Weekly Note - August 26, 2020 - Performance Review, NASDAQ Valuation

 This post contains:

·        Performance Review of 2020 model portfolio performance compared to the DJIA

·        An explanation for why the model portfolios are lagging the DJIA. This section includes charts showing concepts I have explained in text in weekly notes about the progressively higher troughs in the Micro MRI cycles over the last few years

·        Current Valuation of the NASDAQ index that is an important part of the 2020 Recovery portfolio.  This section explains why I believe it is too late in its short-term resilience cycle to switch to this portfolio

Note: I will discuss additional MRI shifts that signal greater longer-term resilience in an upcoming post.  

Performance Review

For this year, unfortunately, the performance for the model portfolios is flat or negative.  The figures in the first column are for the period from Friday December 27, 2019 through Friday August 21, 2020.  Those in the second are for the six-year period beginning at the inception of Focused 15 Investing - they are presented for a longer-term perspective.   

RATES OF RETURN 

                                                                   December 27, 2019     July 18, 2014 -

                                                                     August 21, 2020        August 21, 2020

Diamond uses DJIA-linked ETF “DDM”

  Diamond (DJIA x2) – 3 ETFs (sg131)                -9%                            14%

  Diamond-Onyx 35-65 Mix – 5 ETFs (sg218)       0%                            13%

 

Sapphire and Emerald use DJIA-linked ETF “UDOW”

  Sapphire-Onyx 50-50 Mix - 4 ETFs (sg299)       -8%                           21%

  Emerald-Onyx 50-50 Mix - 5 ETFs (sg301)        -8%                           20%

 

Comparison

  Dow Jones Industrial Average (DJIA)                -1%                          11%

 

Thus, our portfolios have returned about 7 or 8 percentage points less than the DJIA for this year.  However, most of this underperformance has occurred over the last nine weeks, since June 19, 2020.  As of June 19^th, the “Diamond (DJIA x2) – 3 ETFs (sg131)” had returned -10% while the DJIA returned -9%. Although our defensive posture from June 19 through August 21 caused us to miss out on some gains, I believe there have been sound reasons for this defensive posture.  I’ll break this 9-week period into to two sub periods.   

From June 19^th through July 17^th there were no sources of resilience.  All of the MRI were in the downlegs of their cycles.  Thus, the algorithms called for low exposure to the DJIA-linked ETFs.  The DJIA climbed during this period, which can happen even when there is no resilience if there are other mitigating factors.  In the current situation, I believe both the government stimulus and the Fed’s commitment to keep rates low for a long period of time have created support for stock prices in the face of an abrupt economic contraction.  

On July 17^th (six weeks ago), the Micro MRI somewhat unexpectedly formed a trough at a relatively high level and shifted to the upleg of its cycle.  I’d like to show graphs that help explain my past comments on this inflection point in the Micro MRI and why we might miss some of the positive returns of the DJIA associated with this upleg of the Micro MRI.  In the note a few days later (on July 22^nd), I stated

Going forward, one possibility is that the Micro MRI moves higher for a few weeks, taking prices higher than the June highs.  If this is the case, we will have to wait several weeks to assess the potential of a second bottom of the W-shaped market recovery pattern.

 That move has taken place.  In a note sent out August 8, I stated:

Over the last 100 years, there have been many instances of the Micro MRI forming a trough at a moderate level (at roughly the 50th percentile).  In the research that led to the current algorithms, I found that when there is a trough at a moderate level, the subsequent trough may come more quickly and be particularly deep.  This would imply that the DJIA stock prices would move higher for a short time over the next several weeks and then decline to a low level.  This type of delayed and exaggerated decline did not always follow this pattern (i.e., trough at a moderate level), but it did often enough that it is best (from a portfolio-level risk-and-return point of view) for the algorithms not to move aggressively back into the market when the trough occurs at roughly the 50th percentile.  Instead, it is best to wait for that subsequent deeper downleg to occur before moving back into the market. 

Thus, all else equal, we will have low target weights for the DJIA-linked ETFs for the next few weeks.  Of course, if the Exceptional Macro or the Macro MRI move to the positive legs of their cycles or other metrics indicate stronger resilience, the target weights will reflect those changes.

The following images illustrate these ideas.  In the image immediately below, the DJIA price appears on the upper panel. The Micro Market Resilience Index (Micro MRI), which measures the bursts of resilience lasting 5 to 15 weeks, is on the lower.  The Micro MRI moves around the horizontal blue line, which approximates the 50^th percentile level.  The pandemic-related troughs (March 20, 2020) in each panel are labelled. 

(Contact use for the image: https://focused15investing.com/contact)

As of March 20, the Micro MRI formed a deep trough (at less than the 1^st percentile of levels since 1918, meaning it was at the lowest extreme) and indicated a high likelihood of the DJIA moving higher as the Micro MRI moved to the upleg of its cycle. The DJIA did indeed move higher after that trough.  

The next trough in the Micro MRI, which occurred on July 17, was noteworthy and surprising. It was noteworthy because it happened at a relatively high level – at about the 50^th percentile.  The troughs are more typically much lower at around the 15^th percentile.  As mentioned above, when there is a shallow trough, the following Micro MRI trough and price decline tend to be deeper.  This pattern does not always take place, but it does take place often enough that it is best not to chase prices higher.  This is programmed into the algorithms. Thus, the current underperformance of the model portfolios is consistent with the algorithm exercising caution in these circumstances.

The impact of not having exposure to the DJIA-linked ETFs is clearly evident in the performance of the model portfolios that focus primarily on the DJIA-linked ETFs.  The chart below shows the returns of the Diamond (sg131) model portfolio compared to the DJIA since July 18, 2014 (the inception of Focused 15 Investing). 

As you can see, the return of the model portfolio (represented by the blue line) has been flat for several weeks, while the DJIA has moved higher.

For model portfolios that combine the Onyx sleeve with Diamond, the adverse impact being out of the DJIA-linked ETFs this last several weeks has been muted.  The Diamond-Onyx 35-65 Mix (sg218) is a mix of 35% Diamond and 65% Onyx (consisting of four low variability ETFs) and it has a slightly different pattern.  It is represented by the blue line below, which, as one can see in the chart below, moves higher (instead of being flat) over the last several weeks because of the Onyx sleeve’s exposure to ETFs tracking consumer staples and utility stocks. 

Progressively Higher Troughs in the Micro MRI Beginning in 2018

I mentioned that the most recent trough was surprising. It is surprising because it seems to continue a pattern of progressively higher troughs that began in early 2018.  The chart below shows the progressively higher troughs in Micro MRI beginning in early 2018. (Obviously, the COVID-related trough in March of 2020 is an exception to this trend.)

(Contact use for the image: https://focused15investing.com/contact)

 

This 2 ½ year pattern suggests a progressively shorter period of vulnerability and pessimism during the downleg of the Micro cycles, with the March 2020 decline being an exception. 

After the decline in March, I thought that pattern of progressively higher troughs had ended.  But now, it seems that prices might reflect a growing and unsustainable level of optimism. 

Recall that the Micro MRI measures the short-term bursts of market resilience and optimism and the inevitable bursts of vulnerability and pessimism that follow.  I believe these cycles are inevitable because the fair value of the index can never be determined with certainty.  “Fair value” is a function of many variables, including future economic growth, inflation, interest rates and, currently, the pandemic.  Investors as a whole as represented by the market indexes make guesses about fair value, and their guesses tend to overshoot and undershoot fair value on a regular basis as they try to determine it.  The cycles are created when prices move ever higher, to the point where increases are far above the fair value of the index. When continued price increases become unsustainable, prices move lower.  Prices then decline as investors as a whole try to determine a fair value perceived to be lower than the current price.  They typically overshoot fair value as vulnerability and pessimism set in.    

When the period of pessimism is truncated at a high level (i.e., when the troughs occur at high levels, as they have been doing), it is an indication that the market is either (a) identifying a higher level for the fair value, or (b) the market is becoming overly optimistic (or delusional) about the future growth of the economy and/or other factors that are used to determine fair value.  There are examples of both (a) and (b) over the last 100 years. 

The algorithms are designed to be conservative in this situation; that is, they do not chase prices higher after a shallow inflection point. Subsequent price declines may be deep and abrupt.  This conservatism has been the better course of action over the last 100 years.  However, this conservative stance has not been rewarded thus far in 2020. 

The case for this being a period of excessive optimism is supported by the following valuation information for NASDAQ and the high recent returns of a small group of stocks discussed below.    

Current Valuation of the NASDAQ 100 Index:  Too Late to Get Into for this Cycle

The NASDAQ 100 index has had strong performance since the end of 2019.  From 12/27/2019 to 8/21/20202 (last Friday), it returned 32%, which is much higher than the -1% return for the DJIA mentioned at the beginning of this note. 

The NASDAQ 100 ETF “QLD,” which gives two times the return each day, is a key part of the 2020 Recovery portfolio: Diamond-Onyx 35-65 Mix ‘2020’ - 5 ETFs (sg218.2).  This model portfolio has returned 13% over that same period.  As much as I would like to have everyone get the high returns of the NASDAQ in the recent market, I believe it is too late in the Micro MRI cycle to move into this model portfolio right now.  

The Micro MRI for the NASDAQ 100 index is at the 74^th percentile, indicating that it is currently in the upper portion of its normal range.  While the algorithms are intended to reduce the target weight of this index when its MRI approaches a peak, the algorithms may not avoid all losses when the Micro MRI finally does peak.  The NASDAQ has a history of large decline occurring abruptly.  The current target weights for “Diamond-Onyx 35-65 Mix ‘2020’ - 5 ETFs (sg218.2)” indicate a relatively small allocation of 6% to QLD compared to a maximum allocation of 15% for that model portfolio.  Of course, any subscriber can decide on their own to use the Recovery portfolio, but I can give guidance for everyone to make this switch.  

A look at current valuation measures reinforces that the NASDAQ is at high price levels.  A common valuation measure is called the Price-to-Earnings ratio (PE ratio).  This indicates the price compared to recent annual earnings.  As of last Friday, the PE ratio was 37 for the NASDAQ 100, meaning that the price is 37 times recent annual earnings.  The index ended 2019 with a ratio of 27, and the ratio dropped to 21 in March of this year.  Unfortunately, one cannot determine the PE ratio that represents a fair value because it depends on future growth, interest rates, inflation and other factors.  So, we look at the past for reference.    

As a comparison, NASDAQ’s PE ratio was 33 at the peak of the index (10/26/2007), just before the Global Financial Crisis. After that date, the NASDAQ 100 price level dropped by about 52%.  I am not suggesting a drop of the same magnitude, but I am saying we may be closer to the top of the short-term cycle than the bottom.  Differing interest rate environments across time weaken some of these comparisons.  For example, the yield on the 10-year Treasury bond was about 4.5% at the end of 2007.  Today it is at about 0.7%, and so today’s low interest rate environment may justify higher PE ratios, all else equal.  This is where the MRI are useful in comparing cycles across time.  The Micro MRI is currently at the 74^th percentile of levels since 1972 (the beginning of the NASDAQ Composite).  If we assume that the short-term peak of prices and the Micro MRI is at about the 85^th percentile, we might have a few weeks of prices moving higher before prices move lower due to a lack of short-term resilience.  

Thus, I believe there will be a better time to use the NASDAQ later on.  Further, I am evaluating how NASDAQ can be included in the regular model portfolios.  More on this later. 

As further evidence suggesting the wisdom of not chasing the NASDAQ, consider the following article from Bloomberg news.  The stocks mentioned below are heavily weighted in the NASDAQ index.  You have heard of different letters to describe marked patterns (e.g. V, W, L). The article referenced below describes a K-shaped market recovery (what makes it look like a K is described below).  It says that the current wide gap between the return of internet/tech companies that are heavily weighted in NASDAQ such as Facebook, Apple, Amazon, Netflix, and Google (called the FANG or sometimes FAANG index) and the broader market is a sign of an impending market crash. The case for big price gains for the FAANG group of companies is that pandemic-related lockdowns drive business to these internet and high tech businesses. 

https://www.bloomberg.com/opinion/articles/2020-08-25/k-shaped-stocks-recovery-has-fangs-that-may-bite-investors

The blue line rising steeply since the March 2020 lows is the FANG index.  The black line represents the Russell Top 50 (an index of the largest 50 companies in the US).  The growing gap represents the arm and leg of the K.  (The Russell 2000 of small company stocks, is also shown). The article states:

… it is generally a sign that a trend is reaching a peak… When extreme inequity is this obvious and this widely applicable, we’ve reached the point where the arm and the leg of the K are more like alligator jaws, primed to snap closed. 

The message of this article is that the gap between FAANG (and NASDAQ) and other indexes will close.  Some researchers say that the price of FAANG stocks will drop dramatically when there is progress on treatments and vaccines for COVID.  Further, the article predicts that the drop in FAANG will also cause a drop in the broader indexes.   

 

I believe the current price of NASDAQ is far in excess of fair value.  I also see the MRI conditions for the DJIA improving.  The NASDAQ may move down and the DJIA may move up as the jaws of the K close.  The algorithms are likely going to wait for a stronger signal to move back in the DJIA-linked ETFs.  Until then, the model portfolios will be defensive. 

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Weekly Note - July 15, 2020 - 2020 Recovery Version of Existing Model Portfolios

I have added a new portfolio that takes the place of the 2020 Recovery Portfolio (sg117) that I introduced a few months ago. Like the 2020 Recovery Portfolio (sg117) that it replaces, the new version gives a prominent role to the NASDAQ. The new 2020 recovery portfolio is a blend of a main model portfolio in the publication and the original 2020 Recovery portfolio (sg117). It includes not only a DJIA-linked ETF (like virtually all Focused 15 portfolios) but also a NASDAQ-linked ETF.

The new recovery portfolio version is labelled:

  - Diamond-Onyx 35-65 Mix (Main) 2020 (sg218.2)

Note that the sg number for this new recovery portfolio ends in “.2” (point two) to distinguish it from the model portfolio “Diamond-Onyx 35-65 Mix (Main) - sg218” that it is based on. Also note that the portfolio name ends with “2020.”

Another feature of the new version is the omission of the ETF SHY (US Treasury 1-3 year bond ETF). Instead of trading SHY, one simply holds that same amount of money uninvested in one’s account – the amount being indicated as “Cash (no ETF)” in the weekly target weights. This omission of SHY allows the addition of the NASDAQ-linked ETF without increasing the number of ETFs.

Below is a diagram that compares Diamond-Onyx Mix (sg218) and the new 2020 recovery (sg218.2) version.

The maximum exposure to sleeves (green boxes) with the high-volatility equity indexes (DJIA and NASDAQ) is the same—35 percent for both the main model portfolio and its 2020 recovery version. In the recovery version, the NASDAQ occupies a share of that 35 percent. There is a “minimum” of 65 percent allocated to the Onyx sleeve (yellow boxes) of the portfolio. The values shown in the Onyx sleeve are the neutral positions for those ETFs. The weekly target weights for all ETFs vary over time.

Why NASDAQ Was Not Used Earlier

A reasonable question is why NASDAQ was not included in the original Focused 15 Investing model portfolios. In the period 2007 to 2010, when the MRI approach was developed, NASDAQ’s history was just 36 years (beginning in 1971) and much of that history was dominated by the internet and technology boom of the 1990s and the following bust in 2000.

The MRI did a reasonable job navigating that boom and bust, but it was just one major cycle in the historical record, and therefore I was not able to conclude with confidence that the MRI approach was successful for NASDAQ in general. By comparison, the DJIA has usable history back to 1918 and has had many booms and busts during that time. The MRI did a good job of navigating them, which gives greater confidence in the DJIA signals.

But now, we have had additional valuable experience with the MRI and NASDAQ. Not only have the MRI handled the NASDAQ well for the period prior to the 2007-2009 financial crisis, but also the years though 2020 (thus far).

When we are well past the pandemic, we may see that the there is a place in the main portfolios for a NASDAQ ETF, or we may find that we can revert to using just DJIA. That decision, however, comes later – perhaps many quarters from now.

Additional Thoughts on SHY

In my own investing and from discussions with subscribers, I see that people favor trading fewer ETFs. As you may know, many of the model portfolios use the ETF SHY, which is for 1-3 year Treasury bonds, and is our most conservative ETF. From 2000 to 2010, SHY had an annualized return of 3.9%. This is a good return for a very low risk investment. However, from 2010 to 2020, SHY had an annualized return of 1.2%. The Fed has recently said that it will keep interest rates low for the foreseeable future and this decision means that the return of SHY may stay low. For us, it may not be worth the effort to SHY for the next few years. Thus, the new portfolio does not use SHY – instead the same amount of money is simply held in your account uninvested. This amount is indicated as “Cash (no ETF)” in the target weights. If interest rates move higher, we can switch back to using SHY.

Weekly Note - May 27, 2020

The shortest cycle of resilience (the Micro MRI) continues to be in the up-leg of its cycle. Last Friday, it was at the 90th percentile of all levels since 1918. The prior Friday it was at the 85th percentile. With strong price moves yesterday (Tuesday the 26th) and today, this week may mark another move higher. Over the last one hundred years, there have not been prominent cases in which the Micro MRI simply continued going higher for several weeks after being at this high level. Instead, the Micro MRI moves to the down-leg of its cycle and prices tend to follow it lower.

In the main relief rally during the 2007-2009 Global Financial Crisis, the Micro MRI peaked around the level of the 85th percentile. This is good reference point, but is not a hard and fast rule for the current time.

We can think of the current high level of the Micro MRI as meaning the stock market moving into peak short-term optimism: good news is recognized by the market and bad news is not. This sentiment is likely to change soon and will be associated with increased pessimism and a lack of support for higher prices, all else equal.

These resilience conditions are not isolated to the DJIA. Stock markets around the world are also at the upper ranges of their Micro MRI cycles. You may recall from my discussions of the Focused 15 Investing approach that geographic diversification tends not to be useful in a global crisis. These other stock market indexes around the globe have Micro MRI levels very close to those of the DJIA, and my comments above apply to them as well.

  DJIA – US Blue Chip Stock: Micro MRI: 90th percentile

  S&P 500 – US Large Company Stocks, Broad coverage: 87th percentile

  UK Stocks: 69th percentile

  Europe Stocks: 84th percentile

  Japan Stocks: 94th percentile

  Emerging Market Stocks: 89th percentile

The following markets are also moving toward the peaks of their Micro MRIs, but have levels that are not as high as those listed above.

  Russell 2000 – US Small Company Stocks: 67th

  NASDAQ (Biased toward technology stocks): 45th

None of these eight major stock indexes has sources of resilience right now other than the Micro MRI. Neither the Macro MRI nor the Exceptional Macro MRI is providing resilience, making all these indexes precarious in terms of holding on to stock market gains.

Historically, the DJIA has dominated the price trends and conditions of other markets. This means that the MRI-based signals for the DJIA tend to explain the price movements of other stock markets. Yet the MRI signals of other markets tend to have little explanatory power for the price movements of the DJIA. This has been especially true in global crises when all stock markets become highly correlated. Thus, the resilience conditions of the DJIA are more important than those of the others. In today’s environment, the greater upside for the NASDAQ (as indicated by its Micro MRI being at only the 45% percentile) and its recent price strength may be the best case supporting continued stock market moves higher. But historically, the condition of the DJIA seems to overpower the other markets. The algorithms reflect this dominance of the DJIA.

Raising Cash Recently to Preemptively Become More Defensive

A few weeks ago, I gave guidance to raise cash. This was the first time I have taken this step since the beginning of Focused 15 Investing. It had the effect of bringing forward in time by about one week the more defensive positions that the algorithms were moving toward. The algorithms are intended to identify the peak and troughs of the MRI cycles. In the case of relief rallies (like the current one), prices move higher based on just one MRI – the Micro MRI. When that one MRI ceases moving higher, prices can drop quickly, all else equal. In addition, we trade on Fridays, and prices, of course, do not always peak on a Friday. Given the large potential losses and the small potential for gains as the Micro MRI moves toward its peak in a relief rally, raising cash has been prudent, even though it may not have added return over this period. Going forward, I plan to do the same in similar resilience conditions.

This Week’s Target Weight Changes

This week, the algorithms caught up with the more defensive stance of last week. In other words, the allocations to DJIA-linked ETFs have been reduced. Thus, we can reduce our cash levels in Box #2 of the Shares-to-Trade Worksheet to the normal 3%. The net effect will be only a small adjustment to the weights of the ETFs in your account.

If the Defensive Positioning of Our Model Portfolios is Wrong

In the event that our algorithms become out of sync with the market, they will recalibrate. As mentioned, the Micro MRI is still in its up-leg. If stock prices continue to move higher once the Micro MRI moves to the down-leg of its cycle, our framework would describe the market as being driven by news-of-the-day events, which would include optimism about the economic reopening and the massive economic stimulus.

These news-of-the-day effects would be compensating for the market’s lack of inherent resilience. Should these effects more than compensate for upcoming period of "least resilience," the algorithms will recalibrate. This recalibration would take place in a few weeks (as opposed to months) and would likely result in the Macro MRI and Exceptional Macro MRI beginning the up-legs of their cycles and providing resilience. These, in turn, would cause a change in our target weights.

Update of Potential Market Patterns for Coming Period of Least Resilience

Below, I update the charts I introduced in last week’s note. I have added a fourth pattern depicting the market moving higher when market resilience is at its lowest. In addition, I am listing these patterns in order of my subjective view of their probability (highest to lowest) based on historical norms – not any assessment of the current stimulus or reopening plans. Keep in mind that as of this week the Micro MRI is still moving higher and has not peaked. The period described below relates to the period after the peak of the Micro MRI.

A: Typical Market Pattern

The image below shows a typical pattern for a period of least resistance. Soon after the Micro MRI peaks and marks the beginning of the period of least resilience, the DJIA starts to decline. In this pattern, prices decline at the beginning of the period – and the initial decline can be abrupt. Then prices move lower consistently over the period. Moving out of the DJIA at the beginning of the period is the most successful strategy.

B: Delayed-Decline Pattern

In the delayed-decline pattern, rather than a consistent decline over the period, the major decline occurs at the end. A good strategy for this pattern is to be out of the market prior to the decline. The peak of the Micro MRI at the beginning of the period is the clearest and most reliable signal to get out of the market. While doing so at that time seems premature, it is the most effective strategy for this pattern. One should be patient with the defensive position while the market moves up and down without a large gain or loss prior to the larger decline at the end of the period.

C: Flat Pattern

The flat pattern typically occurs when there is an abundance of good news in the marketplace and stock prices remain at roughly the same level over the four to twelve weeks of this phase of the cycle. Prices move higher temporarily on any good news, but the market does not hold on to those gains. In this pattern, staying in the market or moving out does not have a big impact on returns over the period.

D: Prices-Move-Higher Pattern

In the prices-move-higher pattern, good news overwhelms the lack of resilience in the market. Prices move higher because of that good news. In the current environment, the massive economic stimulus by central banks around the world could provide the overwhelming good news. However, our bets are based on resilience, not an assessment of the magnitude of good or bad news. We will miss the gains of this period. The algorithms treat this pattern like it is the “delayed decline” pattern to avoid the decline at the end of the period. If prices do move higher, the pace is not likely to be as steep as when the Micro MRI is ascending. If this pattern takes place, the algorithms will respond quickly (in a few weeks) to it and move assets into the stock market as Exceptional Macro MRI starts to emerge. (See discussion above about how the algorithms respond when news of the day overwhelms vulnerability conditions.) I can usually see Exceptional Macro MRI starting to emerge and may be able to alert subscribers to this situation.

End

Weekly Note - May 20, 2020

The DJIA is close to the peak of its Micro MRI. As of last Friday, it was at the 85th percentile of all levels since 1918. After it peaks and ceases to provide resilience, the DJIA will be “least resilient,” meaning that none of the MRI (Micro, Macro, Exceptional Macro) are in the uplegs of their cycles. For the subsequent roughly 4 to 12 weeks, the market will be very vulnerable to declines. In the absence of very good news, prices are likely to decline.

I’d like to show you a few alternative patterns for what the market may do during this period of least resilience.

Pattern A - Typical

The image below shows a typical decline (a). Soon after the Micro MRI peaks and marks the beginning of the period of least resilience, the DJIA starts to decline.

In this pattern (above), prices decline at the beginning of the period – and the initial decline can be abrupt. Then prices move lower consistently over the period. Moving out of the DJIA at the beginning of the period is the most successful strategy.

Pattern B - Flat

The second pattern (b) is when there is an abundance of good news in the market place and stock prices remain at roughly the same level over the 4 to 12 weeks. Prices move higher temporarily on any good news but the market does not hold on to those gains.




In this pattern, staying in the market or moving out does not have a big impact on returns over the period.

Pattern C - Delayed Decline

The third pattern is a delayed decline (c). Rather than a consistent decline over the period, the major decline occurs at the end of the period.



A good strategy for pattern c is to be out of the market prior to the decline. The peak of the Micro MRI at the beginning of the period is the clearest and most objective signal to get out of the market. While doing so at that time seems premature, it is the most effective strategy for this pattern. One should be patient with the defensive position while the market moves up and down without a large gain or loss prior to the larger decline at the end of the period.



Historically, patterns a and c are most common and create large losses. Pattern b is less common. The Focused 15 Investing strategy is to get out of the market on vulnerability. If pattern b prevails, we might miss some of the positive returns but in doing so we avoid the risk that what initially looks like a b pattern is actually a c pattern. Since the losses in a and c can be very large, getting out of the stock market is the more prudent course of action.

The Current Situation

In the current situation, we are clearly at a very high level in the Micro MRI and will soon begin a period of least resilience (none of the MRI in an upleg) and we are moving out of the stock market. Raising cash over the last few weeks has been a preemptive action to avoid the abrupt declines typical of pattern a.

There is good news in the marketplace that will be influencing returns. The Fed and its counterparts around the world have pledged to do whatever it takes to heal the economy and protect investors, countries are reopening, and potential game-changing cures and vaccines make the news. As for bad news, record unemployment, an emerging wave of bankruptcies, and prolonged social distancing all create a drag on the economy and stock prices.

Since we don’t try to determine the impacts of the current news and we move out of the stock market on vulnerability, we are preparing for patterns a and c. We will see after the fact if either of these patterns were relevant. If it turns out that pattern b is most relevant, we may have taken these steps simply as a precaution.

Looking Forward

At the end of the period of least resilience (at the next market bottom), the market will likely move higher dramatically regardless of the pattern during the period of least resilience. As the market passes through the market bottom, it will become more resilient and it will then be appropriate to be more aggressive.

Weekly Note - April 29, 2020

This is likely to be the last week of the “Wait & Prepare” season. At the end of this week, we are likely to shift to a Harvest season.

I continue to believe a less aggressive stance for your account is appropriate for the reasons reviewed below.

Market Context

As of today (April 29), the relief rally is continuing to push stock prices higher. I do not expect the recent pace of price appreciation to continue for long. As you know, last week I gave the first-ever guidance to reduce account aggressiveness by raising cash or switching to a less aggressive model portfolio. While as of today, reducing account aggressiveness has caused us to forego some returns, I continue to believe the less aggressive stance is appropriate.

Over the next week or so, investor sentiment will likely become more negative than the optimism we currently see in the stock market. As you may recall, I have mentioned that I would issue alerts, if needed, outside of the regular midweek communication schedule. I may take this step over the next weeks, but I believe the step of proactively reducing account aggressiveness will give us some flexibility around that alert and the implementation of guidance at that time.

The comments below describe the reasons for the special guidance issued last week. No new special guidance is provided below.

The Micro MRI is Moving into the Upper End of Its Cycle

As of last Friday, the cycle of short-term resilience, the Micro MRI, was at the 63rd percentile of levels over the last 100 years. It was at an extremely low level (9th percentile) just six weeks ago. A key question is: At what level does the Micro MRI for the DJIA stop moving higher and cease to provide resilience?

I estimate that during the Global Financial Crisis of 2008-9, all three of the relief rallies during that time period had Micro MRIs that peaked at levels just a week away from last Friday’s reading (assuming the average weekly Micro MRI move over the last 100 years). Of course, this time it could be different, but I believe extra caution is justified considering the magnitude of the economic problems the pandemic is causing.

Indexes that Move Opposite to Stocks are At the Lower Ends of their Micro MRI Cycles

Three indexes – namely, the US 10y Treasury bond index, a series called VIX, and credit spreads -- all have Micro MRI that are in the down-legs of their cycles and are at the lower ends of their historical ranges. These indexes move opposite to stocks; their MRI tend to move down when stocks go up (and vice versa). The indexes have been in the down-legs of their cycles for the last 6 weeks, consistent with increases in the stock market that we have experienced. The Micro MRIs for these three indexes are now at very low levels. The US 10y Treasuries Micro MRI is at the 25th percentile. VIX, a popular measure of the stock market’s expectation of variability based on S&P 500 index option (Link: https://en.wikipedia.org/wiki/VIX), has a Micro MRI that is at the 4th percentile. The credit spread index I use has a Micro MRI at the 25th percentile.

These statistics mean that these three indexes are close to beginning the up-legs of their MRI cycles. When they do stocks are likely to move lower. This information supports the view that the Micro MRI for the DJIA is at the upper end of its cycle.

Relief Rallies have Narrow Peaks, Often Occurring on a Single Day

As with other relief rallies in market history, the current relief rally is based exclusively on the up-leg of the Micro MRI – none of the other MRI are in the up-legs of their cycles and, therefore, none are providing resilience. Relief rallies tend to peak on just one day, whereas rallies based on the longer-term Macro MRI tend to have multiple peaks at similar levels over the course of several weeks or months. This means that stock prices in a relief rally tend to move higher quickly, then peak on one day, and then decline. Since the current rally has performed in a manner consistent with this general pattern thus far, I believe it is prudent to reduce aggressiveness in anticipation of the peak in the Micro MRI and hence the relief rally.

As mentioned in prior notes, extraordinarily good news, such as an effective vaccine and a fast economic recovery, could limit the stock market declines after the Micro MRI peaks. Based on historical patterns, stock prices may be flat during periods that have both no resilience and very good news, but it would be very unusual for prices to continue moving higher during a period of no resilience. As you know, the Focused 15 Investing approach does not make bets based on the assessments of such news.

For these reasons, I took the unusual step of suggesting to reduce account aggressiveness. I suspect this guidance will be in place for several weeks.

Update April 23, 2020

This note updates information I sent out last night (April 22).  I have continued to review the MRI conditions of major market indexes today and want to refine yesterday’s guidance.   

As mentioned yesterday, my best estimate is that the relief rally will end within a week or two.  As it ends, a meaningful price decline is likely.  When the Micro MRI peaks and ceases to provide resilience, the stock market will no longer have any resilience from any of the three main sources (the Macro, the Exceptional Macro, or the Micro).  Thus, the market will be considered as “LEAST resilient.” 

I am quite confident of this view – the math behind the MRI is unlikely to allow any resilience measure to become positive for at least several weeks.  In addition, this view is supported by the MRI of other index series that are often related to stock price declines (e.g., US 10y bond index, VIX, USDJPY, CHFUSD). 

The depth of the price declines during this “least resilient period” will depend on the magnitude of bad news we encounter.  Considering that the global economic system has come to a virtual halt, it seems that the potential sources of bad news are plentiful.  There are also potential sources of good news that can counter-balance the bad news. These include the unprecedented economic stimulus around the world, possible medical breakthroughs related to vaccines and/or testing, and measures of unexpectedly fast economic recovery. 

However, as you know, I don’t try to assess the magnitude or market impact of good or bad news.  Instead, we rotate our accounts based on resilience alone.  While the relief rally began and moved higher as expected in the MRI resilience framework, as we move closer to the end of the relief rally, I do not believe we should wait for the algorithms to identify the end of rally in this global economic shutdown.   

For all subscribers, even those with long time horizons, I suggest the following steps:

   1.  For Trading on Friday April 23, 2020: Do “a” or “b” below:
       a. Raise cash by, say, 30%.  For example, if you currently have, 3% in Box #2 of the Shares-to-Trade worksheet, enter 33%.  If you currently have 5%, enter 35%.  This is probably the easiest technique for reducing account aggressiveness and can be adjusted easily over time. 

       b. Switch to a less aggressive model portfolio.

   2. At a later date (which I will identify and alert you about): Consider switching to the “Onyx Special 2020 Recovery (sg117)” model portfolio. I designed this portfolio for an extended period of social distancing. It holds technology, consumer staples, and healthcare stock ETFs.  These sectors have been strong since the beginning of the epidemic and a good case can be made that they will continue to do well when social distancing is prevalent.  We will get a better idea of the value of this portfolio after we see stock price behavior when the stock market is least resilient.

Options a & b are described in the link:  https://marketresilience.blogspot.com/p/changing-portfolio-aggressiveness.html

Of course, you can raise more or less cash if you prefer.  Also, I suspect that some subscribers with long investment horizons may decide not to raise cash at this time. 

I continue to expect the second bottom of the W-shaped recovery pattern to occur in the May through July period.  June may be the most likely.  Also, I cannot determine at this time if the second bottom will be shallow or deep. 

Please contact me at any time with questions!

- Jeff

Weekly Note - April 22, 2020

IMPORTANT – PLEASE READ

The stock market as measured by the DJIA is still displaying the effects of the upleg of the shortest cycle of resilience - the Micro MRI.  The Micro MRI’s level as of last Friday was at the 52nd percentile of levels since 1918, which suggests that short-term resilience may be in place for another week or two, and the relief rally may last about that long as well.

Considering that we are close to the peak of the relief rally, it is time to review where we are with respect to containing the pandemic.  A vaccine is many months – perhaps over a year – away.  Widespread testing for antibodies is also many months away.  While a month ago, there was talk about the shutdown lasting a few weeks, widespread relaxation of social distancing does not appear to be at hand.

Rather than wait for the end of the relief rally as indicated by the MRI, I think it is prudent for subscribers to identify the way they would like to reduce the aggressiveness of their accounts and begin to make the changes. I do not believe that changes must absolutely be completed this week (Friday).  But use the next few days to review the options and contact me with any questions about the model portfolios, changing aggressiveness, and the mechanics of making changes.

Over the last month I have described the options for reducing aggressiveness and they are:

1. Raise cash by, say, 30%.  For example, if you currently have, 3% in Box #2 of the Shares-to-Trade worksheet, enter 33%.  If you currently have 5%, enter 35%.  This is probably the easiest technique for reducing aggressiveness and can be adjusted easily over time.  
2. Switch to a less aggressive model portfolio.
3. Switch to the “Onyx Special 2020 Recovery (sg117).”  I designed it for an extended period of social distancing. It holds technology, consumer staples, and healthcare stock ETFs.  These sectors have been strong since the beginning of the epidemic and a good case can be made that they will continue to do well when social distancing is prevalent.  

Options 1 & 2 are described in the link:  https://marketresilience.blogspot.com/p/changing-portfolio-aggressiveness.html

Of course, you can stay with your current model portfolio if you prefer.  I suspect that subscribers with very long investment horizons may decide to do this.

I continue to believe the W-shaped market recovery pattern is most likely.  We won’t know until we go through it if the second bottom will have a shallow bottom (with no or minimal stock market price declines) or a deep one (with large market declines).  Our strategy will be the same either way – reduce aggressiveness by taking money out of stocks.  At some point over the next few months (I hope) the stock market will be much more resilient and we can unwind the changes discussed above.

Weekly Note - April 15, 2020

The target weights call for an increase in the allocation to stocks.

Current MRI Conditions

Stock prices have moved sharply higher over the last few weeks in a classic relief rally. The Micro MRI has been the only MRI providing resilience during this period. Since the Macro and Exceptional Macro are not currently providing resilience (and are not close to doing so) prices will likely again decline when the Micro MRI peaks in just a few weeks. This will be the end of Upleg A described below.

The Micro MRI has moved from a historically low level at the end of March and is now about the 45th percentile of all levels since 1918. This means that we are about halfway through the normal upleg of the Micro MRI. If we get a few weeks of positive returns, the Micro is likely to be at its peak.

As you can guess, staying invested in the stock market when we believe we will have another leg down is a white-knuckle time. While the MRI have historically done a good job of identifying the end of relief rallies, waiting to see if this will occur again is tense. As mentioned a few weeks ago and also below, I may issue a special alert to reduce account aggressiveness outside of the regular midweek publication if the market conditions deteriorate.

However, if you are losing sleep, you can reduce aggressiveness using the methods described on this page.  Link:   https://marketresilience.blogspot.com/p/changing-portfolio-aggressiveness.html

I believe you be able to make up for any lost return after the second bottom of the W. At that time, there may be more support from the MRI. Please contact me for clarification if needed.

I cannot determine at this time if the second bottom in the W will be as low as the first bottom on March 23 or more shallow. If the second bottom is shallow (meaning prices do not go as low as they were on March 23rd), the buying opportunity at the second bottom will not be as attractive as the first bottom in terms of price. Some subscribers added to their accounts at the first bottom. However, waiting until the second bottom to add additional money to your investment account is probably less risky - at that time there should be far greater market resilience than there has been over the last few weeks.

End of Plant Season

Last week was end of the Plant season. We are currently in a Wait & Prepare season. In a few weeks, we will be in the Harvest season, which may be short this time around.

Market Recovery vs. Economic Recovery Patterns

You may hear on the news about V-shaped or U-shaped recoveries. In some cases, these are referring to the pattern of economic recovery as opposed to market recovery. Regardless of whether we have a V or U-shaped economic recovery, I believe that for the market recovery the W-shaped pattern continues to be most likely.

- Jeff

--------------

2020 Recovery Plan – Repeated from April 8, 2020 (with minor revisions)

The phases and steps described below are most applicable for people with investment time horizons less than, say, 7 years. For people with longer investment horizons, staying with your original model portfolio is reasonable through all these phases.

I have written that the W-shaped market recovery is most likely in this current situation. The graph below shows my estimate of where we are now. The graph is unchanged and the statements have been edited for clarity.  New statements are in italics.

2020 Recovery Plan

Decline #1

Step One – First Bottom: Move to the target weights of your selected model portfolio. DONE: The alert indicating the first bottom was issued on March 25.

Phase 1 – “Upleg A” to the Peak of the Relief Rally

During this phase, adhere to the target weights of the model portfolio you used during the recent major decline. But this is not the time to try to make up for earlier declines by being more aggressive.

Step Two – Peak of the Relief Rally: I will notify subscribers when I think we are near the peak of the rally and assess the target weights of the main model portfolios. If needed, I will issue a special alert to reduce the aggressiveness of your account outside of the normal midweek note and Friday trading schedule. See this link for more information on changing the aggressiveness of your account. (https://marketresilience.blogspot.com/p/changing-portfolio-aggressiveness.html)

During this phase, review the “Onyx Special 2020 Recovery (sg117)” model portfolio prior to the peak of the Relief Rally at the end of Upleg A. I designed this portfolio to be conservative but to invest in stocks that are likely to benefit from an extended period of social distancing. It invests in technology companies, consumer staples companies (think toilet paper and toothpaste), and healthcare companies. We can think of it as the technology and toilet paper portfolio, or TnT. I have placed the prior content on a separate page with a new link: https://marketresilience.blogspot.com/p/addition-of-special-variation-of-onyx.html

Phase 2 – “Decline #2” After the Relief Rally

Maintain a less aggressive stance (using a less aggressive model portfolio or the Onyx Special 2020 Recovery sg117 model portfolio) in your account until the second bottom. If the pandemic and economic situation deteriorates further, the less aggressive stance will be appropriate for a longer period of time.

Phase 3 – Upleg B and Beyond

Step Three - At the Second Bottom - Switch back to your original model portfolio and/or reduce cash in your account to resume the original level of aggressiveness of your account. This is the buying opportunity you don't want to miss. When we get to this time, you can also consider switching to a model portfolio that is more aggressive than the one you used during the decline.

Weekly Note - April 8, 2020

The markets are closed this Friday so any trading should take place Thursday (tomorrow) or Monday.

I have made a few important refinements to the weekly publications over the last few weeks and these are summarized in this link:
https://marketresilience.blogspot.com/p/i-have-adjusted-and-model-portfolio.html.
Please contact me if clarification if needed.

We have technically been in a Plant season, although the sense of crisis has overwhelmed the last several weeks. For those with a long investment horizon, this has been a good time to add money to your account. Some subscribers are doing so. The second bottom, described below, is likely to have clearer buy signals from the MRI. However, we cannot tell at this time if the second bottom will be lower or higher than where the market is now.

The comments below show where we are in the W-shaped recovery pattern and briefly discuss the recent refinements to the model portfolio lineup in the weekly publications. Links provide additional detail.

2020 Recovery Plan

The phases and steps described below are most applicable for people with investment time horizons less than, say, 7 years. For people with longer investment horizons, staying with your original model portfolio is reasonable through all three phases (1,2, and 3).

I have written that the W-shaped market recovery is most likely in this current situation. The graph below shows my estimate of where we are now.

2020 Recovery Plan – A W-shaped Market Recovery Pattern Appears to Be Most Likely

Decline #1

Step One – First Bottom: Move to the target weights of your selected model portfolio. DONE: The alert about the first bottom was issued on March 25.


Phase 1 – “Upleg A” to the Peak of the Relief Rally

We are currently seeing a rally in stocks, which I believe is most likely a relief rally or bear market rally. During this phase, adhere to the target weights of the model portfolio you used during the recent major decline. We appear to be midway through rally.

Step Two – Peak of the Relief Rally: I will notify subscribers when I think we are near the peak of the rally and will assess the target weights of the main model portfolios. I may give additional guidance to reduce the aggressiveness of your account. See (https://marketresilience.blogspot.com/p/changing-portfolio-aggressiveness.html) for more information on changing the aggressiveness of your account.

Prior to the peak of the relief rally, review at the following link the description of the refinements to the model portfolio lineup. This blog page gives an overview of the recent changes that will make managing the aggressiveness of your account easier as we move through the market recovery. Please note the description of the new "Onyx Special 2020 Recovery (sg117)" portfolio. I have designed this to be used in the case of a long period of economic weakness related to pandemic, social distancing and related economic weakness.  Follow this link and go to the last section of the post:
https://marketresilience.blogspot.com/p/i-have-adjusted-and-model-portfolio.html

Phase 2 – “Decline #2” After the Relief Rally

Maintain a less aggressive stance in your account until the second bottom. If the pandemic and economic situation deteriorates further, the less aggressive stance will be appropriate for a longer period of time.

If the pandemic and economic situation improves more quickly, decline #2 may be muted. If the situation improves greatly, the W-shaped market recovery patten could morph into a V-shaped pattern. We will get a better perspective on this several weeks from now.

Phase 3 – Upleg B and Beyond

Step Three - At the Second Bottom: Switch back to your original model portfolio and/or reduce cash in your account to resume the original level of aggressiveness of your account. This is the buying opportunity you don't want to miss. When we get to this time, you can also consider switching to a model portfolio that is more aggressive than the one you used during the decline.

Weekly Note - April 2, 2020

I believe we will be in a more protracted economic hibernation than seemed likely just two weeks ago. I outline my understanding of “Virus Time” in the link below on Three Scenarios.

With this extended timeline, it may make sense for some subscribers to reduce the aggressiveness of their accounts while we move through the early parts of the slowdown, even if we have not reached the end of Upleg A as I describe below. 

This note discusses:

• Where we are in the “W-shaped” market recovery pattern
• A review of recent model portfolio performance compared to the DJIA and funds offered by Vanguard and the Russell Investment Group.
• Additional research notes.  These are not required reading but will give you an idea of things I have been working on.  These include notes about three different economic scenarios, a brief comment about responding to rapidly appearing signals outside of our regular weekly trading pattern, and a few additional points about valuation changes in past declines.

The W-shaped Market Recovery Pattern

In my earlier note (https://marketresilience.blogspot.com/2020/03/update-march-22-2020.html) I described the W-shaped pattern as the most likely.  I continue to believe that is the case.  I believe we have already experienced the first bottom of the W and are now in “Upleg A” mentioned in the earlier post.  It appears that Upleg A may continue for a few more weeks.  However, the DJIA may move down toward the level of the first bottom before it ends higher - the path is not always higher each week. The second bottom is likely to occur May through July; this is the buying opportunity you should take advantage of.

Below are recommended steps for moving through these points in the W-shaped recovery pattern.  These steps are most applicable for people with investment time horizons less than, say, 7 years. For people with longer investment horizons staying with your original model portfolio is reasonable through all these steps:

1. First Market Bottom – If tolerable, move to the target weights of your selected model portfolios. DONE: The alert about the first bottom was issued on March 25.
2. At the End of Upleg A – This occurs at the middle peak in the W. When this time comes, consider reducing aggressiveness of your account by increasing the amount of cash in your account (increase the amount in Box #2 on the Shares-to-Trade worksheet), or switch to a model portfolio to the left of the one you have been using. See (https://marketresilience.blogspot.com/p/changing-portfolio-aggressiveness.html) for more information on changing aggressiveness. 
• We are currently prior to the end of Upleg A.  Based on the likely scenario I link below, our period of high economic uncertainty and damage will continue for several months. Bad upcoming mortality and economic headlines will probably dampen the relief rally over the coming weeks. This makes identifying the precise end of Upleg A more difficult. If the uncertainty and variability of the current situation are intolerable, you can reduce the aggressiveness of your account and still have time to move to a more aggressive stance as the markets and economy emerge from hibernation.  Of course, you are free to use any model portfolio on the publication at any time. 
• I will still try to identify the end of the relief rally as described above.  
3. Second Bottom – At this point switch back to your original model portfolio and/or reduce cash in your account to resume the original level of aggressiveness of your account. This is the buying opportunity you don't want to miss. When we get to this time, you may see that moving to a model portfolio that is more aggressive than the one you used during the decline is appropriate.

Recent Model Portfolio Performance

The link below shows how popular Focused 15 Investing model portfolios performed over various recent time periods. The tables show that even though the declines were significant, the Focused 15 approach still performed favorably compared to the alternatives listed. https://marketresilience.blogspot.com/2020/03/update-march-26-2020-not-urgent.html.  

Ongoing Research

This section is not required reading, but some subscribers might be interested in these comments. As an exercise, I am evaluating three different scenarios for the path ahead to determine what, if any, changes might be needed in our model portfolios to take advantage of them. https://marketresilience.blogspot.com/2020/03/covid-recovery-model-portfolio.html

I am also evaluating how I can reliably provide alerts that a change in the aggressiveness of your account may be appropriate.  I will discuss this more in a few weeks.

Finally, here is a link to additional information on changes in valuation measures in past declines.  This adds more depth than I was able to provide in my comment on valuation a few weeks ago. https://marketresilience.blogspot.com/2020/03/historical-valuation-comparisons.html

Please feel free to contact me with questions or comments.

Jeff

Research Note: Historical Valuation Comparisons

March 30, 2020

Over the last few weeks, the DJIA declined significantly. The DJIA price level declined 37% from its peak on February 12, 2020 to the most recent low on March 23, 2020. Valuation measures can give us an idea of how far prices might fall near term by looking at changes in valuation levels in past declines.  My original note about valuation is in: https://marketresilience.blogspot.com/2020/03/update-march-22-2020.html, in the section titled: "The DJIA May Be in the Bargain Basement."

This note provides additional data.

Price-to-Book Ratio Changes in the Great Depression

The Price-to-Book ratio for major market sectors in during the 1930s declined from their highs in 1929 to about 50% of the prior high values by 1930.  This information comes from "The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929-1933," by Barry Wigmore (1985).  The decline took place over a longer time than the recent Corona decline, and there may have been write-downs in book value during that longer period that make this comparison less meaningful.

As comparison, the Price-to-Book ratio of the DJIA declined to 2.9 as of March 22, 2020 from a high of 4.4 just a month earlier. This represents a drop to 66% of its prior high value.

Price-to-Earnings Ratio Changes in 1987

During the 1987 Crash the DJIA price level declined about 30% from August 25 to October 19. I can locate only Price-to-Earnings ratio information for this decline. Over the same time period, the DJIA's Price-to-Earnings ratio had declined to 67% of its prior high value.

This information is from the New York Times. https://www.nytimes.com/1987/11/27/business/economic-scene-taking-a-look-at-p-e-ratios.html

As a comparison, the DJIA Price-to-Earnings ratio declined to 65% of its prior high level from February 12, 2020 to March 23, 2020.

Summary

This information suggests that the recent decline has already produced low valuations, low enough by historical standards to attract bargain-hunting investors.  I believe the information in the original note linked above and this additional note is relevant for the immediate time period. Please note that earnings and book values will certainly change (decline) as a result of the pandemic and economic decline. As we start seeing additional deterioration in the real economy, other valuation assessments might be needed to give perspective.

As you know, the MRI-based process does not include valuation information because it is difficult to obtain accurate historical information.  But I do refer to it on a regular basis for market context, especially during times of market stress.

Research Note: Three Market Scenarios and Possible Responses

As you may know, my views on forward looking scenarios do not have an impact on the target weights, but they do influence my review of portfolio designs as I evaluate whether there is a change in the economy or markets that requires a shift in their designs.  As an example, the recent price decline was a shock to many investors and affected their short-term risk tolerances. I adjusted the model portfolio lineup and my communication to make it easier to adjust the aggressiveness of one's account.

I am currently evaluating three different scenarios for the path ahead to determine what, if any, changes might be made to model portfolio design to accommodate scenarios more extreme than the one I consider most likely.

The Likely Scenario - Economic Activity Constrained to "Virus Time"

Current expectations:

• Unemployment will spike dramatically over the near term and stay high for many months.
• Bankruptcies will spike as well.
• The Federal Reserve and its counterparts around the world have already stated emphatically that they will do “whatever it takes” to limit the damage of this crisis. Their actions have been consistent with their statements. Additional actions are expected.
• Congress and the President have enacted stimulus packages and have promised more
• Social distancing will continue in some form until a vaccine is developed in 12+ months. Until that time, travel and entertainment, dining out, and shopping for non-essentials will be severely limited.
• Economic activity will begin to resume when there is an effective and scalable way to test for antibodies, which can identify people immune to Covid-19 who can safely return to work. The antibody test is some months away.
• More people are working effectively at home than would have been possible a few decades ago or certainly during the Spanish Flu in 1918-9. Economic activity is continuing during lockdown, which may be the source of some positive surprises.   
• The level of bad news in the market will likely be higher in the US when death rates spike over the next several weeks, employment reports come out, and the scale of the immediate economic damage becomes more apparent.  
• Investors will see some light at the end of the tunnel as Europe moves through its curve of infection, mortalities decrease, and people return to work.  Asia is more advanced in that sequence. India and South America may be behind the US.  

Earlier than expected development of vaccines and antibody tests will accelerate this timeline and would be key events. 

The fact that we just recently had a major financial crisis (2007-9) with bailouts and stimulus packages is important to the current situation. The Global Financial Crisis was just over ten years ago as opposed to something we could only read about in history books. Many of the same people and institutions have been involved in both crises and I believe there is general dissatisfaction with how the past rescues of big corporations and financial institutions failed to benefit the consumer as much as needed. In the subsequent years, interest rates have been pushed lower and lower to encourage growth.

But the debt load carried by the economy has expanded (because of low rates) to the point where any increase in interest rates has a devastating effect on both corporations and consumers. We seem to have come to the end of the long trend toward lower interest rates that started in the 1980s when short term rate (2-year treasuries) was 16.7% in September of 1981 to the current rate of 0.23% (March 2020). While Japan has had negative interest rates for a few years, low rates distort corporate and individual investment and borrowing decisions.

This current crisis may be a way of clearing out the debt load and resetting debt loads and interest rates to a more healthy and sustainable relationship. Thus, the pandemic can be thought of as precipitating important changes that would have come about without the virus but in a perhaps slower and probably less comprehensive manner.

If this scenario is valid, our current lineup of model portfolios is likely to navigate the 2020 recovery reasonably well. The design of the current model portfolios is based on analyses of prior recessions and market crashes and their recoveries. Our portfolios emphasize the DJIA because of the quality and liquidity of the companies it contains. Should there be widespread bankruptcies in the broader market, the DJIA companies generally considered strong and some of the DJIA companies may actually grow stronger as they absorb customers from the competition. For reference, the top 10 holdings of the DJIA are:

• Apple Inc
• UnitedHealth Group Inc
• Home Depot Inc/The
• Goldman Sachs Group Inc/The
• Visa Inc
• McDonald's Corp
• Microsoft Corp
• Johnson & Johnson
• 3M Co
• Boeing Co/The

The DJIA has technology companies (Apple, Microsoft) and healthcare companies (UnitedHealth Group, Johnson & Johnson).

The model portfolios currently hold US 10y Treasury bonds also because of their quality and liquidity. In times of crisis, quality and liquidity make it easy to adjust our asset allocations and to remove money from the market. We do not hold corporate bonds because they may be difficult to trade in times of stress.

A More Positive Scenario

I can imagine a more positive outcome for the global economy from the current events. Many individuals and businesses will suffer and be forced into bankruptcy. In this scenario, the changes happen quickly. There will be some form of debt forgiveness, perhaps in the form of student loan forgiveness or mortgage relief. Reduced debt load among consumers and businesses and the global economic stimulus will encourage rapid economic growth. Fiscal stimulus will help rebuild infrastructure faster than would have otherwise occurred and provide future efficiencies. Surviving business will grow quickly with a lower debt load. In the next couple of years, we may begin to see hints of inflation.

If this scenario becomes more likely, it may be helpful to incorporate inflation-linked bonds as a component.  I have been running inflation signals sets since 2007 and can incorporate them if needed.

A More Negative Scenario

Even though we are seeing an extremely fast response from governments around the world, the inevitable economic contraction may be extremely difficult for many businesses and sectors of the economy. They will not muddle through easily. Individuals and business bankruptcies will grow more than expected right along with unemployment rate. Financial stress and dislocation will reverberate through the global economy for many quarters despite the speed and magnitude of the government response. Economic growth will not rebound evenly throughout the US or global economies.

I am evaluating variations of the current model portfolios that seeks to have more exposure to the parts of the economy that may benefit during the more negative scenario. I tentatively call it the 2020 Recovery model portfolio and its structure is based on the Diamond-Onyx Mixes. It uses existing signal sets (developed over 7 years ago), which makes the historical simulations far less vulnerable to back-fitting the solution to the time period just experienced.

The thrust of the modification is to have greater exposure to consumer staples companies, technology companies, and health care companies. These sectors may experience better growth than other areas of the market.

Consumer Staples companies tend to have steady business in difficult economic times. They may get a boost as more people eat at home and seek to make life at home comfortable and pleasant. We currently use the ETF XLP for Consumer Staples companies in the Onyx mixes.  The modification would increase the allocation to this ETF.  The top 10 holdings of this ETF are:

• Estee Lauder Cos Inc/The
• Mondelez International Inc
• Coca-Cola Co/The
• Procter & Gamble Co/The
• Walmart Inc
• JM Smucker Co/The
• Altria Group Inc
• Sysco Corp
• Kraft Heinz Co/The
• Archer-Daniels-Midland Co

The 2020 Recovery would obtain greater technology exposure by having an allocation to the ETF QQQ, which tracks the NASDAQ 100 index. The Nasdaq 100 Index is composed of 100 of the largest international and domestic companies, excluding financial companies, that are listed on the Nasdaq stock exchange, based on market capitalization. Therefore, QQQ is heavily weighted toward large-cap technology companies and is often viewed as a snapshot of how the technology sector is trading. The growth of online commerce, new technological solutions to address workplace challenges (e.g. remote working and online meetings and classes), the growing need to provide social connections in in a socially distanced world, and investment in new technologies to solve emerging problems will likely boost the NASDAQ. The top 10 holdings of QQQ are:

• MICROSOFT CORP
• APPLE INC
• AMAZON.COM INC
• ALPHABET INC-CL A & C
• FACEBOOK INC-CLASS A
• INTEL CORP
• PEPSICO INC
• CISCO SYSTEMS INC
• COMCAST CORP-CLASS A
• NETFLIX INC

As you can see, there is overlap with the DJIA.  Apple and Microsoft are among the top 10 holdings of both indexes and ETFs.

Health Care companies would be included in the Covid 2020 Recovery model portfolio.  They are likely to get a direct boost from consumer and government spending because of the pandemic. These companies might also be affected by changes in the healthcare system as we move through the recovery. Should this sector deteriorate as an investment, it may be removed from the model portfolio. We would have an allocation to the ETF XLV. Its top 10 holdings are:

• Johnson & Johnson
• UnitedHealth Group Incorporated
• Merck & Co., Inc.
• Pfizer Inc.
• Abbott Laboratories
• Bristol-Myers Squibb Company
• Amgen Inc.
• Medtronic Plc
• Eli Lilly and Company
• Thermo Fisher Scientific Inc.

It is important to recognize that the top holdings in the major indexes are similar; there is a fair amount of overlap. Thus, the change from the current structures may be less than it appears.  Please see this page for the holdings of the ETFs mentioned: https://marketresilience.blogspot.com/p/etf-holdings.html

The resulting model portfolio has similar characteristics of the Onyx mixes currently offered, although it holds more ETFs. While the design of the existing model portfolios considers a very long frame based on historical experiences, the Covid 2020 Recovery portfolio is more thematic and is more likely to be modified over time.

After additional testing, I will report my findings on this evaluation.