ADAPTIVE ADVANTAGE

It’s been a rough year thus far as stocks and bonds bleed together. Many investors find themselves caught offsides.

Yet signs of trouble had been building for months.

Since last summer a fierce bear market has engulfed NASDAQ, yet it failed to register at the index level. This is because the indexes (ex- Dow Jones Industrial Average) are calculated by market capitalization. This means the more a company’s stock price increases, the more significant its index component. Price changes in the largest stocks carry huge sway, especially in the S&P 500 and Nasdaq 100.

At no other point since at least 1999 have so many stocks been cut in half while the Nasdaq Composite index was so close to its peak. When at least 35% of stocks are down by half, the Composite has been down by an average of 47%. – Sentiment Trader

There is no precedent for when so many stocks were in a bear market while the index was near all-time highs.

The herding of investors into indexes through passive funds like SPY and QQQ creates a feedback loop where everyone keeps buying the same names again and again (yes, we own them too, fully hedged). The 10 largest stocks deliver most of the returns for the indexes, creating an illusion of performance not supported by the vast majority. Only when the Top 10 are falling do most people start paying attention. Such as now.

It's behemoths like AAPL, GOOGL, MSFT and TSLA that drive returns, not the other 490 stocks in the S&P 500.

Last summer we noted a significant narrowing of participation in market gains. As highlighted in our 3Q Review (here), market breadth was severely faltering despite the indexes hovering at all-time highs. In September volatility finally made a comeback, and most of Q4 saw extremely erratic price movement.

Similarly, the bond market was flashing red last fall as well. After peaking in August, bond prices first broke trend in late-September, followed by a convincing break in December.

Fortunately, we listened to what the markets were saying and went mostly to cash.

With “risk-off” the current regime, our exposure to stocks and bonds is minimal. As we aren’t bound by a fixed asset allocation, we can be nimble in responding to changing dynamics. This is the Adaptive Advantage.

With all eyes on The Fed these days – how high will they hike? – we think it’s a good time to re-boot our favorite chart, The Only Chart That Matters, here: