’s models continue to be as accurate as any I see, and as the chart below shows in the second half of 2018 the US economy may well shift into Quad 4 from the current Quad 2 position.
I have already shifted into a lower risk position as described in my last note. Rising interest rates, a stronger dollar and falling growth is a challenging part of the cycle. Recent signs of weakness in financials, lower highs in Treasury bonds yields, and a flatter yield curve are already signaling the first signs of slower US growth, while global growth has already confirmed a downturn.