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 down last week. The Dow Jones Industrial Average gave up 1.3%, the S&P 500 Index lost 1.2%, the NASDAQ Composite sank 2.8%, and the Russell 2000 small-capitalization index dropped 2.0%. The 10-year Treasury bond yield fell 21 basis points to 1.747%, sending bond prices higher for the week. Spot gold closed the week at $1,991.19, up $101.85 per ounce, or 5.39%.

Stocks

Equity markets tumbled and commodities soared as the world grappled with the implications of the largest land war in Europe since WWII.

Yet, as we have been reporting, the chart above reveals that inflation began to soar, and the market began to decline, before the commencement of the Russian invasion. However, as shown, the invasion has certainly exacerbated the relative performance of both.

Most of the world’s focus since the invasion started has been on the rising price of oil. As I commented last week, this has not only sent inflation numbers higher, but it also has been providing funding to Putin for his war effort. Many believe we need to unleash domestic oil production, pressuring the oil execs to open new shale properties that can come online quickly, while unfreezing the political climate to encourage the growth of production in the future.

The effect could be a psychological shock to the oil market, reversing the price rise, or stalling it for a while, hurting our enemies and helping our friends, and relieving the rising oil price pressure on the cost of living worldwide. Even if it is only done for political expediency with the midterms approaching, the U.S. needs to do something to tame inflation.

Releasing a day or two’s supply of oil from the strategic reserve is certainly not going to do it. That is literally a drop in the bucket compared to the 12% of world oil production that could be affected by a shutdown of Russia’s share of the oil market. Yet such a move seems increasingly likely. In the meantime, the U.S. registered the highest average price for a gallon of gas … ever.

Unfortunately, oil is not the only commodity being forced higher by the war. Ukraine has often been referred to as the breadbasket of Europe. With the invasion, wheat futures have soared more than 50% in price.

And it doesn’t stop there. As the chart below shows, the average agricultural commodity has dramatically risen in value. Furthermore, prices of base metals used in manufacturing (copper, nickel, etc.) rose to a new high last week. Everything is becoming much more expensive.

On the more positive side, earnings reporting season has come to an end, and earnings were on par with past seasons, while revenues actually outperformed. 67.8% of the earnings reports beat analyst expectations, while over 73% of companies outperformed those predictions.

Economic reports last week were mixed but generally positive as well. Seventeen of those reports exceeded economist expectations, 13 disappointed, and two were as expected. The biggest surprise was the positive labor report, but it carried with it the biggest disappointment. While new employees surged past predictions, the report on hourly wages failed to meet expectations.

Ultimately, the news on inflation, earnings, and economic reports is important in settling the issue of whether the country is going into a recession. Recessions always bring stock market losses. With most economic indicators returning to the halcyon levels experienced before the pandemic, however, this seems like a distant possibility.

Yet, various recession indicators have been edging closer to signaling just such an event. We have often talked of the inversion of the two-year rate over the 10-year Treasury bond interest rate as one such indicator. The ratio there is at 0.87, still shy of the 1.0 reading that would signal the coming of a recession.

On the other hand, the Probit Recession Indicator has already issued an early warning. It just registered an 80% reading, which has always been correct in signaling the coming of a recession within the next three years. One of its principal indicators is a surge in commodity prices. These have accompanied three prior recessions.

Bottom line: Uncertainty continues to plague the markets and the world’s geopolitical scene. While the oversold nature of the markets makes a bounce possible, stock prices seem destined to move lower still in the current environment.

Bonds

Bond prices reflect the health of the economy and the mood of the Federal Reserve. Bonds also provide a safe haven during trying times in the stock market. Last week’s market action reflected all three and led to lower yields and higher Treasury bond prices.

One of the most important implications of the rising inflation gripping the country is the impact on Federal Reserve policy. Still, the influence of all of the reports previously discussed has been blunted by the war in Ukraine. Federal Reserve Chairman Powell acknowledged the uncertainty caused by the geopolitical environment in his testimony before Congress last week.

In his remarks, he indicated support for an initial rate hike of just 25 basis points. The market had already baked in 50, so the bond market rallied. It reduced yields by 24.4 basis points in a single day. This was the biggest single-day drop in yields ever. And even these numbers were surpassed in some European bond markets.

Looking at the chart above, it appears that yields could fall further. The 200-day moving average, which has bounded the yield range, sits at 1.572%. That’s 18 basis points lower than the present yield of the 10-year Treasury bond. On the other hand, a move back above 1.8%, the level of the 50-day moving average, would likely cause yields to resume their march higher.

High-yield bonds continue to move lower. Their actions usually reflect the price decline of the shares of their underlying issuing companies, albeit to a more moderate degree due to their high dividend rates.

Gold

As the following chart demonstrates, volatility of all asset classes has been soaring. The Fed's reversal of policy, the explosion of inflation, and the war in Ukraine have sent volatility measures to an extreme level.

Gold, as it often does, responded to this volatility and the crisis state of world markets. It continued its price breakout, moving to levels close to its record high of just over $2,000 per ounce.

The U.S. dollar also has broken out from its previous price pattern. It, too, is moving higher in the face of the political uncertainty.

This uncertainty has made for strange bedfellows. Both the U.S. dollar and gold hit 52-week highs on the same day last week. This has only occurred three times since gold’s pricing was allowed to float in the early 1970s.

Gold and the U.S. dollar usually move in opposite directions. But they are also both assets of last resort, providing a safe haven in trying times. What will cause the two asset classes to return to their traditional relationship? Will gold fall or the dollar?

History tells us that last week’s downward action is not encouraging for gold bugs. But it usually does not pay to fight the trend, and for now, the trend is higher.

Flexible Plan 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 uniformly negative, although it should be pointed out that we are oversold by most indicators.

The very short-term-oriented QFC S&P Pattern Recognition strategy maintained its 2.0X exposure to the S&P 500 throughout the week. But it switched to cash at the market’s close on Monday, March 7.

The NASDAQ Bottom Finder Indicator is not close to giving an all-clear signal. It remains mired below the 20 level. It requires a move up through 35 to signal that an end to the carnage is in sight.

Since the close on February 23, our Political Seasonality Index has been in the market and will stay there until March 18. (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 -40% 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 moved out of stocks last Tuesday, March 1.

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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