Our portfolios are likely to remain defensive for a few weeks. The specific element of the algorithms causing this change relates to the market being at a possible transition in its long-term trend – moving from a mildly positive trend to a more negative trend. In addition, I expect resilience to decrease as we move through the end of year, based on the drivers of resilience we have identified over the last few years. We could see more resilience during September, as mentioned in prior notes, but the dynamics described below are, according to the algorithms, taking on greater importance.
Figure 1 below shows the price of the DJIA (on a log scale) centered around the low price it experienced on September 23, 2022, which was roughly a year ago. It is difficult to draw conclusions from the one line on Figure 1 but I show it to clearly identify the current period; the line is red.
Figure 2 shows three other market declines that have similar characteristics in terms of when they take place in broader market cycles. The purple line shows the period with a low trough in 1958, the blue shows 1970, and the green shows 1982. The lowest price of these periods is aligned to the low point of the current period, at week number 520 (roughly a year ago).
The current period’s rebound from the low price last September has been less dramatic than the others shown. The same message is seen by looking at just the Macro MRI for the different periods, shown in Figure 3.
The Macro MRI normalizes the index’s price movement and shows the trend more clearly. We can see in Figure 3 that the inflection point at the time of the lowest price (September 23, 2022 for the current period) is not as pronounced as it was for the other periods. The macro MRI has been slower to move the upleg of its cycle and its current slope is shallower than the others. These characteristics underscore the tentative nature of the price recovery for the DJIA.
We can see the weakness of this recovery in how the Exceptional Macro has behaved since the low in September of last year. Figure 4 shows the Macro and Exceptional Macro for same four periods. As you may recall, the Exceptional Macro is designed to be an alert for when a strong upleg in the market is likely to take place.
You can see in Figure 4 that for the other three periods, the Exceptional Macro appeared and (after a false signal for 1983 in green and 1970 in blue) remained present for many weeks (roughly a year). During the current period, the Exceptional Macro has appeared intermittently. This can be more clearly seen in Figure 5.
Although difficult to see in Figure 5, the Exceptional Macro ended in the last two weeks. This is usually a negative for stock prices. The algorithms have responded to this and other indicators of weakness and reduced the target weights of DJIA-linked ETFs.
Since the beginning of the year, the main algorithms that determine the weight of the DJIA-linked ETFs have navigated this situation reasonably well; they have produced positive returns. But the strength of the DJIA recovery has not been sufficient to justify to switch to a more aggressive portfolio as would have been the case in the other periods shown above.
The weekly publications are designed to allow us to switch easily to more aggressive portfolios when the market begins the upleg of its cycle in a more definitive way. The timing of the switch is a subjective call on my part and is heavily influenced by the information presented above. Over the last year, the recovery has not been as strong as is typically the case.
Because it has not been prudent to switch to a more aggressive portfolio, the portfolio we use has been moderately defensive and therefore has a higher allocation to traditionally more defensive ETFs such as XLP (consumer staples companies), XLU (utilities) and those linked to the US 10year bond index (ETFs UST and TYD). However, the utilities and 10-year bond ETFs have been hit hard by rising inflation and have hurt portfolio performance.
Should the market decline more abruptly over the next few months, the defensive ETFs may be useful. The Fed may lower interest rates as the markets and economy soften and our defensive stock ETFs (XLU, XLP) and the 10-year bond ETFs (UST, TYD) will be supported by that shift. Thus, the composition of our current portfolios is reasonable. Should the stock market enter a stronger, more resilient phase we will switch to a more aggressive portfolio. I do have waiting in the wings a set of portfolios that will be effective in a robust market recovery accompanied by persistently high interest rates (they hold minimal weights in the defensive ETFs) and will introduce them later if needed.