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 William Hubbard

The major U.S. stock market indexes were up last week. The S&P 500 extended its winning streak to four consecutive weeks with a 3.26% gain, the Dow Jones Industrial Average increased by 2.92%, the NASDAQ Composite was up 3.08%, and the Russell 2000 small-capitalization index rose 4.93%. The 10-year Treasury bond yield remained at 2.83%. Spot gold closed the week at $1,802.40, up 1.52%. 

Stocks

Last week, the consumer price index (CPI), producer price index, and the preliminary University of Michigan’s consumer sentiment index numbers were reported. But the big news involved the headline and core CPI. 

Headline CPI came in at 8.5% year over year, less than the expected 8.7%, and less than the 9.1% experienced in June, a 40-year high. Core CPI was 5.9%, less than the market forecasts of 6.1%.

The primary driver of the decline in inflation was a reduction in energy prices. Gas prices across the country are now below $4.00 per gallon and 21% below their mid-June high.

Stocks, which were down slightly before the release of inflation numbers, rallied hard Wednesday through Friday as investors began to price in less permanent inflation. Adding to the bullish behavior, the S&P 500 broke above key levels between 4,080 and 4,176 and sat just shy of its 200-day moving average.

Producer prices fell by 0.5% in July after a 1% increase in June. The reduction came primarily from a 1.8% decline in demand for total final goods. Final demand less food, energy, and trade resulted in a 0.2% gain for July. Overall, inflation trends are moving in the right direction but are still at extremely elevated levels. Surprise increases could be detrimental to overall consumer sentiment.

The University of Michigan’s consumer sentiment index came in at 55.1, higher than the expected 52.5. The consumer expectations index surprised by jumping from 47.9 to 54.9. 

“All components of the expectations index improved this month, particularly among low and middle income consumers for whom inflation is particularly salient,” said Surveys of Consumers Director Joanne Hsu in a statement.

The positive mood was echoed by investor equity allocations. National Association of Active Investment Managers (NAAIM) members recently reported the highest level of equity exposure since April, near 70%.

Traders are also in agreement that we are experiencing some relief. The CBOE Volatility Index (VIX), also known as the market’s “fear indicator,” finally fell below 20 on Friday for the first time in 86 days.

Long stretches of VIX readings above 20 followed by a break do not necessarily indicate that a decline or bear market is over. According to Charlie Bilello, CEO of Compound Capital Advisors, the longer the sustained VIX holds above 20, the more likely future returns will be adequately positive for risk investors. At 86 days, it’s unclear if we’re out of the woods or about to retest prior lows. What we’re experiencing so far is likely a strong relief rally.

Michael Gayed, CFA, author of Lead-Lag Report, recently completed a study on relief rallies. In his report, he summed up 2022 so far: “If the first half of 2022 was marked by doom and gloom, July [and August] was marked by unbridled optimism.” 

Relief rallies are frequent, and their outcomes sporadic, but in general, he found that throughout bear market cycles, recessions, and bubbles, there are periods of intense “relief” followed by more investor pain. The tech bubble is an excellent example of this. Between 2001 and 2003, there were four “relief rallies” of 20%. You can just imagine the market commentators calling the bottom each time.

For a decade of nearly 0% interest rates, the Federal Reserve has forced investors into risk-on assets, like stocks, fueling the rise of meme stocks and the increase of gambling on companies with little to no prospects. As that “trade” unwinds, it’s not impossible to see a return of volatility, further market declines, or an increase in inflation if everything doesn’t work out as planned. 

Not all equities were down 20% in 2022. Energy is a notable outlier, being up over 40% year to date. Passive investors, due to their hands-off approach, may have missed the bulk of this rally. In 2009, energy represented 13% of the S&P 500. In 2022, it’s a paltry 2.3%. In environments like this, investors have a choice: (1) Take a passive, “buy and hope” approach, or (2) take control by implementing dynamically risk-managed solutions to protect and compound wealth.

The following chart is the year-to-date performance of the Quantified Common Ground Fund (QCGDX). QCGDX is a dynamic, stock-focused fund that shows how active management can mitigate market missteps and keep your capital invested through the good and bad times. As of August 15, 2022, QCGDX was down 2.6% year to date, while the S&P was down 9.03%.

Bonds

The yield on the 10-year Treasury remained flat, ending last week unchanged at 2.83%. The 10-year Treasury has been in a state of decline this year. Since the beginning of August, it has searched for footing, but it continues to trade below its 50-day moving average.

The current state of bonds could be the result of the inflation rate slowing on a year-over-year basis. In its efforts to battle inflation, the Federal Reserve continues to increase its target range for rate hikes, now targeting a high end of 2.5%. It started the year off at 0.25%. The current momentum of rate hikes is the fastest in 40 years and shows how serious the Fed is about reining in inflation. 

Markets are pricing in a peak early next year. This could mean continued headwinds for bond prices should expectations prove to be false. But if things continue at this pace, the basing we’re seeing in bond prices could be a longer-term buying opportunity as prices increase due to rate declines in the latter half of 2023.

Rising interest rates should slow economic activity and increase borrowing costs. Increased borrowing costs can be problematic for low-credit borrowers. As a result, Schwab’s chief fixed income strategist, Kathy Jones, is recommending investors be more cautious on credit, and instead favor duration. Increasing duration could pay off in the latter half of 2023 as inflation declines and the Fed lowers rates to a more sustainable level.

Gold

Last week, gold gained 1.52%, ending the week trading just over its 50-day moving average. 

Since mid-July, the U.S. dollar started showing some signs of weakness and gold has performed well. In the short term, it looks like gold is benefiting from some mean reversion. But if a new trend is forming, then confirmation would occur if the dollar continues to decline and gold can test and exceed its 200-day moving average.

Typically, inflation depreciates a currency. But this hasn’t been the case for the U.S. dollar over the last few years. Investors seem to prefer the dollar to other options, boosting the value of the currency despite higher-than-desired inflation.

Following the COVID crash, gold moved up over 30% within a few months, mostly due to panic. Gold peaked in August 2020, while the U.S. dollar bottomed and began to go up in value. Since August 2020, a strengthening U.S. dollar has put downside pressure on gold as global investors flocked to the perceived safety of dollars.

A technical headwind for gold in the coming months will be to see if the dollar declines in value relative to other currencies as inflation fears abate. If not, we may see the formation of a long-term “cup and handle.” A cup and handle is a bullish chart formation that begins with a slow basing pattern (the cup) and a quick retracement (the handle), followed by a strong resumption of an uptrend. 

In the current “if this, then that” macro environment, it’s important for your investment mix to have non-equity and non-bond exposure available in dynamically risk-managed strategies.

Flexible Plan Investments is the subadviser to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction 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 started the week 60% long and reduced exposure to 20% long on Friday’s close. Our QFC Political Seasonality Index favored stocks again 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 started last week 40% short the NASDAQ and changed to 20% short exposure on Wednesday’s close. The Systematic Advantage (SA) strategy is 60% 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 remained in 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 more restrictive platforms 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 markets 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 has significantly outpaced 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 also one of the best stages for gold.

The S&P volatility regime is registering a High and Falling reading. From a return standpoint, high and falling volatility favors gold over bonds and bonds over stocks. 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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