Tactical Allocation Back-Tests And Current Trends For Key ETF Asset Categories And Example Portfolios

| About: SPDR S&P (SPY)

Summary

Tactical allocation shifting S&P 500 outperforms Buy and Hold – back-test from 1995.

Tactical allocation shifting among 9 S&P 500 sector ETFs outperforms equal weight sectors - back-test from 2001.

Tactical allocation shifting between S&P 500, Developed ex-US markets, and Emerging Markets outperformed equal weight of the three – back-test from 2006.

Tactical allocation signals monthly history from 6/30/2006 for back-tested ETFs plus gold and long-term zero coupon Treasuries.

Current tactical ratings for 38 ETFs representing key asset categories.

[QVM Client Letter June 19, 2016]

What's inside:

Current US Stock Market Conditions:

  • Bearish: Simple S&P 500 price chart looks like a wilting plant - 3 failures at the approximate 2100 level (but tip of 200-day trend is slightly up) (Figure 1)
  • Neutral to Bearish: 6-mo and 12-mo Buying Pressure is neutral, but 4-week Buying Pressure declined precipitously to neutral, and 1 week Pressure showed strong net Selling (Figure 2)
  • Bearish: Buying money flow and selling money flow both have declined precipitously, but selling money flow has begun to rise while buying money flow has not (Figure 3)
  • Neutral to Bullish: Percentage of S&P 1500 stocks within 2% of their trailing 12-mo high is in normal (pre-Correction) zone (Figure 4)
  • Bearish: Percentages of S&P 1500 stocks in 10% Correction or worse, 20% Bear or worse, and 30% Severe Bear or worse are significantly elevated (Figure 5)
  • Bearish: GAAP reported S&P 500 earnings are down 5 quarters in a row (an earnings recession), but stock prices have not followed (Figure 6)
  • Bearish: Multi-quarter GAAP earnings declines corresponded with start of last two major Bear markets (Figure 7)
  • Bullish: QVM 4-Factor Risk Allocation (trend) indicator for S&P 500 is positive (but vacillating in whipsaw fashion) (Figure 8)
  • QVM 4-Factor Risk Allocation indications for 38 key asset category ETFs for tactical allocation shifting (Figure 9)
  • QVM 4-Factor Risk Allocation indications for 4 example ETF portfolios for tactical allocation shifting (Figure 10)

Back-Test Tactical Allocation vs. Buy and Hold in Tax Deferred Accounts:

  • Tactical allocation shifting S&P 500 (NYSEARCA:SPY) outperforms Buy and Hold - back-test from 1995 (Figure 11)
  • Tactical allocation shifting among 9 S&P 500 sector ETFs outperforms equal weight sectors, as well as tactical allocation of S&P 500 alone - back-test from 2001 (Figure 12)
  • Tactical allocation shifting between S&P 500, Developed ex-US markets, and Emerging Markets outperformed equal weight of the three - back-test from 2006 (Figure 13)
  • Tactical allocation signals monthly history from 6/30/2006 for back-tested ETFs plus gold (NYSEARCA:GLD) and long-term zero coupon Treasuries (Figures 14, 15, 16)

Current Market Conditions Based On Chart Observations

Chart observation can be made simple or complex, but at the root of it are these three simple components:

  • Magnitude of change in price
  • Direction of change in price
  • Volume

Those are the absolutely objective facts that we know, from which many constructs are possible by measuring the change in those three dimensions over a time series.

We use those three components to assess the breadth of stock market action, and the flow of money into and out of the market.

Often, that data provides a logical leading indication of probable near-term stock index behavior.

Let's look at the stock market through that lens.

Figure 1: S&P 500 Unadorned 5-Year Price Chart Looks Like It's Rolling Over

You don't need any fancy technical analysis to see that the S&P 500 price has been basically stopped at the approximate 2100 level three times - showing great weakness.

If the index breaks out from its pattern in either direction, it is likely to do so strongly (and Thursday's Brexit vote has the potential to catalyze such a breakout). Long periods of sideways movement tend to be followed by strong directional moves - but which way it will be is unclear.

We tend to think it will break downward before resuming Bull moves based on our breadth studies and the multi-quarter decline in S&P 500 revenue and profits. However, we allow that the opposite could be true if favorable forecasts are given more weight by investors than the current valuation and global macroeconomic factors.

The prolonged sideways movement of the price exemplifies the tug of war between Bulls and Bear, but failing to break through three visible tops is an ominous sign.

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Figure 2: Buying Pressure Not Supportive Of Stocks Advance

Our "Buying Pressure" indicator among the S&P 1500 stocks is currently roughly neutral (balanced buying and selling) with a downward bias; after a year-long period of declining Buying Pressure, and a six-month period of net selling.

The 4-week average Buying Pressure shot up to over 60% in April after having been down to about 35% (15% below 50% balanced buying and selling).

The 1-week Buying Pressure is only about 21% (which means Selling Pressure last week was about 79%) of trading.

The declining net S&P 1500 Buying Pressure from mid-2014 while the S&P 500 was rising (at above average valuation levels) was a warning sign that a Correction was more likely than not.

The black line is the S&P 500 index. The gray, blue and red lines are 4-week, 6-month and 1-year Buying Pressure plots.

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The long-term average Buying Pressure is just over 50% for all periods, reflecting the growth bias of stocks, but in the past week, Buying Pressure was on 21.17%.

Over the past 130 weeks of our measurement, 83% of weeks had higher Buying Pressure. Last week was a very low net Buying Pressure week.

This table shows the minimum, maximum, median, average and last value of the Buying Pressure for 1 week, 4 weeks, 3 months, 6 months, and 1 year; as well as the ratio of the last value to the average value.

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For those who would like to know how we define and calculate Buying Pressure, here is the method. There are other approaches, but this is how we do it.

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Figure 3: S&P 1500 Buying Money Flow Is Falling Steeply While Selling Money Flow Is Beginning To Rise.

For those who would like to know how we generate this chart, here is the method:

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Figure 4: Percentage Of S&P 1500 Stocks Near High Gives Neutral To Positive Signal

This chart plots in green the percentage of S&P 1500 stocks that are within 2% of their trailing 1-year high, and the S&P 500 index in black.

The green plot is in the middle of its pre-Correction range, giving a neutral to positive signal about the trend in stocks.

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Figure 5: Percentage Of S&P 1500 Stocks In Correction, Bear Or Severe Bear Condition Gives Negative Signal

The black line is the S&P 500 index.

The gray plot is the percentage of S&P 1500 stocks that are in a 10% Correction or worse. The gold plot is the percentage of S&P 1500 stocks in a 20% Bear or worse. The red plot is the percentage of S&P 1500 stocks that are in a 30% Severe Bear or worse. Rising levels of these plots is a negative signal and falling levels is a positive signal.

The rising levels of these plots from early 2014 were leading indicators that the underlying strength of the rise in the S&P 500 index was weakening.

During the double Correction, the percentage of stock prices in trouble increased massively.

As the S&P 500 index has recovered from the Corrections, the percentage of stocks with prices in trouble has receded BUT the current levels of stocks in Correction, Bear or Severe Bear or worse are still quite elevated - a negative signal for near-term S&P 500 index performance.

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Moving on from breadth, let's look at basic fundamental of growth.

Here is commentary from FactSet (Friday, June 17, 2016), which points out that we are in a growth recession within stocks.

Optimistic expectations characterize the consensus Street view, but a lot has to fall into place for that to come true (particularly a rise in the price of oil for energy profits, and a rise in interest rates for financial company profits).

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Figures 6 & 7: Reported GAAP Earnings Are In Decline, Giving A Negative Signal

GAAP profits are in a multi-quarter decline. It is generally difficult for stock prices to rise while profits are declining, because the valuation (price paid for profits) rises, and is currently well above average, and higher than the end of 2014 when the profits peaked.

Consider this daily 3-year chart showing the S&P 500 in black and the reported GAAP earnings for the index in red.

This 20-year monthly chart, shows how the last two times there was a reversal in earnings to the downside, it corresponded with a reversal in stock price trend to the downside and the beginning of a bear market.

Figure 8: QVM 4 Factor Monthly Risk Allocation (Trend) Indicator Is Vacillating Abnormally, Creating Whipsaw Effect

The whipsaw is caused by the volatile sideways movement of the index. This indicator works better in trending markets.

As discussed in prior letters, the top panel is the risk allocation indicator, with possible values of 100 (full risk allocation) 50 (1/2 risk allocation) and 0 (no risk allocation).

The main panel presents the four data components used by the indicator:

  • Direction of the tip of the 10-month average (the most heavily weighted piece of data) - gold line
  • Position of the price above or below the 10-month average - black vertical bars
  • Buying pressure position above or below 50 (net buying or net selling) - dashed green line (left scale)
  • Price performance versus a geometric pace (Wilder Parabolic Stop and Reverse) - red dots

This is the indicator chart for SPY (the leading S&P 500 proxy ETF).

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You can see it did a good job calling for risk asset reductions near the top before that last two Bear markets, and for risk asset increase reasonably close to the bottom of the last two Bear markets.

It was a bit faked out by the European debt crisis in 2011 and it being whipsawed now by two back-to-back Corrections.

Note: Trend following tactical allocation is not suitable for all investors, or all types of accounts; and may only be suitable in a portion of those accounts in which it is deployed. This is not a recommendation that any particular Seeking Alpha reader utilize tactical allocation. It is merely a presentation of back-tests of the specific method we developed. Whether this or any other tactical approach is suitable for any investor is beyond the scope of this article.

Figure 9: Monthly QVM Current Risk Allocation (Trend) Indications For Key Asset Categories

Here is our monthly 4 factor risk allocation indication for key asset categories:

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Figure 10: QVM Risk Allocation (Trend) Indicators For Example Portfolio Components

The first three funds are "all-in-one" ETFs from iShares for conservative, moderate or aggressive investors. They sum up the market conditions. The conservative ETF has a 100 rating. The moderate ETF has a 50 rating, and the aggressive ETF has a 0 rating.

The next group of 6 ETFs are the funds that are the components of the Vanguard Target Date ETFs. As with any target date fund, the proportions are on a glide path from more aggressive to less aggressive as the years to the target date shorten, and there is no tactical element.

If one were to be tactical and to utilize the particular tool we present here, then the international stocks allocation would be sitting on the side in cash, while the other components would be fully invested.

The third group of 6 ETFs represents the asset categories in the "reference portfolio" recommended by David Swensen (the Yale endowment CIO in his 2005 book "Unconventional Success: A Fundamental Approach to Personal Investment"; which was an adaptation from his 2000 book for institutional managers, "Pioneering Portfolio Management."

He and the Yale endowment are long-term serial outperformers.

Yale does frequent rebalancing, but to the best of my knowledge not a tactical approach similar to that discussed in this letter. Our risk allocation indicator would have the ex-US Developed Market and Emerging Markets allocation on the side in cash at this time, waiting for their current downtrends to become uptrends.

Swensen prefers Vanguard for personal investors, in great part because of low costs, which is important in the long-run, particularly in low return periods. He also favors index level diversification for individual investors.

He recommends no less than 5% to any category (so it can make a difference in performance), but not more than 25% to 30% (so it can't make too much difference in performance). He further explains his category choices as have tranches for inflation protection, deflation protection, and growth.

He also stresses the importance of tailoring the portfolio (deviation from the "reference portfolio") to match personal needs, goals, resources, and financial and behavior limitations; to assure success.

The fourth example portfolio of 15 ETFs, if a factor oriented grouping based on Size, Quality, Volatility, Value, and Yield, and including gold; with a spread of durations within the credit (corporate) bond space.

These are not recommendations for any particular person for any specific purpose, but merely sample portfolio components as reference points in portfolio planning.

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Back-Tests Using QVM 4-Factor Risk Allocation Indicator With Various Key Assets Vs. Buy And Hold

Figure 11: Back-Test Using S&P 500 Tactical Allocation Historically Would Have Outperformed Buy And Hold In a Tax Deferred Account

standard disclaimer required for this and all back-test presentations in this letter: past performance is no guarantee of future performance

This chart compares buying and holding SPY in 1995 through now, versus holding either SPY or 3-month Treasury Bills based on the signals from the QVM 4 Factor Risk Allocation Indicator.

The blue line at the top of the chart is the Risk Allocation Indicator signal. The brown line is the tactical result of following the signals. The black line is buy and hold.

The principal value creation from the tactical approach did not come from small, short-term movements to cash, but rather from two of those cash positions starting at the beginning of major Bear markets.

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Figure 12: Tactical Allocation Among The 9 S&P 500 Sector ETFs Outperformed Equal Weight Sectors, Tactical Allocation With SPY, And Buy And Hold SPY

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Figure 13: Tactical Allocation Between US, DM And EM Stock ETFs Outperformed Buy And Hold Equal Weight Of The Three ETFs

US was represented by SPY; developed ex-US markets by EFA and emerging markets by EEM.

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Figures 14, 15 & 16

For of sense of how the Risk Allocation indicator changed signals over time, here are three tables that present the ratings by month from the middle of 2006 for each of the ETFs used in the back-tests shown above (plus for the gold ETF GLD and for EDV, the long-term zero coupon Treasury Bond ETF).

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Securities used in back-tests: SPY, EFA, EEM, XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY

Disclosure: QVM has positions in a variety of ETFs listed in this article as of the creation date of this article (June 19, 2016). We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article, but are compensated retroactively by Seeking Alpha based on readership of this specific article.

General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.