DAY HAGAN TACTICAL ALLOCATION STRATEGY JULY 2018

Based on the July investment model updates and corresponding position changes, the Day Hagan Tactical Allocation strategy (DHTA) is now 61.9% invested in equity and equity alternatives (a decrease of 6.4 percentage points from last month), 23.9% in fixed income (an increase of 7.6 percentage points) and 14.2% in cash and cash alternatives.*

The equity allocation for the DHTA strategy is now neutral, indicating that risks are increasing relative to potential returns. With regard to our fixed income holdings, the allocation has been steadily increasing for the past two months, taking advantage of the rally in bonds following the short-term peak in rates (trough in prices) that occurred in mid-May. Nonetheless, the overall allocation remains below our fixed income benchmark. This indicates that investors should remain cautious on bonds, and by extension, prepare for higher interest rates over time. However, if the indicated bond rally should start to fade, and our models confirm that fixed income exposure should once again be reduced, we will be quick to take profits and redeploy our capital into more attractive opportunities.

With regard to our cash holdings, we’d note that, rather than hold our cash in money market accounts, we have invested the majority in an ultra-short enhanced bond ETF and a short-maturity floating rate exchange-traded fund. The indicated yields for the two are 1.68% and 1.82%, respectively. 

Specifically:

  • It is important to note that the first decision made in the Tactical Allocation process is the percentage of the portfolio that will be allocated to stocks, bonds and cash, using unemotional, quantitative indicators. Once the overall allocation is defined, the strategy then identifies which global equity ETF opportunities are most attractive—also using quantitative modeling.
  • The decrease in our overall equity exposure resulted from sentiment indicators showing signs that optimism for stocks may have peaked and is starting to shift toward pessimism. Historically, this type of activity has been helpful in identifying market peaks as confidence begins to wane and selling pressures begin to intensify.
  • The reduction in equity exposure follows last month’s decrease that resulted from weaker breadth readings based on global equity index trends, indicating that the recent stock rally may be losing steam. In other words, fewer and fewer stocks have been participating on the upside. This continues to be the case this month. We noted that historically, strong, sustainable up-moves are broad-based.
  • We also note that the markets are entering a potentially seasonally weak period as defined by Ned Davis Research’s Cycle Composite. Based on a combination of the 1-year cycle, 4-year Presidential cycle, and 10-year Decennial cycle, U.S. equity markets may encounter headwinds beginning during the July-August months, which historically have lasted through early October.
  • Other signs of caution for stocks include:
  • The spread between global equity yields and global bonds has narrowed, indicating that the risk premium for stocks may be too low. In other words, investors aren’t getting “paid” to take on the risk of owning stocks.
  •  Global manufacturing, as defined by PMI surveys (purchasing manager indexes), shows that manufacturing may be peaking, or certainly has slowed. Whether this is the result of corporate management’s reactions to tariffs and potential trade wars or global economic momentum waning is debatable. We’ll be watching closely to see if this indicator reverses should trade tensions abate.

From a global regional equity perspective, the following changes were made:

  • We lowered the overall equity exposure with a series of reductions from our existing positions. These actions were taken primarily due to the Stock/Bond/Cash model’s conclusion that a decrease in allocation to equities was warranted.
  • We again trimmed our portfolio exposure to Emerging Markets (which was already underweight), Europe ex. U.K., U.S. Small Capitalization companies, and U.S. Growth companies (tickers of ETFs that were trimmed: IWF, IEMG, VIG, EWU, IJR, HEZU, IVV, AAXJ).
  • For the Europe ex. U.K. region, indicators evaluating the region’s Purchasing Managers Indexes, Leading Economic Indexes, Relative Valuations, and Interest Rate trends are signaling caution. With this month’s updates, the technical backdrop has also deteriorated and is now signaling caution.
  • The Emerging Markets region allocation (IEMG, AAXJ) was again reduced as price momentum continues to be weak and other-price related indicators continue to portray a backdrop of waning investor demand. Economically, manufacturing trends have turned negative for the region. The only new positive was the continued strength in Crude Oil prices.
  • We adjusted our U.S. equity exposure lower (IJR, VIG, IWF, IVV), consistent with the overall equity allocation reduction.
  • Last month, we initiated an allocation to Canada (EWC). We added slightly to the position again this month as Canada was the only region to have both its internal and external composite models improve for July.
  • In summary, while there were several slight adjustments made to the portfolio, the overall change was a 6.4 percentage point decrease in equity exposure.

We think it is important to note that there are signs that earnings growth rates may peak in the second half of the year, potentially coinciding with the Fed quickening their balance sheet wind-down (i.e., the process of reversing quantitative easing measures). Add to those circumstances the potential for higher interest rates, a “topping out” of global growth, and higher energy prices, and global equity markets may find it hard to make significant gains over and above previous highs. One might certainly be rational in thinking that, at the very least, corporate margins would be under pressure.

Nonetheless, the aforementioned items continue to remain outside of the view of the average investor, and based on our indicator evidence, none have begun to “bite” enough to impact corporate returns in a way that would make us turn bearish. At this point, economic growth is positive, and consumers and businesses, based on available survey data, remain optimistic (although investors are showing signs of potential fatigue). Economic and financial liquidity is still positive, and money is available for credit-worthy, and some not-so-credit-worthy, borrowers.

As we wrote last month, “All in all, the weight of the evidence supports a healthy dose of equity exposure, but not an overly aggressive positioning that inordinately, and indiscriminately, takes on risk.”

We will be looking for our models and the weight of the evidence to turn more positive before committing additional capital to equities or fixed income. If the market doesn’t find support and takes a second leg down, we will be quick to follow our models’ direction and lower equity exposure. The bottom line is that broad-based indicator confirmation is the key to success.

If you have any questions or comments, please feel free to call anytime.

Sincerely,

Donald L. Hagan, CFA
Arthur Day
Arthur Huprich, CMT

Regan Teague 

PDF Copy of Article: Day Hagan Tactical Allocation Strategy Update July 2018 (PDF)

Disclosure:

(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.)

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