Last month was the first down month for the market this year. The next few weeks ought to be interesting, we have the monthly jobs number on July 5th when most people are probably on vacation and then corporate earnings start in two weeks. No telling at this point about whether the market will want good news or more of the Goldilocks, not to hot, not too cold, news that could keep Quantitative Easing going. Going forward investors will continue to analyze anything the Fed says for clues.
International turmoil has come back this week:
1. Portugal's foreign minister resigned triggering a selloff in Portuguese stocks and bonds
2. Egyptians are protesting for a do over in their revolution
3. Eurozone unemployment data was revised upwards
In the short term these events can roil the market, intermediate to long term they don't seem like a big deal, but they do re affirm the US as a safe haven.
Bonds snapped back last week after the bloodbath over the past few months. This is to be expected as the bond markets had gotten way oversold. Now that the panic selling is over we may start to get the orderly rotation out of bonds and into stocks that everyone is expecting.
Typically, great rotations out of one asset class into another tend to start with panic selling. Oversold markets then typically will rebound somewhat as bargain hunters come in. It is likely that people who still hold large bond positions will look back on the recent strength as bonds as a great opportunity to rotate into stocks.
Recent Moves
The week we made a number of allocation shifts:
1. We repositioned our equity exposure to favor small cap stocks over large cap stocks.
2. We initiated countertrend positions in long term Treasury Bonds based on Treasuries being oversold
3. We sold out floating rate bonds, leaving the Treasuries as our only bond position.
The Peso Problem
The Peso Problem is a quandary in academic finance literature where in sample, or historical data, is not representative of the full range of outcomes that can happen in the future. Basically, it is the problem of investors looking at the past and assuming that what has happened in the past will continue into the future. For example, there are a number of investment products and strategies (asset allocation portfolios, target date funds, risk parity, etc) that assume that the 30 year bull market in bonds will continue and that bonds will be uncorrelated with stocks. If this doesn't actually occur in the future then these products will perform poorly at best and implode at worst.
The solutions to this problem are:
1. Look at the past but never assume that just because it happened in the past that it will continue into the future. A good example of how we do this is in one of our bond models. Including a component that gives us the inverse of the return of Treasury Bonds (betting they will go down) historically reduces the return of the model and increases the risk, both bad things. If I just looked at the past I would be tempted to take the inverse side out of the model but I understand that the entire history of this model has been during a bull market in bonds. Going forward the bull market is not likely to continue, so having the inverse side in the model hurt performance in the past but it should improve performance in the future (the only thing I really care about).
2. Diversify your portfolio by risk, not by asset class. I just wrote a blog post about this here:
How Investors Can Achieve True Diversification
3. Be dynamic by always looking at your methodologies from the standpoint of what could go wrong and always work to improve. Most investors base their portfolio decisions on what happened in the past and then stick with it going forward regardless of what happens. We re-evaluate our models every day trying to improve them.
Top Holdings
1. Cash
2. S&P 500
3. US Small Cap Stock
4. US Dividend Stocks
© Tuttle Tactical Management
