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 mostly up last week. The S&P 500 increased by 0.36%, the Dow Jones Industrial Average lost 0.13%, the NASDAQ Composite was up 2.15%, and the Russell 2000 small-capitalization index rose 1.94%. The 10-year Treasury bond yield rose 18 basis points to 2.83%, taking Treasury bonds lower for the week. Spot gold closed the week at $1,775.50, up 0.54%. 

Stocks

Equity markets finished the week mixed following better-than-feared earnings results and a strong jobs report. The week started cautiously. Some economic data came in relatively weak, and uncertainty surrounded China’s actions following U.S. House Speaker Nancy Pelosi’s visit to Taiwan. China stated that it will perform live-fire military exercises near Taiwan and sanction Speaker Pelosi and her family. China also announced that it will be reducing or suspending cooperation with the United States on matters such as climate change initiatives, counternarcotics, and legal assistance in criminal matters.

On the economic data front, the ISM Manufacturing PMI came in at 52.8, slightly higher than the 52.3 forecast. Construction spending was -1.1% month over month, lower than the expected 0.3%. ISM Services PMI registered at 56.7, better than the 53.5 expected. Unemployment claims were in line with expectations at 260,000. Average hourly earnings came in at 0.5% month over month, higher than the 0.3% forecast. The unemployment rate was 3.5%, lower than the 3.6% expected. The biggest positive surprise last week was non-farm employment change, which came in at 528,000, more than double the estimate of 250,000.

This surprise and the market’s subsequent response could be a sign of continued labor market strength, which could indicate that the economy is able to handle the Federal Reserve’s rate-hike path without experiencing a hard landing. The other interpretation of the data and market response may be that employment is a lagging indicator, and given the lag effect of the Fed’s rate increases, weaker jobs number are to be expected in the coming months. This scenario could lead to a sooner-than-expected shift in monetary policy. It has been difficult to “trade the news” most of this year because of the market’s often unexpected response to the data. 

The S&P 500 Index continues to recover following the lows set in June. Currently, the Index is above its 50-day moving average and on its way to test the upper trend line of this year’s bear channel (see the following chart). The upper trend line (the black negative-sloping line on the following chart) coincides with the Index’s current 200-day moving average, a measure widely used by technicians to identify long-term trends and levels of support and resistance. 

Historically, large declines in the stock market have been a good indicator that widespread contraction in economic activity is taking place, with bear markets largely coincident with recessions. Bespoke Investment Group illustrates this well in the following chart. It shows the average equity market performance indexed to the final day of the final month before a recession begins. The data goes back to 1929 and encompasses 15 recessions. 

Equity market performance typically falls at the start of a recession rather than throughout. That suggests that if the U.S. is not in a recession presently, then it’s less likely to experience one. If a recession were at play, we would expect stocks to be declining now; however, stocks have already fallen. Bespoke believes that if we do not have a recession in the near term, we would not expect the type of “balance sheet” recession that created a massive credit unwind during the 2008 financial crisis. Imbalances simply haven’t built up enough to justify a collapse of that magnitude. 

Therefore, the best proxies for stock market performance around a prospective recession may be the Volcker and Greenspan recessions. They were induced to curtail inflation and did not result in broad credit collapses. As shown in the following chart, two of these four recessions saw stocks climb higher within six months. Extreme tightening to fight inflation in the 1980s led to a generational asset boom that started in the mid-1980s and continued through the highs of last year. The point is that recession isn’t always a major negative for market outlook, especially considering stocks have already retreated so much off their highs from the start of this year.

Earnings continue to exceed expectations. Through last week, more than 800 companies have reported results this season. As shown in the following chart, earnings-per-share (EPS) beats have risen despite high inflation. More than 70% of reported companies have registered revenue beats. Although this rate is slowing, it remains impressive. EPS and revenue beat rates of more than 70% are incredible considering how strong results have been since the start of the COVID-19 pandemic. 

The share of companies missing earnings has been low by historical standards but higher than in recent years. 

Whether this rally results in a new bull market or reverses course to continue the theme of the first half of this year, it’s more important than ever to invest in dynamically risk-managed strategies that are able to respond to changing market conditions. 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 continue to move up and volatility is low, systematic trend-following algorithms are designed to recognize the price momentum and participate in a risk-on fashion. If this is a head fake and prices reverse direction, systematic momentum strategies are designed to identify the change and move to defensive positioning.

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, -8.9%). 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 rose 18 basis points, ending last week at 2.83% as the bond market continues to battle with a long-term trend of rising interest rates. The 10-year Treasury yield remains within the pullback that started mid-June and continues to trade below its 50-day moving average. 

Major pullbacks this year have resulted in short-term “bull flags” (the black lines on the following chart) that eventually break out to the upside (which would be negative for bond prices). Such price patterns are considered continuation patterns, with breakouts targeting new highs and a continuation of the longer-term trend. 

The major difference with the current yield structure is the length of the pullback and the time spent under the 50-day moving average. Both of these factors, especially the trading activity below the 50-day moving average, have signaled a deeper pullback than we’ve experienced this year. 

The momentum, or lack thereof, behind the next up-leg attempt by yields could help establish the next intermediate trend. Technicians are looking for a lower high or a failed break of highs to suggest a possible formation of a longer-term downtrend.

T. Rowe Price traders reported, “Investment-grade corporate bonds were resilient despite an uptick in supply, although the technology sector traded lower amid new issuance from some prominent names. The news that U.S. investment-grade corporate bond funds experienced their first weekly inflow since March 2022 also supported the asset class. High yield corporate bonds benefited from positive cash flows and improving risk sentiment.”

If you are a financial adviser, please join us Tuesday, August 16, at 4 p.m. EDT for our in-depth webinar on risk-managed bonds, focusing on active management in the fixed-income markets.

Gold

Last week, gold gained 0.54%, ending the week trading just under its 50-day moving average. The yellow metal continues its move upward that started in the second half of July following a steep decline in the first half of the month. The early July sell-off set a one-year low and resulted in a death cross (when the 50-day moving average crosses below the 200-day moving average). Price is currently testing its 50-day moving average. 

Since mid-July, the U.S. dollar’s weakness has provided some relief for gold (the purple line in the following chart). 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 as the U.S. dollar has marched higher, geopolitical tensions, recession fears, and the impact of Fed rate hikes continue to make a fundamental case for gold into 2022. Gold may see some upward movement due to mean reversion, 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 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 10% short, changed to 0% exposure at Monday’s close, and changed to 60% long at Tuesday’s close where it remained to end the week. Our QFC Political Seasonality Index favored stocks 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 40% short the NASDAQ throughout last week. The Systematic Advantage (SA) strategy is 30% 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 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 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.

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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