Market insights and analysis

How dynamic, risk-managed investment solutions are performing in the current market environment

2nd Quarter | 2022

Market insights and analysis

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Updates on how dynamic, risk-managed investment solutions are performing in the current market environment.

By Jerry Wagner

The major U.S. stock market indexes finished mostly up last week. The Dow Jones Industrial Average gained 0.3%, the S&P 500 Index rose 1.8%, the NASDAQ Composite picked up 2.0%, and the Russell 2000 small-capitalization index dropped 0.4%. The 10-year Treasury bond yield jumped 34 basis points to 2.493%, sending bond prices lower for the week. Spot gold closed the week at $1,959.90, up $26.00 per ounce, or 1.34%.

Stocks

Stock markets in the U.S. were mostly positive last week, despite the continued Russian invasion, Federal Reserve interest-rate tightening, high inflation, and weaker economic reports amid signs of a coming recession.

Yet even a cursory view of the chart above seems to tell a story of a possible market bottom. The S&P 500 has bounced off an early-March low that failed to take out the late-February low spot. It has since risen above its 200-day moving average. Even a mid-March death cross (when the 50-day moving average crosses below the 200-day) failed to halt the index’s advance.

But now the index faces a new test. It has risen to meet a resistance line (the horizontal red line in the chart) that links the last two tops of the bear market rally that stretched from mid to late February. Will the current advance be a repeat of the last time we were at these price levels? Or will we break out further and reach the old market highs?

The second anniversary of the COVID-related stock market bottom was last week. Since March 23, 2020, the S&P 500 has gained over 100%. This is the best two-year return since 1937.

Last week it became apparent that the Federal Reserve was going to act in earnest on interest rates. It has no choice as inflation is running rampant, not just in energy prices but in virtually all commodities. The market is now expecting up to six rate increases before the Fed is done, with at least one 50-point hike this summer.

Not only have rates been rising (see the “Bonds” section below) but the yield curve has been flattening. That means that short-term and longer-term yields continue to converge. Most economists believe that once rates invert (when long-term bond rates exceed short-term rates), a recession is not far away.

Comparing the rate of the 10-year Treasury bond to the two-year variety (see the chart below), it is apparent that we are nearing such an event. If there is a crossing, history tells us that 98% of the time a recession occurs within two years and two-thirds of the time we experience a recession within one year.

Additionally, the changes in the curve that we’ve been seeing are different from previous times when inversions were close. For example, when the curve nearly inverted in 2018 (before actually inverting in 2019), short-term interest rates rose and longer-term rates were relatively stagnant. This left longer-term bonds almost unchanged for the year. Now we’re seeing the yield curve flatten, but interest rates along all maturities are increasing. They’re simply moving faster on shorter-maturity bonds. This makes investing in bonds more difficult as duration management provides little protection from rising rates.

However, there were positive economic developments in the latest week’s reports. The Manufacturing PMI report exceeded expectations, as did the latest jobs report. Yet, home sales continue to lag predicted growth, plagued by low inventory, higher prices, and rising mortgage rates. In the end, seven reports were better than expected and 11 were worse.

The report on durable goods disappointed. These big-ticket items not only failed to increase their sales as fast as economists had expected, but their price levels continued to increase at an alarming rate, reflecting the inflationary environment worrying the Fed.

Market sentiment continues to improve as prices move higher. Bullish sentiment has steadily increased while bearish emotions have been in decline, moving sentiment out of overtly bearish territory. Since this is a contrarian indicator, it also shifts us out of overtly bullish territory as well.

Perhaps the biggest impediment to a return to market highs in the near term is the limited participation by most issues in the present advance. As a result, the NASDAQ bottom-finder indicator, based on the percentage of stocks making new highs, has yet to move much above the 20% level. It is still a considerable distance from the 35% level that would signal that the worst is over.

Bottom line: We believe stocks have a few more hurdles to overcome before the all-clear can be signaled.

Bonds

In the face of rampant inflation and a more hawkish Federal Reserve, interest rates have been soaring. Just since December, the 10-year bond has seen its yield increase over 110 basis points, or 1.1%. It has gained 125 basis points since August.

At the same time, the two-year bond has increased even more, adding 200 basis points to its yield. This is the greatest increase in the two-year yield since the 1980s, with the exception of the rate upticks in 1987 and 1994.

Still, the chart above shows that the 10-year bond yield has moved quite a distance above its 50-day moving average. Since the yield tends to track closer to this mark, it wouldn’t be surprising if the yield paused in its upward flight for a week or two to allow the average to catch up.

Until now, the interest-rate increases have wreaked havoc on the bond market. All of the indexes are down substantially as the following charts of the long-term Treasury (TLT) and high-yield bond (HYG) ETFs demonstrate.

Gold

Gold has been one of the bright spots in the financial markets this year. Its ability to diversify investor portfolios is the big reason we make it available for use in so many of our portfolios. It tends to move in the opposite direction of the stock market at key crisis points.

Although the yellow metal remains solidly above its 50-day moving average, its advance has stalled a bit. While it gained ground last week, it was slowed by both an advancing stock market and a rising dollar.

The dollar has been able to hold on to its gains since its early-March breakout. It is now challenging the highs made following that breakout.

Flexible Plan Investments (FPI) is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction more than nine years ago to track the daily price changes in the precious metal.

The indicators

The short-term-trend indicators for stocks that we watch are now uniformly positive. It should be pointed out, however, that we are overbought by most indicators.

The very short-term-oriented QFC S&P Pattern Recognition strategy sat out last week’s stock market, remaining defensive for the week.

Our Political Seasonality Index has been in the market since the close on March 18 and will stay there until March 31. It has gained over 2.5% this year. (Our QFC Political Seasonality Index—with all of the daily signals—is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.)

In contrast, FPI’s intermediate-term tactical strategies are positioned very defensively, although to varying degrees. The Volatility Adjusted NASDAQ (VAN) strategy has a -20% exposure to the NASDAQ, the Systematic Advantage (SA) strategy is 30% exposed to the S&P 500, and our QFC Self-adjusting Trend Following (QSTF) strategy has an exposure of 0%. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%. Our Classic strategy remains out of stocks.

Among the Flexible Plan Market Regime Indicators, our Growth and Inflation measure shows that we are in a Normal economic environment stage (meaning a positive monthly change in the inflation rate and positive monthly GDP reading). This occurs about 60% of the time and favors gold and then stocks over bonds, although gold carries a substantial risk of a downturn in this stage.

Our S&P volatility regime is registering a High and Rising reading, which favors equity over gold and then bonds from an annualized return standpoint. The combination has occurred 23% of the time since 2003. It is a stage of lower returns and higher volatility for all three major asset classes. In fact, the S&P 500 registered a maximum drawdown of over 49% during one of these regimes during the period.



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