Weekly Note - March 18, 2020

Revised 11:50 am 3/18/2020

The stock market decline has been startling.  If you are uncomfortable with the level of aggressiveness of your current model portfolio, I believe it is reasonable to consider shifting near-term to a model portfolio that has a lower maximum exposure to ETFs linked to the DJIA.  These ETFs include DIA, DDM, and UDOW.  The rest of this note describes changes to the Diamond publication and my communication that will make shifts in aggressiveness easier. Again, these changes affect the Diamond publication. For now, the publications other than Diamond have not changed - please contact me with questions about the other publications.  

If you are comfortable with your model portfolio's the level of variability, you need not change.   

I think everyone is now fully aware of the coronavirus crisis.  The economic impact of fighting the virus is just beginning. The extent and duration of stock price declines, layoffs and rising unemployment are likely to reverberate through the economy for some time. I believe the likelihood of a near-term, price rebound has diminished. At the end of this note, I discuss the current MRI conditions, which drive my belief that the likelihood of a rapid increase in stock prices (the key reason one would maintain the current level of aggressiveness) is diminishing. 

As economic and market conditions stabilize, we can shift to model portfolios that have higher maximum exposures to these DJIA-linked ETFs. We do not want to miss price appreciation when it does occur.  I have laid out a framework below for doing this.  The framework has three phases and makes wider use of the Onyx sleeve of low volatility sectors, which is designed to do well in challenging market environments, as I describe below. 

Three Phases and an Expanded Set of Diamond-Onyx Mixes

Considering recent events and the ambiguity around us, we need to shift our goals. At this time, they are to be able to sleep at night, to recoup losses rapidly in a methodical and low risk manner, and to shift back to a model portfolio that is a good long-term fit when doing so is prudent. Ultimately, we want to take full advantage of the once in a generation investment opportunities that this crisis will present. I see three likely phases over the next several months:

1. High Uncertainty and Market Volatility – We are here now and can expect high uncertainty about the markets’ reaction to the government measures and the real virus situation. Generally speaking, few asset classes are performing as expected. During this phase, I suggest that subscribers who have found the recent losses intolerable consider a model portfolio with lower risk than the one they currently use.  One can select a model portfolio to the left (i.e., lower variability) of the one they currently use on the scatter chart provided on the first page of the weekly publication.  Patient subscribers with longer investment horizons (say, more than five-years) time horizon can probably stay with their current portfolio. This phase may last a few weeks or more.  
2. Greater Clarity on the Path the Markets Take – During this phase, I expect the various stock and bond markets to perform more consistent with expectations in terms of magnitude of ups and downs and in relationship to other asset classes. Based on historical precedent, there are two major paths the markets can take after significant declines such as those we have experienced (and may still be experiencing) and formed a bottom:  A) the stock market moves higher at a moderate pace for an extended period (as in 1987), or B) the stock market move higher more aggressively (a relief rally) followed by declines in a few months (as in 2008).  During this phase, I will alert you when I believe that you should consider having more exposure to the stock market by shifting to a model portfolio to right on the scatter chart.   
3. Transitioning to the Desired Model Portfolio – One would transition (as needed) to a model portfolio that is a good long-term fit. I suspect this would take place in roughly early summer. Obviously, potentially unknown factors may affect timing.  

Because we are now in phase 1, part of our focus is on looking for the time to move to portfolios that have higher allocations to DJIA-linked ETFs. The price declines we are experiencing will ultimately create very attractive opportunities. When the economy and markets settle, prices are very likely to move quite a bit higher than they are now.  The MRI provide reliable signals for the long-term market bottoms. 

To provide greater flexibility in carrying out the framework’s phases, I have adjusted the line-up of model portfolios on the weekly publication.  Specifically, I have added additional Diamond-Onyx Mixes. each has a different maximum allocation to the D5 signal set using DDM. The D5 signal set was caught off-guard by the virus but provides very strong signals in many market environments.  The Onyx segment (or sleeve) of the model portfolios rotates among four low volatility sectors that tend to perform well in bad markets for the DJIA. Onyx rotates among these four sectors based on their resilience and vulnerability:

1. Consumer staples company stocks in ETF “XLP.” These are food companies, drug stores, and grocery stores. When the economy is bad, people still need food, toothpaste, and toilet paper.

2. Utility company stocks in “XLU.” In many economic downturns utility stocks do well because they benefit from lower interest rates and lower energy costs.

3. US 7-10 Year Treasury bonds in “UST.” This ETF provides two times the return of the 7-10 year index and tends to move higher as interest rates decline.

4. US 1-3 Treasury bonds. This is the lowest volatility ETF and essentially cash.  

This link shows the holdings of our most important ETFs, including those listed above.  Scroll down to see XLP and XLU.  https://marketresilience.blogspot.com/p/etf-holdings.html 

The family of Diamond-Onyx Mixes are variations of the Diamond-Onyx Mix (sg218) that has been on the Diamond publication.  Together they cover a range of maximums allocations to the D5 signal set using the ETF DDM (DJIA x2).  Use of the term “Diamond” in the portfolio name indicates that it relies on the D5 signal set using DDM.  Members include:

   Diamond-Onyx 50-50 Mix (sg118)* A maximum of 50% to the D5 signal set using DDM

   Diamond-Onyx 35-65 Mix (sg218)  A maximum of 35%

   Diamond-Onyx 18-82 Mix (sg318)  A maximum of 17.5%

   Diamond-Onyx 10-90 Mix (sg418)  A maximum of 10%

   Diamond-Onyx 5-95 Mix (sg518)  A maximum of 5%. 

* This line was added at 11:50 am 3/18/2020.  This model portfolio has a 50% maximum exposure to the D5 signal set using DDM.  Diamond (sg131) has a 70% maximum.  Sg 118 represents a less dramatic change in exposure than does the Diamond-Onyx Mix (sg218). 

As of last Friday (3/13/2020), the Diamond-Onyx 5-95 Mix (sg518) does not have losses for the year.  The Diamond-Onyx 35-65 Mix (sg218) is down 8%.

I have removed model portfolios Zircon (sg206), which appears in the Zircon publication.  I have also removed sg249 and sg289 – if you are using one of these please consider using one listed above.  Please contact me with any concerns about the removal of these model portfolios. 

It is useful to have some allocation to the D5 signal set and the DJIA-linked ETFs (i.e., DIA, DDM, or UDOW). We want to watch it and be ready to move up to a more aggressive portfolio as the market recovers. In Diamond-Onyx 5-95 Mix (sg518), the 5% maximum allocation to the D5 signal set using DDM will have very little impact on portfolio returns - this is a good model portfolio for those just starting out with the Diamond Onyx Mixes. One can get a feel for the variability of DDM; it is high. 

An advantage of organizing the model portfolios in this way is that once you set up your Shares-to-Trade worksheet for one of the Diamond-Onyx model portfolios, you can shift to one of the other model portfolios without altering that sheet.  In fact, all the model portfolios on Diamond can use the same sheet.  A very slightly revised worksheet can be found here: https://focused15.net/training-level-2-1. The new sheet has names of the ETFs for the Onyx Mixes in the fields. 

As market conditions improve, I will indicate when it is appropriate to move to a more aggressive (higher maximum exposures for D5 signal set and the DJIA) in the weekly publications or by special e-mail. Using this approach, we have a better way responding more rapidly to crises and opportunities. 

Of course, you are free to move up or down this list as you want to change your maximum exposure to the DJIA. Also, you can reduce the aggressiveness of any one of them by holding more cash (adjust the cash level in Box #2 in the Share-to-Trade worksheet), and this approach may be more suited to those using Diamond (sg131) and Zircon (sg206) - they hold just three ETFs and focus on the D5 signal set.

MRI Conditions

We will be looking for evidence of inflection points in the market dynamics to determine when it is wise to consider increasing one’s maximum exposure to the DJIA.  At the moment, none of the MRI are providing resilience.  I consider the stock market to be at its most vulnerable.  The market has shifted from “somewhat resilient” to “most vulnerable” in just a few weeks.  This happened in the 1987 crash and the economy was not significantly harmed by that crash.  Prices recovered slowly but steadily from the bottom of that crash. 

At present, the Micro MRI has been poised to move higher for a week or so but has not yet moved higher. When it does move higher, that will signal greater short-term resilience and a likely move higher in prices.  The D5 signal set will respond to that change and increase the target weights of the DJIA-linked ETFs.  The upleg of the Micro MRI will identify when to participate in that rally.  However, unless the other MRI become positive and provide resilience, the price increase is likely to be temporary – a bear market rally.  Bear market rallies are traumatic – investors pile into stocks quickly on expectations that there is relief from the crisis, only to experience further declines when the short-term resilience ends the upleg of its cycle.

Currently, neither the Macro nor the Exceptional Macro are close to providing support.  At this moment, it seems mathematically unlikely that the Macro or Exceptional Macro will provide support over the next several weeks.  This reinforces my view that the next rally could easily be, sadly, temporary and end tragically for those who over-allocate to the stock market (through DJIA-linked ETFs or other means).  Also, generally speaking (based on 100 years of history), when a Micro MRI cycle takes longer then normal to complete, an adjoining one is cut short (as opposed to being simply delayed). This could mean that any bear market rally is cut short simply because it was delayed - in addition to any bad news that comes into play. We may need to be more nimble than we are in less turbulent times. This situation causes me to believe that shifting to a lower risk portfolio AFTER the recent big declines can be acceptable. 

As you know, the MRI dynamics are evaluated each week and my views will likely evolve. I understand the economic situation is difficult and the economic woes are likely to expand from here. The government responses around the world are huge. This is good, but the massive government stimulus may also raise the risk for inflation.  Also, we may be positively surprised by the effectiveness of the drastic measures being undertaken or an effective vaccine.

In summary, if you are comfortable with your current model portfolio no change is needed.  But if you are concerned and losing sleep at night, the framework above can help us navigate this challenging time more effectively and still have a very good chance of achieving your investment objectives. 

--

Here is a link to the note I sent out what seems like a year ago - it was last Sunday.  https://marketresilience.blogspot.com/2020/03/update-as-of-march-15-2020-this-note.html

Research Note: Covid-19 and Global Response - March 15, 2020

This note lays out my view of the current investment situation, my response to a subscriber who is taking a break from the stock-linked ETFs, and a brief comment about the Focused 15 investment approach.

We are in a period of extremely high uncertainty. Because of the rapidly emerging and expanding Covid-19 pandemic, we are seeing a highly synchronized cessation of economic activity on a global basis. We have not seen this before. In the Global Financial Crisis n 2007-8 for example, we saw different markets around the world react at different times as the extent of the financial system’s woes became more apparent. Red flares of stress occurred every few weeks as another portion of the financial system broke down or another industry was being hit.

The pros of the current environment:

• The global cessation of economic activity we are seeing is NOT primarily driven by economic failings. Essentially, we are reducing economic activity to prevent the pandemic from claiming many lives. As of just a few weeks ago we knew that the US had low unemployment, interest rates were low, the global economy was healing from a series of trade wars, and, very importantly, we had a reasonably strong financial system. If the reduced economic activity is brief, we stand a good chance of resuming strong economic activity in a few months, which the markets will start to consider very quickly.
• We have the Global Financial Crisis of 2008 in recent memory. We have institutions and people in place that have looked into the abyss of that financial meltdown and tried many tools until they found success. Today, policy makers (the Fed and its counterparts around the world) have tools and are not afraid to use them. On the fiscal side, Congress should be more responsive than it was in the Global Financial Crisis.
• We have seen China and South Korea have success in containment and mitigation in the matter of just a few months. We can do that as well. 

 
The cons:

• Interest rates were already low by historical standards, making rate reductions a less powerful tool to stimulate economic growth. Yet, as mentioned above, the Fed has many other tools to use.
• There is uncertainty about the response of Congress (and law makers around the world) regarding fiscal stimulus. This may be addressed in the US by the bill being sent to the Senate on Monday. If that bill is not enough, other bills are very likely to be put forth.
• There is unfamiliarity among investors about how a non-economically driven market crisis will play out. I suspect this is the major issue. Many investment decisions are made, understandably, based on economic and financial drivers. These include economic growth, earnings growth, valuation, etc. Currently available data related to these measures is viewed by many as no longer relevant to the future. Investors can look at numbers, but they are likely meaningless numbers.
• I believe that if governments act soon and completely, we can weather the reduced economic activity without excessive (2008-like) damage. I am even optimistic that the actions we have seen over the last week around the world will have that impact. As you know, these views do not influence the algorithms or target weights.

Nonetheless, we have extremely disoriented investors right now. Until we get more data points that let people know the status of the economy, investors and markets are likely to continue to be disoriented and erratic. This is different than the rhythmic tug-of-war between the optimists and pessimists behind the MRI signals we use. During this data vacuum, many investors are selling.

If the Recent Declines Are Too Much

I have spoken with several subscribers this weekend. All have been surprised by the magnitude of the decline, as have I. Most are tolerating the decline. One subscriber sold out of the DJIA-linked ETF “DDM” a week ago and is wondering when to get back in. In this case, I think it prudent to wait for a clearer link between market price moves and the MRI. An important feature of the model portfolios is that we can be aggressive during the rebound in stock prices. This means that stepping out of the market for a while may cause you to miss some of the positive returns of the ultimate rebound but your Focused 15 Investing returns can still be quite strong in the longer term.

Review of Investment Approach

As I do frequently, I reviewed the Market Resilience Indexes and the algorithms this weekend. I am comfortable that the MRI have tracked the resilience shifts over the last months. A weak spot, however, is that the rapid shifts in resilience over the last month could not be accommodated in a weekly trading discipline. I have seen similar periods (Jan 2018, for example) and am contemplating a shift in my communication to subscribers.

I am considering issuing “a loss warning” outside the regular weekly schedule. Over the next few weeks, I will outline what can be done on the occasions where actionable alerts can be issued outside of the normal weekly schedule. On a personal note, I follow the target weights of the publications and have not responded to the loss warnings in the past – I believe the weekly trading discipline helps performance in most environments. Any “loss warning” would be used infrequently and under exceptional conditions.

Please let me know if you have any questions or would like to discuss any of these points.

Is the Current Market Like 1987, 1998, or 2008? - Update #2

This post is the second update of my post, “Is the Current Market Like 1987, 1998, or 2008?” The original post was published December 27, 2018.  The first update was published January 9, 2019.  While the key points of these posts are described in this post, the prior posts can be found here:

LinkedIn     Original post                     Update #1

Blog            Original post                     Update #1 

This post discusses where US stock prices may go from here based on the status of CPM’s Market Resilience Indexes (MRI) as of February 1, 2019.  A brief description and the current status of the MRI for the Dow Jones Industrial Average is mentioned below.  Three scenarios mentioned in the prior posts are: 

Scenario #1 - reflects the experience of 2008 – A bear market rally moves prices higher but does not establish new highs and is followed by dramatically lower lows. The price declines of December 2018 would be seen as an indicator of coming slower economic growth. The bear market rally would be like the one that began in February of 2008.  The market ultimately bottomed quite a bit lower in March of 2009. There may not be the excesses in the financial system that we had in the 2008-2009 period, and we may not experience the same degree of loss that we experienced then.  Nonetheless, following the bear market rally, which we are now approaching the end of, there would be another meaningful decline. 

Scenario #2 - reflects 1987 – A bear market rally would be muted, but a longer-term positive price trend follows. The declines in late 2018 would ultimately be seen as a rapid, large-scale adjustment of valuations similar to the price declines of October 1987. There was not a strong rally (bear or otherwise) immediately after the October 1987 decline, but the decline did not foreshadow further deterioration in the real economy. Economic growth was strong pre-October 1987 just as it is now.

Scenario #3 - reflects 1998 – After the initial price declines, a rapid recovery to price levels as high or higher than what had been previously experienced. The declines at the end of 2018 would be seen as being driven by negative news-of-the-day events occurring at a vulnerable time. This would be like the decline ending in August of 1998 related to the Long-Term Capital Management crisis, which was quickly resolved. Economic growth was strong in 1998 just as it is now. However, then, as now, the Macro MRI indicated a negative trend in stock prices.  A more recent period reflects the same pattern.  The 2015-2016 period was similar.  The Macro MRI turned negative in mid-2015, and the yuan devaluation scare precipitated stock market price declines in August of 2015.  The US stock market remained vulnerable until mid-2016 and then became “most resilient” through the beginning of 2018.  During this period, the Fed cited global weakness and held off raising rates, which seemed to accelerate the shift to a positive Macro MRI trend. 

All three of these periods have Market Resilience Indexes in similar positions to their current status. 

Briefly, the MRI framework decomposes market price movements into three main cycles of resilience that support higher prices.  The up-legs of these cycles provide thrusts of resilience. Conceptually, the cycles represent the tone or mood of the market.  The up-legs indicate investor euphoria and market resilience.  The down legs indicate investor despondency and market vulnerability.  We focus on the up-legs of these cycles and give an index (e.g., DJIA) a rating based on how many of these three cycles are in their up-legs.  

These cycles of resilience are:

·       The Macro MRI indicates long term cycles lasting several quarters or years.  Currently, the Macro MRI is absent and indicates persistent investor despondency and a negative long-term trend in stock prices.  This status is consistent with all three scenarios. 

·       The Exceptional Macro, indicates a strong thrust of resilience and occurs infrequently, typically at major market bottoms.  Currently, the Exceptional Macro is not close to occurring, which indicates we are not at a major market bottom.  This status is consistent with all three scenarios. 

·       The Micro MRI indicates thrusts of resilience lasting 6 to 18 weeks.  The Micro MRI has been in the up-leg of its cycle from late December 2018.  It is currently at the 79^th percentile of levels since 1918.  It is not unusual for the Micro MRI to peak at levels close to the 80^th percentile. It is not unusual for the Micro MRI to move up about 10 percentile ranks in a week.  Thus, the Micro MRI could cease being positive this week or over the next few weeks. 

When all three MRI are providing resilience, a market index is rated 3, which means “most resilient.”  A resilient market is likely to recover quickly from price declines associated with bad news.  When none are providing resilience, a market index is rated 0, which indicates that the market is vulnerable to bad news and more likely to move lower. I provide additional information about the MRI framework at the end of this post

At the moment, the Dow Jones Industrial Average is rated 1, with only the Micro MRI providing resilience.  With only the Micro MRI currently providing resilience and its level being at the upper end of its historical range, we should expect a much more vulnerable market over the next few weeks.  When the Micro MRI ends the up-leg of it cycle, the DJIA index will be rated 0 (least resilient).  Without any positive MRI, it will be most susceptible to negative news and price declines are more likely. 

Recent price gains for the DJIA since 12/21/2018 have recovered (retraced) 62% of the decline from the prior high on 9/21/2018 (based on weekly closing prices).  This recent move higher is a greater move than was made after the abrupt October 1987 decline.  By the time the Micro MRI had reached a similarly high level (roughly the 80^th percentile) in early 1988, it had recovered only 23% of its prior declines.  The relatively strong current bear market rally suggests that portions of the investor base continue to have high expectations for economic growth and that there has not been a large-scale revaluation of stocks.  This observation suggests scenario #2 (reflecting 1987) is less like current conditions and can probably be discarded from further consideration.     

The recent moves higher are more similar to the price recovery in 1998.  By the time the Micro MRI had reached a similarly high level (roughly the 80^th percentile) in 1998, it had recovered roughly 76% of its recent declines.  This supports Scenario #3 (reflecting 1998) as being a possibility, considering current conditions.

Thus, current conditions are most similar to scenarios #1 (2008) and #3 (1998).  The important difference between these scenarios is price behavior at the very end of the up-leg of the Micro cycle.  In scenario #1 (reflecting 2008), prices failed to make a final push higher and then fell dramatically.  In scenario #3 (reflecting 1998) prices pushed higher at the end of the Micro cycle and subsequent declines were muted. 

Thus, discerning between these two scenarios will most likely be determined by price action and Micro MRI movements over the next two weeks.  If stock prices do not move higher, scenario #1 (2008) becomes more likely.  If prices move markedly higher, the scenario #3 (reflecting 1998) becomes more likely.  At the moment, the price trend seems relatively weak and most like scenario #1 (2008). 

It is important to note that the Micro MRI is still positive and providing resilience. Accordingly, our model portfolios have had relatively high allocations to stocks beginning January 4, 2019. The MRI algorithms had indicated a bear market rally was likely. The next market inflection point will occur when the Micro MRI does cease to be in the up-leg of its cycle, which is likely to occur over the next few weeks.

Please contact me with any questions or comments.

Jeffrey Hansen (Jeffrey.Hansen@me.com)

Background on The Market Resilience Indexes (MRI)

The CPM Investing framework is organized around three main MRI that are generated each week for each index (e.g. DJIA, US 10y Treasury).

1.      The Macro MRI indicates the long-term trend of resilience and is indicative of the long-term trend in index price. Macro resilience increases and decreases with a cycle lasting several quarters or years.  Each weekly reading indicates the level and direction of the long-term trend.  The peak of the Macro MRI generally coincides with a peak in index prices. The cycles of the Macro MRI are only somewhat rhythmic compared to the Micro cycles; the cycles are often interrupted or truncated. 

2.      The Exceptional Macro MRI indicates when the Macro MRI is nearing the bottom of a cycle and is likely to turn positive.

3.      The Micro MRI indicates bursts of resilience typically lasting 6 to 18 weeks.  The Micro MRI cycles are most apparent in the ups and downs of index prices throughout the year.  They can be thought of as normalized price movements. 

The MRI are additive. When they move together in one direction, they reinforce each other, and prices tend to follow that direction. When they move in opposition to each other, they tend to cancel each other out, and prices tend to be flat.

To describe the level of the Macro and Micro MRI, we indicate its percentile level within all its weekly levels since the inception of the index.  For example, the DJIA has over 5200 weeks of history since 1918. A level is described as, say, the 31^st percentile within the historical range of levels.  Its direction is also important.  If it is moving higher (i.e., it is on its up-leg cycle), we say it is present and providing resilience.  If it is moving down (i.e., it is on its down-leg), we say it is absent and not providing resilience.  From readings of level and direction, we can estimate the MRI’s likely near-term course. 

For example, if a level of a Macro or a Micro MRI is at a low level and moving down, we can guess that it will not move down much longer. As it nears the 1st percentile, the very lowest level of its historical range, we can expect the MRI to shift to the positive leg of its cycle and move higher.   

The Exceptional Macro is either present or not.  When it is present, it can overwhelm the Macro and Micro MRI to produce price gains even when the Macro and Micro MRI are absent. 

The rating for a market index (e.g. the DJIA, S&P500) is defined by the number of positive MRI and range from 0 to 3:

            3 = Most resilient

            2 = Moderately resilient

            1 = Slightly resilient

            0 = Least resilient

If all three MRI for an index are providing resilience, it is rated 3, “most resilient,” and prices may decline in response to bad news, but prices recover quicker and more completely. 

When none are providing resilience, it is rated “least resilient” and bad news produces bigger declines with slow and incomplete price recoveries.

The MRI levels and directions at a given time for different asset classes can help us position portfolios to favor the asset classes (e.g. stocks, bonds, and cash) rated most resilient and to avoid those rated least resilient. Trades based on MRI levels and directions tend to be more reliable than trades based on actual price levels and directions. 

For purposes of estimating stock market resilience, the Dow Jones Industrial Average is superior to other major indexes.  It has a 100-year history, has fewer constituents and indicates inflection points more distinctly, and has less interest rate sensitivity and commodity sensitivity than do the Russell 1000 and the S&P 500.  Thus, while it sounds very old school to use the DJIA, it produces reliable signals and justifies the focus.  We do track and evaluate other indexes for context and confirmation.    

Performance Review - 2018

Performance of the Focused 15 Investing portfolios for 2018 was negatively affected by the rapid up and down moves in stock market prices in November and December.  By the end of the calendar year, most of the model portfolios posted losses.  The immediate cause of the rapid price changes late in the year seemed related to global trade concerns, mid-term elections, government shutdown, slowing global growth, and general Washington chaos. 

These oscillating concerns occurred at the end of the year against the backdrop of:

• Unsustainably high stock market returns beginning in November of 2017, coinciding with investor optimism about US corporate tax cuts. 
• The perception that the stock market was “old.” Many observers perceived that the bull market that began in 2009 was getting old and it was time for declines. 
• A US stock market that had already displayed signs of peaking. The US stock market started sending warning signs about peak earnings (lower Price-to-Earnings ratios and persistently high Price-to-Book ratios) beginning in January of 2018.

CPM’s Market Resilience Index (MRI) conditions provide additional perspective.  During 2018, the measure that indicates the long-term trend of stock prices shifted from being decidedly positive to being decidedly negative.  This shift took place in May 2018.  From that time on, it was unlikely that the market would attain new highs before visiting dramatic new lows. 

From the MRI perspective, the age of the bull stock market was not 2018’s most distinct feature.  The bull market that began in 2009 was rejuvenated in 2015/6 with a moderate decline in what I have called a phantom bear market.  Therefore, the age of the bull was not a primary issue.

Instead, the degree of euphoria in late 2017 and in January 2018 was a distinctive feature.  The Macro and Exceptional Macro indicate levels of euphoria.  The level of the Macro MRI in January of 2018 was among the five highest over the last 100 years.  The other highly euphoric weekly readings were 8/21/1997, 9/28/1986, 10/21/1955, 9/13/1929.  This comparison is cautionary.  Large declines followed the periods of high euphoria in the cases of 1997 (the 1998 declines associated with LTCM crisis mentioned below), 1986 (the large 1987 decline), 1929 (the stock market crash of 1929).  Regarding the Macro peak in 1955, the market declined almost 20% in 1957.  While these are the most euphoric periods, there have been many highly euphoric over the last 100 years. 

Since we expect that a major price decline may follow a peak in the Macro MRI, it is reasonable to wonder if it would be best to sell stocks as the Macro MRI trends higher – before it peaks.  Testing over the last 100 years of market history indicates that selling in the presence of high euphoria is not a strategy that delivers high return and low risk.  Doing so causes one to miss the periods when high euphoria persists for long periods of time.  

Instead, it is best, in general, to sell after a peak in the Macro MRI has occurred.  For example, if we had sold US stocks at a level of euphoria (i.e., a level of the Macro MRI) that represented the highest point in the 2007-8 period, we would have missed most of the returns for 2017.  Diamond returned about 39% in 2017, and this level of return can compensate for the challenges of 2018. 

Our portfolios did well in 2017 because the algorithms were trained on the similar earlier periods, such as 1920–1929, 1945-1966, 1990-2000.  The experience over these periods indicate that it is better to pick up the pieces in years like 2018 than to miss the years like 2017. 

Timeline

• We were invested in the stock market through 2017 and into early 2018. 
• After the peak in the Macro MRI in early May, the Focused 15 Investing portfolios became more completely defensive in early July of 2018 after the Micro MRI had peaked. A “Harvest 2” designation ended at that time and the target weights called for zero weight in stocks in model portfolios based on the D5 signal set (i.e., signals driving Diamond and Zircon). The expectation was for declines in stock prices. 
• On July 20, 2018, the algorithms recognized that the period of very low resilience passed without major declines. The algorithms started recommending higher target weights for stocks and prices did indeed move higher. My commentary reflected the deteriorating longer-term market conditions. 
• By October 12, 2018, the algorithms indicated that the short-term period of resilience was nearing an end and issued the last “Harvest 2” week, which had indicated a good time to remove assets from the stock market. 
• There was a bounce after the midterm elections (November 6) that occurred as generally expected. 
• By November 23, the Diamond model portfolio had returned about lost about 1% year-to-date and was about 1% behind the performance of the default portfolio. 

To this point in 2018, the algorithms were performing in a manner that I consider to be within the range of normal behavior.

• By November 30, the Diamond model portfolio had a return of about 2% for 2018. However, this was about 5% behind the return of the default portfolio. 
• Through the rest of 2018 and in the beginning of 2019, we had false starts on a short-term rally in stock prices. 

The time to override the algorithms would have been right after the election. Our portfolios were defensive at that time for the right reasons. But the algorithms responded to the post-election bounce as the bottom of a short-term (Micro) cycle, which was not the case. Trade concerns and other news-of-the-day issues seemed to depress stock prices beyond responses typical of the last 100 years.

I reviewed the algorithms and their performance for 2018 and have these observations:

• High Volatility (or Variability) Alone was Not the Problem - I evaluated the level of variability of stock prices in November and December. Some market observers have said that the level of variability is at historic highs. I have not found strong evidence to support this view. I evaluated weekly variability, daily variability, and changes in weekly and in daily variability. While high, the levels of variability were not unusually extreme. 
• Reversals Without Establishing New Trends - Several price reversals in November and December did not initiate a new price trend as quickly as has been typical over the last 100 years. News-of-the-day elements seemed to have a big impact but conditions that developed since late 2017 are set the stage. Without these conditions, I believe the same November and December events would not have produced the same market dynamics. 
• "Slow-Twitch" was Better for 2018 - Some of the Focused 15 Investing model portfolios avoided losses and did quite a bit better than their default mixes during 2018. The prime example of this is sg129, “Institutional: D5, LC/SC, Multi-sector Bonds”. The better performing model portfolios relied more heavily on algorithms that moved more slowly. Because of this, they stayed out of the market and were not affected by the exogenous forces in November and December. Consistent with the nature of those algorithms, those portfolios have low allocations to the stock market as of January 14, 2019, despite the rally in US stocks. These slower responding model portfolios have lower return than the others when viewed over a longer time horizon, as shown in the figure above. However, for the 2018, their level of responsiveness fit the events of the year nicely. 
• None of the algorithms should be changed at this time - In general, I do not believe any of the model portfolios should be changed. The rotational portfolios based on the Macro Rotation Signal, which I describe in a blog post dated December 30, 2018, would not completely address the performance issues of 2018. Over the last several weeks, I have evaluated numerous other ways of using the Macro Rotation Signal. While there are some promising options, thus far, none are clearly superior to Diamond in terms of risk, return, and ease of implementation. I will provide updates on this research as it progresses. 
• Losses Will Occur from Time to Time – The following section looks at the longer-term historical simulation of the current algorithms as used in Diamond. This information shows that there are periods of loss in otherwise attractive performance histories.

The Historical Perspective

The CPM investment strategies have been evaluated for their strength over 100 year of stock market history.  Over that time, there have been numerous periods of performance declines like what we experienced in 2018.  A recent one is 1998.  During the 1990s and especially in the late 1990s, US stock market gain were high.  During 1998, the surprise collapse of the Long-Term Capital Management (LTCM) investment manager rippled through the capital markets and required intervention from regulators and other financial institutions.  Performance of the model portfolios was poor during that period.  This is indicated by arrow “A” below.  Arrow “B” indicates the end of 2018. The blue line is the model portfolio.  The tan line is the default mix.

On the figure above, we can see that the model portfolio (and the stock market) hit their highest levels in early 2018.  This makes the recent period more extreme when viewed within the calendar year.   

The figure below shows a general simulation of Diamond since 1919, with the 1998 decline indicated by arrow “A.”  The green line is the model portfolio.  The brown line is the DJIA.  

Once can see several instances of large declines prior to 1998.  Even with these declines, the traded portfolio is superior to holding the DJIA over the long period of time.  Subscribers should understand that losses will occur. 

Performance of Diamond Compared to Alternatives

Diamond is the main model portfolio.  Up through early 2018, most subscribers were using it and this section focuses on it.  I also list other model portfolios for comparison.  All of the portfolios and performance figures are based in US dollars based on data supplied by Bloomberg.  CPM offers publications for investors in other countries.  As an aside, the best performing Focused 15 Investing model portfolios are those offered to Australian investors.  Please contact me for information about these model portfolios. 

Figure 1 below shows the performance for Diamond compared to alternatives that have been described in the past:

                The Dow Jones Industrial Average (DJIA)

                Vanguard’s Balanced Index Fund – VBINX

                The Russell LifePoints Growth Strategy - RALAX

Section A shows the performance of Diamond, along with two other model portfolios.  Mosaic (sg129) is included because it consists of all major sleeves used in other model portfolios and it was one of the original model portfolios in the publications.  It holds 8 ETFs.  I have also shown Zircon, which is just like Diamond but less aggressive.  Both Diamond and Zircon hold 3 ETFs.  

We will focus on the performance of Diamond.  In order to have a fairer comparison to other funds, we need to reduce the returns of the Focused 15 Investing model portfolios. This is because the performance for the other funds reflects actual costs associated with the management of those funds.  The average expense ratio for the alternative funds is 1.13%.  To be conservative, I subtracted 2.00% from the returns of Diamond for the comparison.  For example, the Diamond model portfolio returned 14.9%, annualized, over the 52-month period since the inception of the publication.  The return adjusted for costs is therefore 12.9%.  The variability of returns is not adjusted for costs. 

Figure 1

As one can see from the figure above, Diamond (adjusted for costs) returned -8.9% for 2018.  The DJIA returned -4.6%.  The worst performance among the alternatives is the Russell LifePoints fund (RALAX) at -8.1%. 

Over the roughly 52 months since the inception of the publication, Diamond (adjusted for costs) returned 12.9%, which is better than any of these alternatives.  The alternatives returned 1.9% to 9.6% over the 52-month period. 

The ratio of the return to variability is an important statistic.  The higher this number the better.  The ratio for Diamond (adjusted for costs) is 0.95.  The highest ratio of any of the alternatives is 0.71. 

Figure 2 below adds sections D and E.  Section D of the table shows the returns of alternative ETFs that do active asset allocation.  This information is from Bloomberg.  Diamond (adjusted for costs) is within the range of performance for 2018, but has higher returns and a higher ratio over the 52-month period than any members of this set of alternatives.    

Figure 2

Section E shows summary statistics for an additional set of alternatives.  These 114 funds that resulted from a search of the Bloomberg database.  The selection criteria targeted allocation funds (ETFs and mutual funds) and excluded private equity, money market, commodity and real estate funds.  The complete list of the 114 funds is shown in Appendix 1. 

The conclusions are similar across these different groups.  Diamond had a poor 2018, but its longer-term performance is still quite good compared to alternatives. 

Performance of the Range of Model Portfolios for 2018

This section reviews the performance of 14 model portfolios.  This section is detailed.  The bottom line is that most model portfolios performed better than their default mixes in 2018 and over the 52-month period. 

There are fourteen Focused 15 Investing model portfolios in two main publications.  Of the fourteen, only two had positive returns the year (12/29/2017 through 12/28/2018).  However, 11 of the 14 performed better than their default mixes.  The performance of the default mix is the return of ETFs in the model portfolio but held at constant weights over time.  All but one of the fourteen has less variability of returns than their defaults.  Less variability is a desirable feature.   

Figure 3 below shows the model portfolio returns for the fourteen main portfolios for 2018.  The publication for individuals has model portfolios with fewer ETFs for easier trading.  The publication for institutions holds portfolios that tend to hold more ETFs and fit commonly used asset classes.  Note that these figures are from the newsletter itself; an amount for fees has not been subtracted.

Column A shows the sleeve group number, shown as “sg’ on the weekly publication.  Column B shows the return of the model portfolio for the period.  Only two of the portfolios had positive returns (shown in green). Column C shows the variability of returns – the lower the number the better.  There are many numbers and I present a simpler graphical representation later. 

Figure 3 – 2018 Performance Information

Diamond returned -6.9% for the period.  Zircon returned -2.3%.  For comparison, the DJIA returned

-4.6%. 

A convenient way to understand performance is to review the return and variability of the model portfolio less the corresponding figures for the default mixes.  These figures are shown in columns F and G. 

In Figure 4 below, Columns D and E shows the return and variability of the default mixes for the different model portfolios for 2018. Our focus is on columns F and G, which show the difference between the traded and the default model portfolios.    

Figure 4 - 2018

For all but three of the fourteen model portfolios, returns were higher than their default mixes (column F).  For those underperforming their defaults (Diamond, Emerald, and Zircon) the underperformance with less than one-half of a percent for the period.  In all but one, the variability was lower than that of the default mix (column G).    

A few of the model portfolios had performance quite a bit better than their default mixes (Mosaic Plus sg213, Mosaic sg129, and sg 122).  All of these use what might be called a “slow-twitch” loss avoidance technique, which did not attempt to respond to the rapid return reversals that we experienced during late 2018.  I discuss this issue in greater detail later. 

The figures below show this information graphically.  The orange boxes indicate the return and variability of the default mix for the model portfolio.  The blue box indicates the return and variability for the traded portfolio.  The green arrows connect the model portfolio t its default.  The DJIA and Vanguard’s VBINX (60/40 Stock/Bond ETF) are shown for comparison; the names are listed in the table above.

Figure 5 

Ideally, we want the blue boxes to be very high and far to the left of the corresponding orange box.  That position would indicate that the Focused 15 Investing loss avoidance approach is working as intended.   For 2018, Diamond and Zircon had lower variability (a positive), but the returns were slightly less than the defaults (a negative). 

The figure below shows the broader list of model portfolios.  It shows only the sg numbers for clarity. 

Figure 6

This shows that for 2018, the traded portfolios generally had better performance characteristics than their default mixes.  Most of the blue boxes are to the left and higher than their default mixes (orange boxes) for the 2018 period. 

Model portfolio sg129 did very well in 2018 compared to its default.  The green line connecting the orange box representing the return and variability of the default mix and the model portfolio is the longest in the figure.  The model portfolio for sg129 is the second from the top. 

Figure 7 below is in the same format but shows performance since the inception of Focused 15 Investing on July 18, 2014.  

As indicated, these figures include the relatively poor performance of the 2018 period. I have indicated the position of Diamond and of sg129. While sg129 performed better than Diamond in 2018, its return for the 52-month period is not as high and it is more time consuming to trade (8 ETFs). For these reasons, many subscribers prefer Diamond.

The first page of the weekly publications shows the general performance expectations for the different model portfolios based on their returns since January of 2000. I consider these expectations to be attainable.

The only model portfolio that goes against the general trend on the figure above is sg200; its default mix is located at the lower left corner of the cluster. This is Onyx. Onyx is designed to be different from the others. It invests in four ETFs that have low variability, SHY (US 2y Bonds, 10y Bonds), XLU (Stocks of Utility companies), XLP (Stocks of Consumer Staples companies), and UST (US 10y Bonds x2). It shifts money into the ETFs expected to have higher returns. In contrast, all the other sleeves and model portfolios made from those sleeves invest in high return ETFs and then shifts away from them when they are expected to have low resilience. While Onyx’ performance has not been outstanding, I believe it may be useful in the future when interests rates are higher and move in a historically more normal manner. Thus, Onyx has a special role to play. I have two versions of Onyx, one with weekly trading and one with monthly trading. The monthly version is shown. I highlight Onyx because it might be useful for pairing with an aggressive version of Diamond. I will provide updates on this over the next few months.

Appendix 1 – Alternative Asset Allocation Funds (n=114)

RYDEX SERIES NOVA FUND-INV

KINETICS MARKET OPP-ADV A

WELLS FARGO DIV CPTL BLD-A

BOSTON TRUST ASSET MGMT FD

WALSER PORT AKTIEN USA

PLUMB BALANCED FUND

BRIDGES INVESTMENT FUND

STATE ST US EQTY VIS

VALUE LINE CPTL APPREC-INV

SIT BALANCED FUND

AMERICAN BALANCED FUND-A

JANUS HNDRSN BALANCED-S

BLCKRCK BALANCED CAPITAL-I

WF INDX ASST ALLOC-A

FIDELITY PURITAN FUND

VANGUARD WELLINGTON-INV

AMG CEP BALANCED-Z

VANGUARD BALANCED INDEX-INV

FIDELITY BALANCED FUND

USAA GRWTH & TAX STRAT

ABERDEEN INCOME BUILDER-INST

DODGE & COX BALANCED

LKCM BALANCED FUND

TOUCHSTONE BALANCED-A

GEORGE PUTNAM BALANCED-A

T ROWE PR PERS STRAT GRW

FIDELITY STR DVD & INC

PGIM BALANCED FUND-Z

EQUINOX AMPERSAND STRAT-A

TRANSAM M/M BALANCED-A

COLUMBIA BALANCED FUND-I

HARTFORD BALANCED HLS-IA

CALAMOS GROWTH & INCOME-C

T ROWE PRICE BALANCED FUND

MAIRS AND POWER BALANCED FD

T ROWE PR PERS STRAT BAL

TETON WESTWOOD BALANCED-AAA

DREYFUS BALANCED OPPORT-A

STATE FARM BALANCED FUND

EATON VANCE BALANCED FUND-A

GREEN CENTURY BALANCED-INV

TRIBUTARY BALANCED-INST

PIONEER CLASSIC BALANCED-A

JAN HND BAL-A US ACC

FIDELITY ASSET MANAGER 85%

FEDERATED MDT BALANCED-IS

HARTFORD BALANCED FUND-A

WF GROWTH BALANCED-ADM

ARCHER BALANCED FUND

ISHARES CORE AGGRESSIVE ALLO

HENNESSY BALANCED FUND

AMER CENT BAL-INV

AMER FNDS INC OF AMER-A

MFS TOTAL RETURN FUND-A

AMER CENT STR ALLOC AGG-INV

FDLTY ADV STR DVD & INC-C

CALVERT BALANCED FUND-A

FIDELITY ASSET MANAGER 70%

FIDELITY ADV ASST MGR 85%-A

JOHN HANCOCK BALANCED-A

CAVANAL HILL ACTIVE CORE-INV

FIDELITY ASSET MANAGER 60%

JPMORGAN DIVERSIFIED-L

FIDELITY ADV ASST MGR 70%-A

WESMARK BALANCED FUND

FRANKLIN BALANCED-A

FIDELITY ASSET MANAGER 50%

INVESCO EQUITY & INCOME-A

HOLLAND BALANCED FUND

SCHARF MULTI-ASSET OPP-INST

FIDELITY ADV ASST MGR 60%-A

PNC BALANCED ALLOCATION FD-I

PUTNAM DYN ASST ALL BAL-C

AMER CENT STR ALLOC MOD-INV

AMERICAN BEACON BALANCED-INS

FIDELITY ADV ASST MGR 50%-A

BRUCE FUND INC

BMO US DOLLAR MONTHLY IN-ANL

ARCHEA FD-NORDAM-B1

THRIVENT BALANCE INCOME PL-A

OAKMARK EQUITY & INCOME-INV

MAINSTAY BALANCED FUND-I

MANN & NAP PRO BLND MAX

FPA CRESCENT FUND

IVY BALANCED FUND-A

CORNERCAP BALANCED FUND

IRONCLAD MANAGED RISK FUND

BUFFALO FLEXIBLE INCOME FUND

CGM MUTUAL FUND

LK BALANCED-INS

DELAWARE FOUND MOD ALL-A

SATURNA SEXTANT CORE FUND

EATON VANCE HEDGED STOCK-A

GLDMN SCHS INC BLDR-A

USAA CORNERSTONE MODERATE

VIRTUS TACTICAL ALLOC-A

USAA CORNERSTONE MODER AGGR

MSIF GLOBAL STRATEGIST-A

GLDMN SCHS ALT PREMIA-A

MANNING & NAPIER INC-PB MO

1789 GROWTH & INCOME FUND-C

DAVIS APP & INCOME FUND-A

PALMER SQ STRAT CRDT-A

ICON RISK-MANAGED BALANCED-C

AMERICAFIRST TACT ALPH-A

DWS REAL ASSET-A

TOEWS TACTICAL MONUMENT

JAMES BAL GOLDN RAINBOW-RTL

EAS CROW POINT ALTERN-A

VILLERE BALANCED FUND

VIRTUS RAMPART M/A TRND-A

AMERICAFIRST QUANT STRAT-A

TOEWS TACTICAL OPPORTUNITY

CATALYST HEDGED FUT STRAT-A