Weekly Note - October 27, 2020 - Add-in Sleeves

Add-in Sleeves

Using the new add-in sleeves is completely optional. Some will decide to continue doing what they have been doing and not use them. Their current model portfolios will adjust to changes in market dynamics. If you decide not to use the add-in sleeves, simply continue using your current Shares-to-Trade worksheet; the mechanics of the sheet have not changed.

Use of the add-in sleeves is probably best suited to those who are already comfortable trading their Focused 15 investing portfolios.

I think we have a week or two before using the add-in sleeves will have an impact. This is a good time to review them and how they can be used.

My goal in creating the add-in sleeves is to make it easier to move gradually into the ETFs that have been part of the 2020 Recovery portfolios and the Emerald portfolios. The updated Shares-to-Trade worksheet allows you to continue with the model portfolio you are currently using, let’s call it your core model portfolio (or simply “core portfolio”), and at the same time allocate a portion of your account to an add-in sleeve.

On the weekly publications, I list two add-in sleeves. The first is the 2020 Recovery sleeve, which has ETFs linked to technology, healthcare, and communications stocks. The second is the Emerald sleeve, which includes ETFs for green energy and technology.

2020 Recovery Add-in Sleeve

This add-in sleeve focuses on NASDAQ, healthcare, and telecommunications stock ETFs. These ETFs are likely to be favored in the presence of social distancing and government efforts to stimulate economic recovery from the COVID pandemic. This sleeve includes ETFs linked to the tech-biased NASDAQ, the S&P Healthcare sector, and the S&P Communications sector. The ETFs will be dynamically weighted to avoid losses, although some losses will occur. The ETFs included may change over time.

We maintain two versions of the 2020 Recovery add-in sleeve, one for the Zircon, which does not use levered ETFs, and one for the Diamond and Sapphire publications, which use ETF “QLD” that magnifies the return of the NASDAQ 100 two times - essentially giving this ETF twice the market exposure of the NASDAQ 100 Index. Both 2020 Recovery versions have the following exposures to the ETFs (based on equivalent market exposures).
60% NASDAQ (ETF QQQ for the Zircon version and QLD for the Diamond/Sapphire version)
40% A mix of the ETFs VOX (telecommunications) and XLV (healthcare) ETFs

The 2020 Recovery add-in sleeve is designed to a) provide exposure to these sectors, b) avoid losses in the NASDAQ-linked ETFs (using historically tested algorithms), and c) rotate between VOX and XLV to favor the most resilient of these two sectors. This add-in is a good fit for those seeking to invest in sectors favored by the current economic and pandemic conditions.

Emerald Add-in Sleeve

The Emerald add-in sleeve focuses on clean energy and technology stock ETFs and a green bond ETF. This sleeve seeks to take advantage of what many believe is a mega-trend favoring investments in environmental sustainability.

We maintain two Emerald versions, one for the Zircon, which does not used levered ETFs, and one for the Diamond and Sapphire publications, which use ETF “QLD” that magnifies the return of the NASDAQ 100 two times - essentially giving this ETF twice the market exposure of the NASDAQ 100 Index. Both versions of the Emerald add-in sleeve have the following exposures to the ETFs (based on total market exposures).
30% NASDAQ ((ETF QQQ for the Zircon version and QLD for the Diamond/Sapphire version))
25% Clean Energy (PBD)
25% ARK Innovation (ARKK - an actively managed ETF focusing on disruptive technology)
20% Green Bonds (GRNB)

This Emerald add-in sleeve is designed to a) provide exposure to these sectors, and b) avoid losses in the NASDAQ-linked ETFs (using historically tested algorithms) and the Ark Innovation (ARKK) ETF (using a judgmental application of MRI-based disciplines). This add-in is a good fit for those with longer time horizons and/or a strong belief in the presence of the trend toward investments in environmental sustainability and who can tolerate temporary losses. THE EMERALD SLEEVES EMBODY MORE RISK THAN IMPLIED BY THE RETURN-TO-RISK CHARTS ON THE WEEKLY PUBLICATION. Some of these ETFs have short histories and are narrowly focused (PBD is focused on energy-related businesses). Also, this sleeve may be revised over time (including replacing ETFs), which will cause of restatement of historical performance figures.  Links:
   ARKK – Ark Innovation ETF. This is an active ETF, which means that the investment team at Ark buys companies that it believes will benefit from future trends. Website: https://ark-funds.com/arkk
   GRNB - VanEck Vectors Green Bond ETF. Website: https://www.vaneck.com/etf/income/grnb/overview/
   PBD – This ETF tracks the WilderHill New Energy Global Innovation Index. Website: https://www.invesco.com/us-rest/contentdetail?contentId=3dd2fd05f0e21410VgnVCM100000c2f1bf0aRCRD&dnsName=us


Weekly Note - October 14, 2020

  • A historical perspective on our missing recent market gains
  • The current status of the market (DJIA) in terms of longer-term changes in MRI conditions, focusing on the Macro and Exceptional Macro MRI
  • A comment about high current stock valuations compared to key points in the last roughly 20 years
Historical Perspective on Missing Recent Market Gains

Our portfolios have fallen behind the market, and one might ask if something in the algorithms are broken.

Focusing on the Diamond (sg131) model portfolio, it has returned -9% thus far year to date. Its Upper Risk Mix (URM) holds the same ETFs at constant weights and and the positions are very aggressive. The URM has returned 1% over the same time period.  Thus, the model portfolio is lagging the URM by about 10 percentage points so far this year. Over the last several weeks, we have been on the sidelines in cash while the market has pushed higher. I watch the markets every day and some days it is painful to see our performance shortfall.

In prior notes, I have described how the markets’ current movements have been distinctive. Specifically, the Micro MRI troughed at a moderate level in mid-July, and, based on historical precedents, the algorithms have stayed out of the stock market ETFs in the subsequent upleg. Yet as of today, this has not been profitable and has contributed to the ten-percentage point shortfall compared to the URM.

Long-Term Performance of the D5 Signal Set 

To provide more historical detail, I evaluated the 100 years of performance for the DJIA signal sets we use and compared the current shortfall (over the last 8 weeks, roughly two months) to all the eight-week rolling periods over the 100 years. The first image should be familiar, and I show it now simply for background.

This shows the DJIA in the brown line. The green line shows the performance of the “D5 signal” set that drives the target weights of the DJIA-linked ETFs (DIA, DDM, UDOW). The performance reflected by the green line does not include bond investments because bonds do not have 100 years of history. Nor does it reflect any leverage that is included in the ETFs DDM and UDOW. Nonetheless, the green line is a reasonable estimate of the value added by the MRI-based signals (based on the Macro, Exceptional Macro, and Macro MRI). The vertical dashed line shows when I started using the MRI-based approach. One can see that the D5 signal set has provided good returns over the 100-year period and also the period of actually being used in portfolios.

At the far right on the green line for the D5 signal set, one can see the recent decline related to the COVID pandemic. The D5 signal set has experienced other declines of similar magnitude and still gone on to produce a strong subsequent performance track record. The years of some of these declines are shown in the chart above.

The Shortfall

The decline in 2020 for the D5 signals set was abrupt and deep (although not as deep as for the buy-and-hold DJIA shown by the brown line). One can see that the buy-and-hold DJIA (brown line) has recovered more fully than has the D5 signal set (green line). That difference creates a performance shortfall of the D5 signal set relative to the buy-and-hold DJIA of roughly ten percentage points since the beginning of 2020.

To give an idea of how common (or unusual) this shortfall is, I have calculated the eight-week shortfalls over the last 100 years. I selected the eight-week (two month) period arbitrarily. The image below shows the performance shortfall over all eight-week rolling periods for the entire 100-year history.

The current shortfall is the third worst since I started using the MRI-based approach in 2007/8, and the ninth worst over the 100 years shown. Thus, the current period of shortfall is not unprecedented. While such a shortfall can be painful, I believe that such a shortfall is insufficient reason to modify the D5 signal set.

Current MRI Conditions – Macro MRI

I often discuss the Micro MRI because that resilience cycle fits most closely the market returns we see each day and week. As mentioned recently, the Micro MRI has been in its downleg over the last few weeks and may trough sometime in November.

In this note, I’d like to discuss the Macro MRI and how it has changed over the last few years. As a reminder, the Macro MRI indicates longer-term resilience with cycles lasting a few quarters to a few years. It is the broad market context that the Micro MRI operates in.

In early 2016, the Macro began a long upleg that lasted until early 2018. Diamond (sg131) had these returns:

  2016    30%
  2017    40%

In January of 2018, the Macro MRI peaked at a remarkably high level. It was at the 98th percentile of its levels since 1918. Since then, it has been in its downleg, indicating that the market lacked long-term resilience. Over the last 100 years, when the Macro MRI is in the downleg of its cycle, there can be deep declines. There can also be periods of strong positive performance for the market and the algorithms seek to capture these returns – but it is more difficult. My notes and comments were influenced by this negative Macro MRI backdrop, resulting in a tentative (rather than emphatic) view that the market would move higher during Micro MRI uplegs, reflecting the difficulty of achieving high returns with low long-term resilience.

  2018    -7%
  2019    33%
  2020    -9% (year through 10/9/2020)

However, today the Macro MRI is now at a relatively low level. It has declined and is now at the 32nd percentile of levels since 1918. This suggests that we are getting closer to a trough of the Macro MRI and a subsequent upleg. The lack of resilience associated with a downleg of the Macro MRI may be coming to an end over the next several weeks or months.

Current MRI Conditions – Exceptional Macro MRI

In the MRI-based framework, the Exceptional Macro plays an important role in the D5 signal set and therefore the target weights of the model portfolios. The Exceptional Macro typically indicates a change in the direction of the Macro MRI (i.e., downleg-to-upleg or upleg-to-downleg). It is sensitive to changes in the slope of the Macro and often foreshadows a peak or trough of the long-term price trend.

The image below shows the Exceptional Macro as vertical green lines on both the price line of the DJIA (upper panel) and the Macro MRI. When it appears, longer term resilience is building and the algorithms tend to favor the DJIA. When it disappears, we tend to avoid investing the DJIA.

Point A is in early 2016 when the market started a strong ascent. Point B is the peak of the Macro MRI and the beginning of a long period of low long-term resilience. The Macro MRI declined until late 2019, when it started moving higher. It did so until the Exceptional Macro appeared briefly at point C, which was just before the COVID-related decline. Between points C and D, the Macro has been in its downleg.

One can see that at points A, B, and C above that the appearance and disappearance of the Exceptional Macro often foreshadows a change in the direction of the Macro. It appeared briefly and then disappeared at point C, which was on January 31, 2020 – well before the Covid crash. A similar appearance/disappearance occurred in January of 2018. As mentioned in prior notes, guidance to adjust Box #2 Cash will be used to reduce losses associated with the disappearance of the Exceptional Macro.

The period from B to D in the image above is similar to the late 1990s when the internet bubble expanded and collapsed. In the late 1990s, NASDAQ and the DJIA moved higher propelled by internet stocks despite the Macro MRI being in the downleg of its cycle. The narrative was that the world would be remade by the internet. As prices moved higher, valuations of stocks moved higher and ultimately came to the point where price increases could not be sustained. When company earnings growth failed to materialize, prices moved lower. As they moved lower, more investors sold, pushing prices even lower.

The take-away from this example is that while we may be getting closer to the beginning of a period of long-term resilience (because the Macro MRI is at a low level – 32nd percentile), the key issue for us is what takes place between now and then.

Current Valuation Levels

While our MRI-based system does not consider valuation (e.g., price-to-earnings, price-to-book), valuation is another useful metric to assess the condition of the market. At this time, the price of the DJIA is high compared to the DJIA companies’ recent earnings and the book value of their assets. I will focus on the price-to-book ratio because earnings are questionable right now, considering the economic shutdown. The current price-to-book ratio for the DJIA is 4.6. This means that for the typical DJIA company, the current price is 4.6 times the recent book value of the company.

The last time this ratio was this high was in late 2007, just before the major decline of 2008. Before that, the price-to-book was this high in early 2000, just as the internet bubble was collapsing. Thus, when the DJIA has been at similarly high valuation measures over the last 20 years, price declines have followed. These valuation measures support us being conservative (low exposure to DJIA-linked ETFs) at this time.  That said, interest rates have been higher over the last few decades than they are now, and today’s very low interest rate environment may simply tolerate higher valuation measures, all else equal.  Thus, I do not consider this valuation level as a conclusive indicator of an imminent major decline.  

Between now and the next period of high Macro MRI resilience, we may experience price declines that move the index toward more reasonable price valuations. While our being out of the market may be painful, there are currently good reasons to stay with the disciplines and wait for the market to be more resilient.

Under Development: Add-In Sleeves

The 2020 Recovery portfolio introduced earlier this year has performed well, but switching to it was too abrupt for many subscribers. The switch would have changed the overall risk profile of their accounts to much for comfort.

I am developing a method to move more gradually into this type of special situation investment. I am creating what I am calling “Add-In Sleeves,” which a subscriber can combine with their current model portfolio in a more gradual way over time. Recall that our model portfolios have “sg” numbers, which refers to sleeve groups, such as the Diamond-Onyx Mix. “Diamond” is one sleeve. “Onyx” is another. I am making it easier for users to add an additional sleeve of their choice.

One add-in sleeve is the “2020 Recovery” sleeve. This is very similar to the 2020 Recovery Portfolio that has been in the publications for several months.

Another add-in sleeve what I call the “Emerald Innovation” sleeve. This is useful for subscribers wanting to invest in longer term mega trends such as the decarbonization of energy and technological innovation.

Users can add one of these sleeves to the current model portfolio using a modified Shares-to-Trade worksheet. They can add, say, 5% or 10% of their account into these sleeves and change this amount over time if desired.

Thus, if you currently use Diamond (sg131) and would like to add in the 2020 Recovery sleeve, you can easily do so. I will describe these sdd-in sleeves after further development over the next few weeks.

Please note that these new capabilities will not require you to change what you are doing.