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 Jerry Wagner

Last week, the Dow Jones Industrial Average lost 4.6%, the S&P 500 Index fell 5.1%, the NASDAQ Composite dropped 5.6%, and the Russell 2000 small-capitalization index gave back 4.4%. The 10-year Treasury bond yield rose 22 basis points to 3.16%, sending bond prices lower for the week. The U.S. Aggregate Bond ETF (AGG) lost 1.5%, while the 20-year Treasury Bond ETF (TLT) tumbled 1.95%. Gold futures closed the week at $1,876.30, up $26.10 per ounce, or 1.41%.

Although Monday and Tuesday of last week were positive, selling commenced Wednesday and accelerated through this past Monday (June 13). The last three days of that period were especially vicious. Such a severe three-day slide has occurred only three times in history. The market quickly bounced higher in two of the three instances, but the last time, in the pandemic fall of 2020, the market fell another 20%-plus over the next two weeks.

The market has not yet moved to what I call “grizzly bear” status (a decline of over 30%) on the S&P, but it has reached the bear market level (a decline of 20%) on all of the major indexes, including (perhaps surprisingly to some people) long-term government bonds. This is particularly damaging to so-called balanced portfolios that hold 60% in stocks but hope to hedge the risk of the portfolio with 40% in bonds. Obviously, that has not been at all helpful in this market cycle.

The move by the S&P into bear territory was one of its fastest. Only four past declines of 20% or more occurred in less time. Although, its dive was the fastest decline from a 7% bear rally high ever. On Monday, only five of the S&P 500 stocks were able to advance.

All that being said, grizzly bear status has been obtained on the NASDAQ, which is now down over 31%. The NASDAQ Composite Index has fallen for 10 of the last 11 weeks.

It’s not all gloom and doom. I checked Flexible Plan Investments’ 50-plus Quantified Fee Credit (QFC) strategies and suitability profiles. As of Friday’s close, all of them outperformed the S&P 500 last week, and all were ahead of the month-to-date and quarter-to-date benchmark returns. What’s more, year to date, all but three of those strategies have beaten that mark.

It’s not surprising that the stock and bond markets are tanking. Investors feel attacked by the Federal Reserve and besieged by inflation, and sometimes it feels like the markets are taking no prisoners.

It seems like the two antagonists just keep playing a game of tag. The Fed tags inflation and shouts “You’re it.” Then when inflation starts to run, it tags the Fed and shouts its own, “You’re it.” Then it’s the Fed’s turn to run with it.

First, the Fed inflates. Then inflation overheats. Finally, the Fed steps in to cool things off. It’s a vicious circle that often only ends when a recession occurs and the economy slows. Unfortunately, that seems to be the inevitable final arc of the vicious circle again this time.

Inflation certainly has been running, and running hard. The cost of living reports are posting numbers we have not seen in over 40 years. The annualized rate of the monthly consumer price index (CPI) increase was almost 13%. In the 2½ hours after the report’s release on Friday, the S&P responded by dropping 3%.

We’ve all heard that inflation is a tax on us. And that is certainly proving to be the case. Inflation-adjusted hourly earnings were reported to be down last week—for the 14th straight month.

Gasoline has soared. Oil has more than doubled in price since January 2020, with only the last 29.11% occurring since the Russia-Ukraine war began. At the same time, the price of natural gas in this country has jumped about 55%, while in Europe it has risen “only” a bit over 26%.

To cool things off, the Fed has been tightening. It does this by talking up its future moves, by actually raising the federal funds rate, and by selling from—instead of buying for—its vast inventory of fixed obligation loans.

All of these actions have had a very real impact on interest rates. For example, the 2% government bond, which was yielding almost 0%, has increased by 2.786 percentage points in the last nine months. That’s one of the fastest rates of increase in history, about matching the 1989 and 1999 rate explosions.

The effect has been a daily onslaught of weakening economic reports that investors can no longer ignore. The net number of year-over-year economic reports is now negative. And the number of economic reports that have failed to meet economist expectations in the last month is the lowest since 2020.

As a result, sentiment numbers are crashing. The University of Michigan consumer sentiment index sank to 50.1 versus an expectation of 58.1. Not only was that a huge miss, but it was the weakest reading since 1978. The year-over-year decline of 41% was the sharpest fall on record. In the past, sharp declines have inevitably resulted in recessions.

Why do all of the stock market discussions of late seem to end up mentioning recession? Because bear markets accompanied by a recession within one year are 25% deeper than the run-of-the-mill bear market (one that reverses quickly after hitting the -20% mark). The recessionary bear markets also last 2.5 times longer and recover more slowly.

Bottom line: A bounce in stock prices seems warranted between now and the end of the week. The severity of the declines, as well as the oversold nature of the stock market, has historically spawned such a rebound. However, as I wrote almost a month ago, longer-term and intermediate-term indicators suggest that an ultimate bottom to the current market has probably not yet been reached.

Bonds

In classic fashion, the interest rate of the 10-year government Treasury bond approached its 50-day moving average and quickly reversed higher. Spurred on by the CPI report, the rate easily moved above the series’ recent high point. The move higher has continued this week as investors feared that Wednesday’s Fed meeting would generate more than the expected 50-basis-point increase, with the body opting for a higher 75-basis-point hike.

Responding to the higher interest rate environment, long-term Treasury bonds sank precipitously in price, decisively breaking through a line of resistance stretching back to 2018.

Reflecting the downturn in stocks, high-yield bonds (represented here by the HYG ETF) have also been declining. If we see a bounce this week in stocks, this descent may be reversed in the high-yield sector as well. In addition, we are nearing a long-term resistance point. But that may prove as insubstantial as the government-bond version vanquished last week.

Gold

While gold has long been considered a storehouse of value and a bulwark against inflation, that has not been the case lately. Gold has been hit hard as stock prices have fallen. This is reminiscent of 2008, when gold plummeted during some of the worst days of that market collapse. I would note, though, that when the smoke had cleared on that bear market, gold again turned out to have been one of the best defensive investments.

The reason for the decline is rising interest rates, which makes holding nonyielding gold seem more costly. Those same rising rates, also make our dollar seem safer, as our Fed’s actions of late appear to be taking inflation more seriously than other countries have been. Of course, the reason for this is that inflation here is worse than in most other countries and the Fed has had little choice. In any event, high interest rates tend to send the dollar higher, and a rising dollar is anathema to the price of gold.

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 negative. However, short-term patterns favor a one-to-five-day bounce given the severity of the negative action last Wednesday to Friday. Our very short-term-oriented QFC S&P Pattern Recognition strategy, however, has sold out of stocks.

Our Political Seasonality Index has been in the market since the close on May 31 and will stay there until the close on June 14. After nine trading days in a defensive posture, it will then return to stocks at the close on June 27. So far, this has not been one of our better trades as the S&P 500 fell 5.6% through June 10. Our subadvised Quantified Common Ground Fund (QCGDX), the fund used to trade the QFC Political Seasonality Index strategy, fell 4.12% in the same period.

The QFC Political Seasonality Index strategy is included in our QFC Multi-Strategy Explore portfolio within Special Equities. The next two weeks in the market are down a higher percentage of the time than all other two-week periods in an average year.

(Our QFC Political Seasonality Index—with all of the 2022 daily signals—is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.)

FPI’s intermediate-term tactical strategies are very mixed. The Volatility Adjusted NASDAQ (VAN) strategy is 40% inverse to the NASDAQ, the Systematic Advantage (SA) strategy is 100% in its defensive positions (100% out of equities), and our QFC Self-adjusting Trend Following (QSTF) strategy moved into a 100% inverse position on Thursday’s close (6/9), having spent the balance of the week in cash. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

On Tuesday, June 7, 2022, Classic generated a buy signal and a move into equities. Since that signal through Friday, June 10, the S&P 500 has fallen 6.54%, while QCGDX, the fund used to trade the QFC Classic strategy, fell 4.19%.

At the beginning of May, our All-Terrain indicator, one of Flexible Plan’s Market Regime Indicators, registered a major change. Our Growth and Inflation measure began signaling that we were in a Stagflation economic environment stage (meaning a positive monthly change in the inflation rate and negative monthly GDP reading).

This occurs only about 9% of the time and favors gold and then bonds over stocks. It is a time of moderate risk for gold, but stocks have their second-worst drawdown of all the regimes. Only the Deflation economic environment has seen larger drawdowns for stocks. The last time we saw this condition was in the late 1970s and early 1980s, when substantial shrinkage of the Case/Shiller P/E occurred, driving stocks and the ratio down to as low as 7 times earnings

Our S&P 500 volatility regime is registering a High and Falling reading, which favors gold over bonds and then equity from an annualized return standpoint. The combination has occurred 13% of the time since 2003. It is a stage of lower returns for equities and higher volatility for both gold and stocks. The S&P 500 registered a maximum drawdown of over 29% during one of these regimes, while gold’s maximum price loss was over 21%.



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