TAP Performance Q2 2023

Tactical Allocation Performance January-June 2023

 

IN THIS REPORT I’ll explain how the portfolio performed in the first half of the year, explain the rationale for the recent changes, and then briefly look at how we’re positioned for what comes next.

Before beginning, I would like to remind readers that the Tactical Allocation Portfolio (TAP) is designed for risk-controlled growth over time. While it does put out income, these dividends and interest payments mostly come in a lump sum near the end of the year. This means they don’t generate regular monthly interest income. For clients who take monthly distributions from their TAP account, we do so with a plan in place that typically involves swapping current dividends and interest for, hopefully, larger capital gains later on.  (For more details and to receive a retirement income plan, please contact Jeff Warren – jeff@secureretire.com or myself – richard@secureretire.com .)

First Half 2023 

January through June was the continuation of a pattern we’ve experienced many times these past years. Stocks began to rise beginning last October. While they did fall 18% all of last year (S&P 500), by the end of this June they were back to within 7.5% of where they were before beginning their little plunge the first nine months of 2022.

Last October, I wasn’t in the least surprised to see the stock market stage a furious comeback, as all serious bear markets contain numerous bull markets within them. You find out you were in a real bear market when stocks keep hitting “lower highs and lower lows.”

We still strongly suspect what we’re seeing is merely the craziest “bear-market bounce” – perhaps ever. I say that because we’re witnessing the largest stock swings ever seen, in any sector of the stock market, in the large tech stocks. Last year the high-fliers from this year were mostly down around 65% – due we were told to the fact their prices are tied at the hip to long-term interest rates.

Interest rates are now up 5% since last year, showing no signs of retreating anytime soon, yet a year later these same stocks are now in a bubble rivaling the 2000 tech bubble extreme. Wow is about all I have to say. By the way, if you remove the “performance” of the top 7 tech stocks, the rest of the stock market has made essentially nothing this year.

This gave investors a choice of 1. Buy the largest tech stocks or 2. Don’t make any money. (Assuming they weren’t buying Japanese or Indian stocks this year.) Of course, as has been the case, since a mega-bubble was the only way to make money in growth, I chose door number three – alternatives.

Risk

As always, the first thing I look at in portfolio management is risk. The fact is that the biggest risk our portfolio faces is an abrupt, sustained, completely irrational reversal sending stocks and other assets at risk shooting up. In other words, exactly what started last October and continued for the first 6 months of 2023.

How have we done facing risk? The largest risk we face in TAP occurred in the first half of the year and we went down approximately 1%. From a risk-control standpoint, this is how it was designed.

Of course, we’re hardly satisfied with a drop of even a dollar – ever. How did we respond to risk returning to the ascendent, and how should you grade our response? First, understand that we began the year with 25% of our portfolio – the Federated Hermes Market Neutral and Hussman Strategic Growth funds – with a negative correlation to the stock market. This means they were set to go up immediately whenever stocks resumed falling. It also meant they would continue to go down for as long as stocks continued to rise.

In the first two quarters, everything we own had either modest gains or held steady,  except these two funds with negative correlations to a rising stock market. In response, in mid-June, I removed the modestly negative correlative TAP had with the stock market by swapping the Federated Hermes fund with the Catalyst Systematic Alpha fund. Our entire portfolio is now almost completely uncorrelated to any single market in the world (though all our quantitative funds have different amounts of protection that kick in should stocks and/or other markets fall hard and fast).

How did this swap of funds remove the negative correlation to stocks? This is also fairly simple. Quantitative funds adjust their correlation to various markets all the time based on a huge, wide variety of market conditions. Then they all change those correlations over time. Some funds try to spot and invest in shorter market cycles, so these funds will switch, for example, to being long to short a given market more quickly. Other funds are more patient as they attempt to get the potential gains from further advances in markets. They accept more short-term risk in the attempt to get higher long-term gains.

The Catalyst Systematic Alpha fund is one of the more patient funds, and it has had a positive correlation with stocks since late last year. By selling the Federated fund with it’s negative correlation, and combining the Catalyst Systematic Alpha fund with the Hussman fund and its negative correlation, we get a combined correlation with stocks and bonds quite close to zero. In other words, the Catalyst fund offsets our largest risk which is that stocks and risk assets continue to rise for months.

You’ll notice that, just like the other quantitative funds, I directly monitor and change our correlations with various asset classes based on current market conditions. Right now, even though I expect one of the largest stock market crashes ever to resume at any time, what I actually observe in markets tells me to be completely neutral today.

Looking Forward

The most positive development for TAP in the first half of the year is that both Treasury bonds and gold have shown signs of life. While gold is back to flat on the year, at least it touched $2,000 an ounce for a few days. Long Treasuries have done fairly well, with the Wasatch-Hoisington US Treasury fund we own up 3.88% – modest but respectable.

Looking forward, we expect gold to stay unpredictable – though perhaps more valuable as “insurance” today than normal. Long Treasury bonds are beginning to look more and more attractive. Right now we have only 8.41% in long Treasury bonds. As prices continue to firm up, this will be doubled to 17% by selling the Catalyst/Lyons Tactical Allocation (up 5.21% YTD) and PIMCO Enhanced Short Maturity (up 3.06% YTD).

This will then give us 25% in Treasuries/gold & silver, 25% in alternative quantitative funds, and 50% in managed futures. That should do the job through the long-awaited bear market quite well. Until then, we will do everything possible to move forward safely.

Closing

All the quantitative funds we are using – and the Tactical Allocation Portfolio itself – are designed to converge on the exact same side whenever we finally have a real, bona fide bear market. They all end up with a correlation close to a negative one with stocks and commodities, and a positive one with Treasury bonds and the US dollar. This means they end up making a lot of money if stocks fall anywhere near their present fair value.

In the meantime, we’ll continue to try to create the right combination of assets which can profit when stocks and/or bonds rise while being fully prepared to deliver larger profits when the markets (finally) reverse themselves. Our approach hasn’t always worked when markets distort into bubbles, or at least it’s a lot harder to get good profits safely when madness rules markets. But that madness will indeed pass, and as risk hits and
removes the large but ultimately fleeting gains stock investors show today, in
TAP we’re positioned to pass them on the way up.