Market insights and analysis

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

1st Quarter | 2022

Market insights and analysis

rss

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

By Tim Hanna

Major U.S. stock market indexes were mostly higher last week. The S&P 500 increased by 0.77%, the Dow Jones Industrial Average gained 1.34%, the NASDAQ Composite was up 0.01%, and the Russell 2000 small-capitalization index lost 0.98%. The 10-year Treasury bond yield rose 1 basis point to 1.77%, taking Treasury bonds lower for the week. Spot gold closed at $1,791.53, down 2.39%.

Stocks

In a volatile week of trading, small-cap stocks continued to underperform as investors moved to blue-chip stocks. The S&P 500 was met with resistance at the 200-day moving average several times last week.

Investors were concerned that the Federal Reserve’s upcoming aggressive tightening policy could slow down economic growth. Following the Federal Open Market Committee meeting on Wednesday (January 26), projections now point to at least five rate hikes this year, with the first occurring in March. The Fed also left the federal funds rate unchanged. Federal Reserve Chair Powell stated that policy needs to adapt to high inflation risks and that very accommodative policy does not seem to be appropriate anymore considering current circumstances. Economic conditions appear to be generally strong, which is one of the factors contributing to the upcoming Federal Reserve policy shift.

On the economic data front, the Flash Manufacturing PMI came in at 55.0 compared to the 56.9 forecast. The Flash Services PMI came in at 50.9, lower than the 54.9 forecast. For both, readings above 50 indicate expansion, while readings under 50 indicate contraction. Advance GDP came in at 6.9% quarter over quarter, above expectations of 5.3%. Unemployment claims were in line with expectations of 260,000. Pending home sales were down 3.8% month over month, lower than the -0.9% forecast. The Core Personal Consumption Expenditures (PCE) Price Index (month over month) was in line with the 0.5% forecast. The University of Michigan Index of Consumer Sentiment was revised downward to 67.2, below expectations of 68.8.

Last week, large-cap benchmarks moved temporarily into correction territory (down more than 10% from highs) and the Russell 2000 small-capitalization index ended last week down almost 20% from its November high. Some individual high-growth tech stocks have sold off more than 40% from highs.

Some economic indicators are showing signs of slowing. The IHS Markit’s composite gauge of service and manufacturing activity was at 50.8 last week, its lowest reading in 18 months. It is now barely in expansion territory. Sentiment has also changed in recent weeks as Americans continue to worry about inflation and falling real wages. The revised reading of the University of Michigan Index of Consumer Sentiment last week was the lowest since November 2011. Technicians are also grappling with uncertainty as the S&P 500 traded around its 200-day moving average for the first time in almost two years. The 200-day moving average is a commonly followed indicator by technicians, often used as a risk-on/risk-off signal.

As markets trade off lows of the leg down that started at the beginning of this year, several bull and bear cases for U.S. stocks are presenting themselves. Bespoke Investment Group noted one bull case: Over the past year, high-yield spreads have narrowed to the tightest levels since before the 2008 financial crisis. Because of their more risk-averse investor base and lower position in the capital stack, high-yield spreads tend to be more sensitive to the market outlook than equities. The recent equity volatility has seen a widening of high-yield risk premiums, but spreads are still well below 52-week highs.

Another bull case is that companies are beating earnings and sales estimates at a better-than-normal rate even with inflation and supply-chain headwinds. Bespoke noted that 163 out of 271 stocks have beaten both earnings-per-share and sales estimates. However, even these stocks have averaged a one-day decline of almost 25 basis points this season. Such a relationship is far outside the norm. Bespoke believes that we should start seeing strong earnings rewarded eventually.

Taking a more short-term view, the 10-day advance-decline (A/D) line is at its lowest level over the past year. In other words, recent market movements pushed the line about as oversold as it can get. Extreme overbought and oversold readings do not last long. Based on this indicator specifically, expectations for further weakness in the short term are low, with a near-term retracement possibly bringing the indicator back to neutral levels.

Now for the bear cases. The Federal Reserve is faced with some critical decisions that have the potential to drive market performance over the coming years. Inflation is clearly an issue, and Fed Chair Powell has indicated a willingness to hike at every meeting if need be. Markets are pricing in almost six hikes over the next 12 months, almost twice the most aggressive hike pace priced in last cycle. Such a rapid pace of hikes could prove challenging for the markets.

The S&P 500’s performance in January could support another bear case. Through January 27, the S&P 500 lost 9.2% for the month. If the month had ended then, it would have been the worst January on record. Historically, when the S&P 500 falls 5% or more in January, February and the rest of the year have been weaker than normal.

Another bear case is that midterm election years tend to be the weakest year of the four-year election cycle. Bespoke Investment Group looked at the NASDAQ since its inception in 1972, highlighting the disparity between midterm years and all other years.

With the recent volatility and the highest level of uncertainty since the start of the pandemic, it is critical to incorporate active, risk-managed strategies in a portfolio. Such strategies within a portfolio give investors the ability to adapt to market changes, which may help limit losses if this turns into a full-fledged bear market. Aside from moving to a more defensive position when markets go down, some of these strategies have the ability to profit during downturns by going inverse. Most importantly, combining strategies that use different methodologies to trade similar asset classes has been shown to reduce risk compared to holding a single strategy.

Bonds

The yield of the 10-year Treasury ended last week around its one-year-high breakout level (see the black horizontal line in the following chart). Compared to recent moves in the 10-year Treasury, last week was fairly calm. Technicians are keeping their eyes on 2% as the next level of resistance, and 1.75% support is still intact.

T. Rowe Price traders reported, “The Fed's policy meeting also seemed to weigh on investment-grade corporate bonds, although higher-volatility energy-sector bonds outperformed the broader market in the wake of the meeting. Primary issuance was subdued and fell short of weekly expectations. … The high yield bond market traded lower as the prospect of tighter Fed policy and decelerating economic growth weighed on risk assets.”

As the implications of the Federal Reserve’s monetary policy continue to worry bond investors, being able to navigate the fixed-income market during rising and falling interest rate environments is paramount to long-term success. At Flexible Plan Investments, we have many strategies that seek to manage risk in the fixed-income markets, with each being able to take advantage of rising interest rate environments.

Gold

Last week, gold fell 2.39%, pushing it back below the 50-day and 200-day moving averages. Price action remains in the middle of the one-year trading range, and the story hasn’t changed from a technical perspective. Potential weakness in the U.S. dollar, worse-than-expected inflation, and geopolitical tensions between military powers could help move the price of gold up as uncertainty continues across asset classes.

Flexible Plan Investments is the subadviser 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

Our very short-term-oriented QFC S&P Pattern Recognition strategy’s equity exposure was 80% long to start the week, changed to 160% at Monday’s close, changed to 80% long at Tuesday’s close, and changed to 160% long at Thursday’s close to start this week. Our QFC Political Seasonality Index favored stocks last week. (Our QFC Political Seasonality Index is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.)

Our intermediate-term tactical strategies have been moving into more defensive positioning, although to varying degrees. The key advantages these strategies offer to investors is their ability to adapt to changing market environments, participate during uptrends, and adjust exposure to more defensive posturing during downtrends.

The Volatility Adjusted NASDAQ (VAN) strategy started last week 40% long to the NASDAQ. It changed to 20% long on Monday’s close, 0% exposure at Wednesday’s close, and to 20% long on Friday’s close. At Monday’s (January 31) close the strategy initiated a 20% short (negative) exposure. The Systematic Advantage (SA) strategy is 30% exposed to the S&P 500. Our QFC Self-adjusting Trend Following (QSTF) strategy was 100% long throughout last week. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic model is moving to a defensive position at Tuesday’s (February 1) close. Most of our Classic accounts follow a signal that will allow us to buy back into stocks in as little as a week. A few accounts are on platforms that are more restrictive and can take up to one month to generate a new signal.

Flexible Plan’s Growth and Inflation measure is one of our Market Regime Indicators. It shows that we remain in a Normal economic environment stage (meaning a positive monthly change in the inflation rate and positive monthly GDP reading). Historically, a Normal environment has occurred 60% of the time since 2003 and has been a positive regime state for stocks, bonds, and gold. Gold tends to outpace both stocks and bonds on an annualized return basis in a Normal environment but carries a substantial risk of a downturn in this stage. From a risk-adjusted perspective, Normal is one of the best stages for stocks, with limited downside.

As of February 1, our S&P volatility regime was registering a High and Falling reading, which favors gold over bonds and then stocks from an annualized return standpoint. The combination has occurred 13% of the time since 2003. It is a stage of higher returns and lower volatility for bonds relative to the other volatility stages.

 



Comments are closed.