DAY HAGAN TACTICAL ALLOCATION STRATEGY JANUARY 2019
Based on the January investment model updates and corresponding position changes, the Day Hagan Tactical Allocation strategy (DHTA) is now 40.0% invested in equity and equity alternatives, representing a decrease of 28.3% from last month. The fixed income and cash allocations are now 43.4% and 16.6%, respectively.
The global equity allocation for the strategy is mildly bearish, with the worst December returns since 1931 causing the model to become more defensive. The model remains somewhat cautious toward international equity markets, preferring the U.S. over other global regions. Outside of the U.S., equity reductions were made from the Japan and Emerging Market regions.
We had been underweight international equity markets most of 2018. This, in part, was due to global economic activity slowing coincident with a steady deterioration in measures of consumer and business confidence around the world. This was reflected in the negative 2018 returns from all of the equity markets we follow, as shown below (2018 ETF price returns):
|The U.S. equity market ETF evidenced relative strength, but was still down for the year:|
|S&P 500 iShares Core ETF (IVV)||-4.47%|
|International equity ETFs were very weak last year:|
|Europe iShares Core MSCI ETF (IEUR)||-14.85%|
|Emerging Market iShares Core MSCI ETF (IEMG)||-14.93%|
|Japan iShares MSCI ETF (EWJ)||-14.09%|
|Pacific ex-Japan iShares MSCI ETF (EPP)||-10.77%|
|Canada iShares MSCI ETF (EWC)||-17.16%|
|Even fixed income had a tough year, up marginally:|
|US Aggregate Bond iShares Core ETF (AGG)||+0.10%|
From a stock vs. bond/cash perspective, the model’s technical (price trends) indicator composite currently indicates that momentum, breadth, seasonality, and overbought/oversold evaluations favor fixed income and cash.
Additionally, investors have been rotating out of more risky equity sectors in favor of cash and defensive sectors, which is often a sign that market risks are high and that a more cautious equity allocation is warranted.
The model’s macro indicators show that negative sentiment for equities may be nearing a bottom. From a contrary opinion perspective, this can often identify short-term support as investors begin to rebuild positions from lower levels.
Other potential positive indicators for equities include overbought/oversold indicators (now more oversold) and central bank monetary policy still generally reflected as accommodative.
Conversely, there are still a few indicators that are keeping the model from recommending a higher equity allocation. For example, global PMIs are deteriorating, confirming our concerns around economic activity. Furthermore, global earnings yields are becoming less appealing versus the now-higher global bond yields. In other words, the expected return from stocks isn’t enough to justify the increase in risk over and above fixed income returns (which are generally considered safer).
From a regional equity perspective:
The U.S. composite model has the highest reading of all the regional models
Our highest equity allocation is still to the U.S., though due to the overall reduction in equity exposure, we reduced U.S. equity exposure as well
Caution signs are illustrated by a deterioration in relative strength vs. other regions, adjusted earnings growth being rated as somewhat slow relative to U.S. GDP growth, and the narrowing of the yield curve
The Emerging Markets composite model is the second-strongest model, but has declined below 50% bullish
Momentum and breadth are improving
Weaker PMI readings (likely due to trade concerns), elevated overall valuations based on ROE, earnings yield and long-term earnings growth estimates, and the weakness in crude oil continues to negatively impact export-based emerging market economies
The Europe ex-U.K. composite model is now the third-strongest model but is also well below 50% bullish
While the majority of indicators for the region are mixed, price-related indicators are showing a hint of breadth improvement. Nonetheless, macro indicators, overall, remain very negative, and we are underweight the benchmark allocation to the region.
With regard to our fixed income (plus cash) allocation, we are now above the benchmark weighting. This indicates that as of the December monthly close, the models were more positive on fixed income than equities.
We note that since the January allocation changes, there have been signs that the equity markets may be on firmer footing. Following extremely oversold readings into December 24th, there have now been two breadth thrusts (as defined by daily up volume being more than ten times daily down volume, occurring on December 26th and January 4th), which are often good signs that selling pressure is abating. While not perfect in calling market lows, it’s a good start.
Valuations are also somewhat better. The 12-month Forward Price-to-Earnings multiple for the S&P 500 has declined from its November 2017 peak of 19x to 16.2x. While not cheap by any means, if global economic growth stabilizes and shows signs of improvement, there is arguably room for multiple expansion. Accordingly, we are also closely watching earnings estimates for 2019. S&P 500 earnings growth estimates for 2019 ended last year with analysts expecting a 12.44% increase. Those expectations are being revised lower, and now stand at an 8.97% expected growth rate just a few weeks later. Our view, based on historical precedence, is that earnings growth is likely to move lower over the year. With valuations a little lower and earnings expectations less optimistic and potentially more achievable, we see valuation headwinds diminishing.
Yes, there are still potential problems with economic and earnings expectations being revised even lower, historically high debt levels (corporate and sovereign), more than half the world’s central banks raising policy rates, the Fed reducing its balance sheet, higher interest rate term structures, increasing volatility, Brexit getting closer, geopolitical risks, and the most recent ding to investor confidence.
With that in mind, we call your attention to a study by Ned Davis Research that identified previous periods when the S&P 500 had four straight down days (of more than one Standard Deviation) followed by an extremely strong up day (of more than four Standard Deviations) and the market’s subsequent performance.
They found three comparable periods: 8/26/2015, 7/24/2002, and 5/29/1962. In each of those cases, following the explosive up-move (after the explosive decline), the S&P 500 ultimately retested the lows, and in fact, declined below the lows before finally establishing a longer-term uptrend.
In 2015, the S&P 500 retested and bottomed 5.5 months after the explosive 1-day up move, and was up 12% one year later
In 2002, the S&P 500 retested and bottomed 2.5 months later and was up 16% one year later
In 1962, the S&P 500 bottomed 1 month later and ended up 21% one year later
It is clear that the December swoon in the market was due in large part to systematic and technical market machinations taking hold and alleviating some of the froth that had been building. Nevertheless, there are still concerns around the world economic outlook, margin pressures, inventory builds, interest rates, oil prices, political risks, rising populism, the shutdown, tariffs/trade, central bank policy and even visibility around the duration of the U.S. tax cuts, among many other things.
Bottom Line: While the recent gains in the market have alleviated a portion of December’s decline, our overall equity allocation continues to oscillate between mildly bullish and mildly bearish, much like it did during 2018. Whether a tradable retest occurs, the markets resume their decline, or a bottom has formed setting the stage for strong gains in 2019, we will continue to unemotionally evaluate the weight of the evidence and adjust the allocation accordingly.
If you have any questions or comments, please feel free to call or email anytime.
Donald L. Hagan, CFA
Arthur Huprich, CMT
— Written 1-10-2019
PDF Copy of Article: Day Hagan Tactical Allocation Strategy Update January 11, 2019 (pdf)
(Note: *The fixed income and cash allocations reflect holdings within the exchange-traded funds that are utilized. Therefore, individuals may look at their portfolios and see slightly different stock/bond/cash allocations.)
The S&P 500 Index is an unmanaged composite of 500 large capitalization companies. This index is widely used by professional investors as a performance benchmark for large-cap stocks. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, or sales charges.
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