Weekly Note - March 30, 2022

Market Comment

The algorithms call for reducing weight to the DJIA-linked ETFs. This change is consistent with the DJIA’s recent move higher in a counter-trend rally. A counter trend rally means that, while the longer trend of the market is still down, the index price moves higher against that trend. The expectation is that the counter trend rally is temporary, and the market will be more vulnerable to declines over the next few weeks.

The long-term trend of the market became negative (as measured by the Macro MRI beginning the downleg of its cycle) in late November of last year. The timing of that inflection point coincides with when it was expected based on the dynamics of the market from 1940 to 2010. The downleg of the Macro MRI became more pronounced in January. At that time, there were only faint concerns about a war in Ukraine.

Once the Macro MRI is in a downleg, there are typically one or more counter trend rallies before the market reaches the low point of the downleg in the Macro MRI. I expected a counter-trend rally to begin in late January and one did occur at that time, and I designated a Plant season for just one week.

In mid-February, the Exceptional Macro MRIs for commodities and gold indicated strong “buy” signals. There were heightened concerns about inflation at that time, and we moved into the commodity ETF PDBC and the gold ETF GLD.

In late February, Russia invaded Ukraine, and this action resulted in concerns about reduced supply of commodities. This concern added further upward pressure on the prices of PDBC.

Recent Allocations to Commodity ETF PDBC

I mention this background because the investment rationale for holding commodity ETF PDBC shifted over the course of a few weeks. It went from a concern about inflation to a concern about both inflation and supply of key commodities, both of which are likely to cause PDBC to increase in price. With the supply of commodities, especially oil, affected by the war, the returns of PDBC will be more heavily influenced by the status of the war, OPEC, and potential government action to affect oil supply and price, such as releasing oil from the strategic reserves. Our process does not provide any insight into these variables and I thought it best to reduce our exposure to PDBC. I reduced the allocation to PDBC and increased the Box #2 Cash level. 

Because of these concerns, I reduced the allocations to PDBC, and hold more GLD than PDBC. In a prior note, I mentioned that I may use a different ETF for commodities – I am not considering a switch at this time.

Higher Interest Rates May Help Precipitate the End of The Counter-Trend Rally

The stock market has moved sharply higher over the last two weeks. One might wonder if the market will move higher from here.

The Macro MRI for the DJIA is clearly in the downleg of its cycle and is likely to remain that way for several weeks or longer. From this perspective, the period of vulnerability is still present and I believe that we should consider the recent price appreciation as simply a temporary counter-trend rally.

Over the last eighteen months we have seen that government support for the economy has overwhelmed the natural cycles of resilience; the stock market did not decline during periods of vulnerability. However, I believe that there will be less government support going forward if the war stays contained.

Since the beginning of the pandemic, government support has come through stimulus payments and low interest rates. Both forms of stimulus have indeed produced economic growth. Along with that growth we also have a tight labor market and inflation. It is important to remember that the effects of government stimulus continue after the active stimulus has ended. Thus, we will see the positive aspect of stimulus, economic growth, and the negative, inflation, for some time.

The Fed is now speaking as though it will be very aggressive in increasing interest rates. Rate hikes can slow both the economy and inflation. It also means that the stock market is not likely to be buoyed by the low interest rates of the recent past.

When interest rates move higher, bonds decline in price. In the performance section below, you will see the year-to-date performance of two bond ETFs. UST is the ETF used in many of the model portfolios. It has lost about 14% of its value this year. The ETF IEF tracks the same set of bonds as UST (and TYD in Sapphire) but does not use leverage. IEF has lost about 7% this year. Many retirement portfolios have stable allocations to bonds and would have had losses in their bond segments this year. This is reflected in the relatively poor performance of the Vanguard funds VBINX and VASGX, shown below.

From the mid-1980s to the recent period, when the stock market did poorly, bonds tended to do well. Currently however, increasing interest rates that has a negative impact on the performance of both stocks and bonds. The Macro MRIs for both the DJIA and the US 10-year bond index are both clearly in the downlegs of their cycles. Thus, we are holding cash. This has helped our performance.

If the war in Ukraine continues and/or expands, the Fed may reconsider its harsh stance; it may not be as aggressive about raising rates. But at the moment, a more lenient Fed seems unlikely considering the very high inflation readings. Thus, both the DJIA and bonds are likely to follow their cycles of resilience, which means that both are vulnerable to declines.

The Utility stock ETF XLU and the Consumer Staples stock XLP are likely to follow a different path. Their MRI are decidedly more positive. Thus, this week we are shifting assets into those ETFs by reducing Box #2 Cash levels.

This picture – vulnerability for the DJIA and moderate resilience for the Utility- and Consumer Staples-linked ETFs – is most like early 2018 when the market had moderate declines that we want to avoid, but not major declines. I’ll describe this more in a future note.

Performance

The US stock market has declined from December 31, 2021 through last Friday, March 25, 2022. I have calculated the returns that one would get by following instructions since the beginning of the year for the “main” portfolios for each of the publications. Please see the endnote for a brief comment on the main portfolios.

The year-to-date returns as of 3/25/2022 are:

Diamond:       -2.8%
Sapphire:        -3.9%

These returns compare favorably to these alternatives:

DJIA:             -3.6%
S&P500:        -4.4%
NASDAQ:     -9.3%

UST:            -14.5%   UST is the ETF for the US 7-10-year Treasury bond index, with 2x leverage
IEF:               -7.6%   IEF is the ETF for the US 7-10-year Treasury bond index, with no leverage

VBINX:       -5.9%    VBINX is a Vanguard Fund that has 60% of its assets in stocks and 40% in bonds
VASGX:       -5.8%   VASGX is a Vanguard Fund that has 80% of its assets in stocks and 20% in bonds


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Note – Main Portfolios

The main portfolio in the Diamond publication is sg235. The main portfolio in the Sapphire publication is sg325.

If you use either of these as your long-term portfolio and have followed the instructions since the first of the year by switching to the target weights of a less aggressive portfolio (by adjusting Box #3) and holding Box #2 Cash as instructed, your account’s performance should be close to the figure above.

Some deviation between your account and the numbers above can be expected. The performance figures above assume trading is done at the close of trading on Fridays. Most people trade earlier in the day. In addition, we sometimes trade before Friday. If you use as your long-term portfolio one that is more or less aggressive than the main portfolio, your actual performance will be different.

The figures above are based on the actual ETFs in the model portfolio. The figures in the weekly publication are based on the index that the ETFs track.

Weekly Note - March 9, 2022

This note covers:

1. The performance of accounts that follow the weekly instructions for the main Diamond and Sapphire portfolios since the beginning of the year
2. Three themes affecting the markets
3. Outlook and Possible Changes in Theme ETFs

1. Performance – Year-to-Date

The US stock market has declined from December 31, 2021 through last Friday, March 4, 2022.  I have calculated the returns that one would get by following instructions since the beginning of the year. Specifically, if you followed the “main” portfolio in Diamond (sg235) and switched to alternative target weights and held Box #2 Cash as instructed.  

Similarly, if you followed the “main” portfolio in Sapphire (sg325) and switched to alternative weights, etc. as instructed.  These figures are based on the actual ETFs in the model portfolios (in contrast, the figures in the weekly publication are based on the indexes that the ETFs track). 

The returns are:

  Diamond:          -2.6%

  Sapphire:           -3.2%

If you use as your long-term portfolio one that is more or less aggressive than the "main" listed in each publication, your actual performance will be different.  These returns compare favorably with these alternatives:

  DJIA:                    -7.2%

  S&P500:               -8.9%

  NASDAQ:           -14.8%

  VBINX:                -7.1%    VBINX (Vanguard Fund that has 60% of its assets in stocks, 40% in bonds)

  VASGX:               -8.5%    VASGX (Vanguard Fund that has 80% of its assets in stocks, 20% in bonds)

The Vanguard funds appear on the Return-to-Variability charts on the first two pages of the weekly pdf.  You can see that our portfolios have better return and variability characteristics than the Vanguard funds over the time periods shown. 

2. Current Market Themes

Three major themes appear to be affecting the market.

   Theme One – Lower Resilience 

From fall 2021 through to the present, the MRI have indicated decreasing market resilience (greater vulnerability).  In the fall of 2021, the computer models and algorithms reduced aggressiveness of our portfolios, which meant that we moved out of the stock market.  Many of these were false alarms and the stock market moved higher.

As you may remember, the investment process tends to underperform in the late stage of an ascending market and there are numerous false alarms just before a major market decline.  This is an apt description of the last months of 2021. The Macro MRI finally made a clear move to the downleg of its cycle in mid-December and prices subsequently peaked at the end of December.  However, the false alarms suggested that we were in the late stage of the strong ascending market that would be followed by a meaningful decline.

The research I’ve done on developing longer-term forecasts of market resilience has pointed to lower resilience in the coming weeks as well. The longer-term forecast done in December for the first four months of 2022, called for the Micro MRI for the DJIA to make a double dip, which is for the Micro to form one low point (which occurred at the end of January), move higher, and then return to form another low point before moving toward its normal high level.  This happens from time to time and it is happening now, as forecasted in December. The Micro MRI is now in the downleg of a cycle. Unfortunately, this downleg is occurring when there is high inflation, a war in Europe, supplies of commodities are being reduced because of the war, the Fed is poised in raise interest rates, and the Macro MRI is clearly in the downleg of its cycle.   

Since mid-December, the market has moved generally in accordance with the forecasted resilience levels.  If that continues to be true, we can expect additional stock price vulnerability and possibly price declines over the next few weeks.   

In addition, some valuation measures (price-to-sales, price-to-book ratios) suggested that late 2021 might be a period of peak company earnings; the market may have been anticipating a decline in earnings. Thus, both the MRI and the valuation measures suggested future economic weakness. 

The forces in this theme are not part of the computer models or algorithms but they do affect my decisions about Plant/Wait/Harvest designations, the inclusion of theme-related ETFs (such as the current commodity and gold ETFs we currently hold), and Box #2 cash levels.      

    Theme Two – High Inflation

The prevailing narrative during late 2021 was that inflation would be high going forward and the Fed would be forced to increase interest rates. Inflation was moving higher because of Covid recovery spending and very low interest rates.  Commodity prices were indeed moving higher.  The major commodity index (S&P Goldman Sachs Commodity Index) peaked in price in October of 2021 and was somewhat lower at the end of the year, which was consistent with slower economic growth discussed in theme one. 

There was much discussion of when and by how much the Fed would increase rates.  Increasing interest rates would tend to make investors more concerned about the high stock valuation measures that had developed during the Covid stimulus spending and abnormally low rates. The NASDAQ index, which is biased toward growth stocks with high valuations, peaked at the end of November and has had the biggest year-to-date decline mentioned above.   

While stocks can well during periods of high inflation and interest rates over the long term, over the short term, prices often drop in order to achieve valuation levels better suited to higher interest rates.     

   Theme Three – Economic Upheaval Related to Russian Invasion

This theme is new.  The Russian invasion of Ukraine has resulted in higher oil and grain prices.  The commodity ETF “PDBC” has increased by a startling 10.7% in the two weeks since its inclusion (February 18) through today.  That figure includes today’s (March 9, 2022) sharp decline.  While the price of oil is volatile and we can expect sharp moves (both positive and negative), the 10.7% figure is a very sharp move up in only two weeks.  

From Barrons: “Russia is the third-largest producer of petroleum after the U.S. and Saudi Arabia, exporting almost 5 million barrels a day of crude oil in 2020, according to the U.S. Energy Information Administration. Almost half of those exports went to European countries, while 42% went to Asia and Oceania.”

    (https://www.barrons.com/articles/russia-oil-imports-ban-crude-prices-51646667317)

In addition, Russia and Ukraine supply 30% of the world’s major grains.

From Time magazine: “Russia and Ukraine together supply nearly a third of the world's wheat and barley exports, which have soared in price since the invasion. The products they send are made into bread, noodles and animal feed around the world.

    (https://time.com/6156160/ukraine-bans-wheat-exports/#:~:text=Russia%20and%20Ukraine%20together%20supply,places%20like%20Egypt%20and%20Lebanon.)

All else equal, higher commodity prices can reduce demand.  This is especially true when energy prices move higher.  People drive less, turn down their thermostats, and companies find alternatives to oil.  In addition, higher commodity prices in general increase inflation readings and therefore encourage the Fed to increase rates.  But, considering that we have open battles in Europe, the Fed is, I believe, less likely to raise rates aggressively out of concerns for helping to tip the country into recession during a time of war. 

One scenario is that the Fed raises rates only slightly and allows economic growth and inflation to be higher than they otherwise would be.  Others include increasing rates and helping to tip the economy into recession. 

3. Outlook and Possible Changes

My current concern in this quickly evolving situation is that theme one – the inherently low resilience of the coming weeks - is not widely recognized.  Low resilience means that when there is bad news the market goes down and stays down; it doesn’t recover quickly or completely.  We may have tipped into a mild recession anyway without theme three (Ukraine).  The price movements of the major stock indexes so far this year generally support the validity of this concern.  In addition, themes two and three seem able to provide several opportunities for bad news to occur. In many past crises, the main event (in this case war in Ukraine) produces follow-on events over the subsequent weeks and months that are themselves bad news for stocks.   

I am therefore increasing the Box #2 Cash to 35%. As mentioned last week, we may see a counter-trend rally over the next week or so, but I believe that it will be fleeting if it does occur. 

Also, the level of Box #2 Cash has remained high since the beginning of the year.  The Plant designation lasted just one week (the beginning of February), but an expected countertrend rally failed to materialize. I anticipate reducing this cash level during the next Plant season.    

I can envision scenarios that would result in us selling the commodity and gold ETFs.  Should we need sell out of them outside the regular Friday trading schedule (most likely on a Tuesday), then I will alert you by email.  

In addition, I am considering:

• A different ETF for the commodity exposure – one that has less weight in energy and more in agricultural commodities
• Including the clean energy ETF that we used in the Emerald portfolio, which is starting to move higher after being down for several months. Low carbon energy companies may get a boost in the current situation. 
• Including an ETF for aerospace and defense companies. Regardless of what happens in Ukraine, there will be more spending on defense in the US, Europe, and Asia.

End

Weekly Note - March 1, 2022

Portfolios have higher allocations to the gold ETF “GLD” and the commodities ETF “PDBC.”  These ETFs already have or will soon have positive Exceptional Macro MRIs, which means their prices are very resilient.  This MRI condition is consistent with current market dynamics.  Gold tends to do well in times of global stress and/or inflation.  Commodity prices are likely to increase because of sanctions against Russia, a major commodity exporter. 

These are temporary holdings.  The commodity ETF invests primarily in energy (crude oil, gas) and high commodity prices can inhibit growth and further demand for commodities leading to price declines.  As mentioned in prior notes, the algorithms driving our investment in commodities were developed in 2008 and 9.  They have been successful over the years in identifying buy and sell points.  But energy prices are volatile and we can expect the price of the commodity ETF to move up and down.  

From the narrow perspective of the stock markets around the world, the war in Ukraine is coming at an unfortunate time because the natural cycles of resilience are shifting to a more vulnerable phase.  This means that even if there are positive news events related to the conflict, any jump in prices is likely to be temporary.  If there is negative news, prices are likely to fall. 

In more normal times, we would have seen a counter-trend rally over the last four or five weeks and extending for a few more weeks.  A counter-trend rally is a temporary rally in stock prices that would fades as the market resumes a downward trend. In this case, the downward trend began at the end of December 2021 and it likely to continue for a several weeks more. 

The war, inflation concerns, and high stock valuations have weighed on the market and likely subdued the counter-trend rally.  Because of this, we are running out of time for that temporary rally to occur. While a counter-trend rally may still happen, it will be short and difficult to capture without experiencing the subsequent price declines.  

I believe it is unlikely that the markets will shift to a strong positive trend from here.  Investors globally will need time to adjust expectations for growth, interest rates, inflation, and fair stock prices considering geopolitical events.  The upcoming period of vulnerability may induce some panic, which could cause stock prices to drop more than the figure above.  I believe there will be a better time in the future to be aggressive in our portfolios. 

Considering these dynamics, I have reduced portfolio aggressiveness over the last few weeks.  This period of vulnerability is likely to last several weeks. 

Because of the recent changes in the portfolios and the weekly reports, it may be difficult to get a sense of how defensive the portfolios are.  The tables below show the target weights from last week and new target weights for the ETF; the ETFs are grouped by how they are likely to perform during this crisis and a vulnerable stock market.  There is one table for the Diamond and one for the Sapphire main portfolios.   Don’t be concerned if you don’t follow all the details of the table. The key points of this table are in the highlighted boxes:

• Our portfolios have been conservative (or Defensive) for the last few weeks
• This week’s target weights call for:
• Two-thirds of our accounts are in Defensive ETFs that may move higher in times of crisis, including large weights in gold and commodities.
• Less than 10% is in Aggressive ETFs

Portfolios have high target weights for the consumer staples ETF XLP. The companies in this ETF tend to be resilient when economic growth slows or inflation is high because they sell everyday needs. A list of the top 10 holdings of this ETF is at the end of this note, along with the holdings of the DJIA-linked and utility stock ETFs. The categories for the ETFs are:

“Defensive” ETFs are likely to hold and perhaps increase in value a stock market decline or a crisis such as the current one.

“Moderately Aggressive” ETFs may experience losses but will move higher should the stock market declines be small and the Ukraine-related crisis be less severe than it currently appears.

“Aggressive” ETFs will move higher on renewed optimism in the stock market.