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 Tim Hanna

The major U.S. stock market indexes were up last week. The S&P 500 increased by 6.45%, the Dow Jones Industrial Average gained 5.39%, the NASDAQ Composite was up 7.49%, and the Russell 2000 small-capitalization index rose 6.01%. The 10-year Treasury bond yield fell 10 basis points to 3.13%, taking Treasury bonds higher for the week. Spot gold closed the week at $1,826.88, down 0.68%.

Stocks

Equity markets finished the shortened week up, bouncing from a recently deeply oversold environment. Last week saw a momentum-driven bounce following heavy selling in the first half of June. Bad news for the economy was interpreted as good news for U.S. equities as the move last week was able to pull the S&P 500 out of bear market territory. Fundamentally, growth concerns were tempered by better-than-expected guidance from FedEx (FDX), but markets continue to teeter as volatility persists.

On the economic data front, existing home sales came in at 5.41 million, slightly above expectations of 5.40 million. Unemployment claims reached 229,000, slightly worse than the expected 227,000. The Flash Manufacturing PMI registered 52.4, below the expected 56.0. The Flash Services PMI was 51.6, less than the anticipated 53.9. The University of Michigan Consumer Sentiment was revised to 50.0, just above the expected 50.2. New home sales surprised to the upside with 696,000, well above expectations of 590,000.

Last week’s rally pushed the S&P 500 off 2022 lows, but volatility remains elevated and moves in both directions continue to be above average. Price remains in a bearish channel as the S&P 500 continues to trade below both its 50-day and 200-day moving averages, currently toward the lower half of the bearish channel.

Inflation around the globe is on the rise, and most central banks are following a similar course. Bespoke Investment Group reported that in testimony to Congress last week, Federal Reserve Chair Jerome Powell admitted that he “would not think so, no,” when asked if higher rates would bring down gas prices. He characterized food prices similarly. This response makes the Fed’s recent focus on headline inflation (which includes gas prices) confusing.

Historically, coordinated global tightening regimes similar to what central banks are doing this year in response to higher commodity prices have not worked out well. Extremely weak economic conditions followed the 1972 (oil embargo) commodity price surge, the late 1970s peak in inflation, and the mid-2000s.

As shown in the following chart, the move higher in developed-market policy rates over the prior six months has been the fastest since 2000. If the Fed hikes rates by 75 basis points in July, it would result in the fastest tightening pace since the early 1980s. Bespoke Investment Group believes that Powell is wrong when he states that rate hikes won’t bring down gas prices. The Fed could tighten to the point where oil demand falls thanks to a global recession, in turn lowering gas prices. Although the future is uncertain, the possibility of a global recession looks more likely as the weeks go by.

Bear markets and recessions are closely linked. Since WWII, only two bear markets have occurred without an accompanying recession, in 1966 and 1987. During all other bear market periods, a recession was already underway or would start during the bear market. In both exceptions, the Federal Reserve started easing during the course of the bear market. As of now, the Federal Reserve has not expressed any interest in easing as they battle inflation not seen in decades.

The two-year yield, a good proxy for overnight rates one year ahead, has started to fall despite Fed guidance for even faster rate hikes. This can be interpreted as the market lowering its expectation of how high rates will go.

The U.S. bond market is currently pricing in an elevated risk of recession. The two-year/30-year yield curve is very flat in term structure. Historically, the three-month/10-year yield curve is the best recession indicator; however, when the two-year/30-year yield curve is near or below zero, it is also a warning signal that the Fed is being too aggressive.

The rest of the world has also seen rate swings over the last few weeks. Europe and Australia have experienced a yield trajectory very similar to that of the U.S., while Japan and China remain on their own yield paths. Europe, Australia, and the U.S. have seen a sharp move up in yields since the start of this year. Even though all have experienced pullbacks, the trend is clear in the following chart.

Commodities (specifically energy) have been the top-performing asset class this year, accelerating higher after the supply shock due to Russia’s invasion of Ukraine and strong demand. Over the last few weeks, the asset class has seen drops greater than 20% across grains, natural gas, and metals. All major commodity groups in the Bloomberg Commodity Index, except for energy, have closed with a lower spot price compared to the night before the invasion of Ukraine. Energy prices have fallen as a result of the recent decline in commodity prices broadly.

With so much uncertainty across markets and the globe, active, risk-managed strategies that are able to respond to changing market conditions are more important than ever. With the continued disconnect between fundamentals and technicals, it’s critical to respond to price movements as they come, rather than trying to predict them based on news and emotions. If prices go down and volatility elevates, systematic momentum strategies can move to defense or remain defensive. However, if a new uptrend emerges, systematic trend-following algorithms are designed to recognize the price momentum and reduced volatility, stepping back into the “risk-on” camp.

The following chart shows the year-to-date performance of the Quantified Managed Income Fund (QBDSX, -0.8%) compared to the iShares Core US Aggregate Bond ETF (AGG, -11.3%). The Quantified Managed Income Fund is an actively managed income fund that can seek various income classes as well as the safety of cash when market exposure is undesirable. The Fund is a key defensive component in several actively managed strategies at Flexible Plan Investments.

Bonds

The yield on the 10-year Treasury fell 10 basis points, ending last week at 3.13% as the bond market got some relief during its battle with rising interest rates. The 10-year Treasury is currently pulling back off highs; however, it is still in an upward channel since the start of this year.

The 10-year is finding support above its 50-day moving average, and the major pullbacks this year have resulted in short-term “bull flags” (black lines on the chart below) that eventually break out to the upside. Such price patterns are considered continuation patterns, with breakouts targeting new highs and a continuation of the longer-term trend. The price structure is not currently suggesting a longer-term reversal. That may change if a lower high is confirmed or a failure to break highs results in the formation of a downtrend.

T. Rowe Price traders reported, “A relatively quiet primary calendar supported investment-grade corporate bonds from a technical perspective. However, Powell's acknowledgment to lawmakers that the tightening cycle may induce a recession and the below-consensus manufacturing data weighed on market sentiment.

“After tightening at the beginning of the week, corporate credit spreads widened alongside the less supportive macro backdrop.

“In the high yield market, higher-quality credits outperformed given the move in Treasury rates.”

Gold

Last week, gold fell 0.68%, ending the week trading right below its 200-day moving average as it made multiple attempts to break above it. Price movement remained slow in recent weeks relative to the large swings experienced earlier this year.

The U.S. dollar rally that started at the end of 2020 has paused again following a test of highs in mid-June. A higher dollar is a restraint on global liquidity and a headwind for inflation in the U.S. In general, a stronger dollar lowers the price of imports. The U.S. dollar and other non-equity or bond exposures are available asset classes for consideration within certain strategies at Flexible Plan Investments.

Although gold has struggled since late April, geopolitical tensions, inflation fears, recession fears, and Fed rate hikes continue to make a fundamental case for gold into 2022. Just as the historical stock and bond relationship hadn’t been there for investors this year until a few weeks ago, gold’s run may regain steam, especially if we see sustained weakening in the U.S. dollar over the coming months.

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

The very short-term-oriented QFC S&P Pattern Recognition strategy was 0% exposed throughout last week. Our QFC Political Seasonality Index favored defensive positioning throughout last week. (Our QFC Political Seasonality Index is available—with all of the daily signals—post-login in our Weekly Performance Report section under the Quantified Fund Credit category.)

Our intermediate-term tactical strategies have been varied in their degree of defensive positioning. 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 was 60% short (negative) the NASDAQ throughout last week. The Systematic Advantage (SA) strategy is 60% exposed to the S&P 500. Our QFC Self-adjusting Trend Following (QSTF) strategy was 100% short throughout last week, changing to 0% exposure at Friday’s close. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic model moved out of stocks last week. Most of our Classic accounts follow a signal that will allow the strategy to change exposure 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, one of our Market Regime Indicators, shows that we continue to be 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 favors 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 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 regimes.



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