Market insights and analysis

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

1st 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 Jason Teed

The major U.S. stock market rebounded strongly during the last full week of May, taking a breather from significant declines experienced year to date. The NASDAQ Composite climbed 6.84% for the week, and the Dow Jones Industrial Average gained 6.24%. The 10-year Treasury bond yield fell 4 basis points to 2.74%. Rates are down from their May 6 high of 3.13%. Spot gold closed the week at $1,853.72, up 0.39%.

All 11 sectors were up last week. Consumer Discretionary was the best performer, up an astonishing 9.24%. Health Care and Communications were the worst performers, up only 3.21% and 3.59%, respectively.

Stocks

Why did stocks rally last week? Technically, the market was oversold. In addition, weaker economic results began to come in, which, counterintuitively, could also have contributed to last week’s strong performance.

To the first point, recent sharp drops have taken the market into oversold territory when compared to the 50-day moving average. While some economic and corporate expectations suggest further drops may be necessary, the market tends to adjust to changing expectations at a typical “speed.”

When prices of companies (and the market as a whole) adjust too quickly from a statistical standpoint, market participants often sweep in, making purchases they hope will appreciate—at least in the short term. This can often become a self-fulfilling prophecy for the markets, which leads to a de facto speed limit in terms of pricing declines.

The market reached extreme oversold territory in mid-May, which no doubt contributed to last week’s rebound. Whether that price action will continue or is more of a technical bounce remains to be seen. However, after last week, the market is no longer oversold from this perspective.

For example, manufacturing appears to be slowing. When compared year over year, four out of seven recent releases indicate a slowdown from March, which was a further slowdown from February.

And housing is not immune to the current rising rate environment. New home sales are now nearly 27% weaker than last year, and existing home sales have also fallen. This is not surprising as the current mortgage payment is up 57% versus the same time last year based on increased interest rates alone. This has put a damper on the markets. While prices are not yet declining, further slowing is expected in this sector.

The main impact that rising rates attempt to achieve is slowing inflation. The markets have cheered the fact that Federal Reserve policy appears to be doing just that. Core inflation for April came in at 4.9%, lower than the 5.2% that we saw in March, and largely within expectations. Additionally, month-to-month inflation was up only 0.2%, much lower than the 0.9% reading in March. These initial signs that Federal Reserve policy has begun working is a relief to the markets. The Fed has indicated that they intend to pursue aggressive rate hikes in the near term to allow for potentially softer policy stances later on.

Additionally, some economic indicators have come in weaker than expected. This would usually be negative news for the market. However, the Federal Reserve is actively pursuing a tightening policy, and these weaker-than-expected reports are indications that the policy is working. This reduces the likelihood that the Fed will need to be even more aggressive going forward. If the market anticipates a less aggressive Fed later this year, the impact of further rising rates on stocks may be muted, leading to the rebound in prices that we saw last week.

The question is whether the Fed can slow inflation without causing a recession. If the Fed can be more aggressive earlier, then it should have some wiggle room to engineer a soft landing without causing a recession.

However, recessions are a typical part of the business cycle. The most recent two recessions, which resulted from asset bubbles and a pandemic, were atypical and severe (particularly the 2008 financial crisis). Standard recessions are the result of the Federal Reserve raising rates in response to an overheated economy.

The probability of a recession, as measured by a composite of private institutions, remains around 30%. However, it has been steadily increasing since the end of last year (see the following chart). While any future recession is likely to be unpleasant, it is also unlikely to be as dramatic and as deep as the recessions of the past 15 years.

Bonds

Treasury yields were mixed for the week. Shorter-term yields rose, while maturities of one year and beyond fell.

The term yield rose 6.4 basis points, and credit spreads fell by about 17 basis points. Both movements indicate expected economic growth going forward. Overall, long-term Treasurys underperformed high-yield bonds, and longer-term bonds outperformed shorter-term bonds.

The yield curve has flattened slightly over the week but the slope still appears healthy. The market expects that rates will continue to rise, with potentially a couple more 50-basis-point increases this year, as the Federal Reserve begins to combat inflation. Overall, economic messaging from the bond market seems optimistic.

Gold

Spot gold was up last week. This was after the metal bottomed in early May, eliminating its gains for the year. Year to date, gold is up about 1.3% after having experienced significant volatility.

Gold has faced recent headwinds. The Federal Reserve has increased rates significantly over the past few months and is expected to continue to do so. Rising rates make the U.S. dollar more valuable when compared to other currencies. Being priced in dollars, the value of gold appears to have downward pressure for a U.S. investor. However, weakening expectations for U.S. economic activity going forward have increased speculation that Fed interest rate increases in 2022 may not be as aggressive as feared. This has provided some relief for gold investors as the dollar has taken a breather from its recent run-up.

Non-currency safe-haven assets, such as long-term Treasurys, were also up for the week as rates moderated—despite a clearly risk-on environment. The moderation of rates themselves led to the rising stock market.

Flexible Plan Investments 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

Our Political Seasonality Index began the week out of the market, entered on Tuesday, exited again on Thursday’s close, and remained there to begin this week. (Our QFC Political Seasonality Index is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.) The very short-term-oriented QFC S&P Pattern Recognition strategy’s equity exposure began the week 1.6X long, changed to 1.3X long on Thursday, and exited the market on Friday to begin this week.

Our intermediate-term tactical strategies have mixed exposure. The Volatility Adjusted NASDAQ (VAN) had a 60% inverse exposure to the markets. The Systematic Advantage (SA) strategy began last week 60% exposed to the market, changed to 90% on Friday’s close, and remained there to begin this week. Our QFC Self-adjusting Trend Following (QSTF) strategy was neutral to the market for the week. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic strategy remained out of the markets for the week. The strategy can trade as frequently as weekly.

Our strategies mostly remain relatively underexposed to the market, having exited several weeks ago. Volatility remains high and overall market direction is indeterminate as we go through some relief after recent selling.

Flexible Plan’s Growth and Inflation measure, one of our Market Regime Indicators, shows that we remain in the Stagflation economic environment stage (meaning a positive monthly change in the inflation rate and negative quarterly GDP reading). This environment has occurred only 9% of the time since 2003 and has been a positive regime state for gold, and bonds, while equities tend to fall. Gold tends to significantly outpace both stocks and bonds on an annualized return basis in this environment, with a lower risk of drawdown than equities. From a risk-adjusted perspective, Stagflation is one of the best stages for gold.

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 2000. It is a stage of lower returns and higher volatility for all three major asset classes.



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