Time to Read: 6 Minutes
In a recent webinar, we discussed our market outlook for 2022, including the likelihood of a correction due to the appreciable amount of time since a 10% selloff last hit the S&P 500, as shown below.
Just a few days later, the S&P 500 hit the 10% correction threshold on an intraday basis. While not enough to reset the chart, it was a reminder that volatility is a part of investing in equities. What was unique about this correction, however, was that bonds also sold off as inflation fears and a change in tone from the Federal Reserve (Fed) prompted market participants to adjust their interest rate forecasts higher.
Here we examine the allocation adjustments we’ve undertaken in light of these recent market moves, including further reducing sensitivity to interest rates and increasing international exposure in certain accounts.
Cutting duration and raising cash
While it is still too soon to tell if inflation will become a persistent problem beyond the first half of 2022, the Fed has put forth a plan to reduce its bond purchases and raise interest rates. This intention was known before the correction—but the newly implied speed of the rate hikes has put markets on edge. According to Ned Davis Research (NDR), the Fed is expected to raise rates from roughly 0% to more than 1.7% in the next 12 months! This steep upward move is illustrated by the orange line in the lower portion of the chart below.
Compared to expectations at the time of our January webinar, the currently implied path of rates represents three additional hikes of 25 bps each. While it is too soon to tell whether these hikes will occur, we believe it makes sense to further reduce our bond exposure and duration, a move we first made in our tactical portfolios last October. Our most recent actions include cutting overall portfolio duration—which means our portfolios will be less sensitive to interest rate moves, both up and down—as well as decreasing overall bond exposure and increasing our cash position using very short-term Treasury securities. By using short-term Treasury securities, we should be able to participate in higher interest rates as the Fed increases its benchmark rate.
Increasing international exposure
Additionally, we are increasing overall international exposure in retirement and other non-taxable accounts. At BWM Financial, we plan to be more tactical moving forward in accounts where clients do not pay taxes on gains as they occur. As we have upgraded our trading systems and enhanced the depth of our investment committee, we can now be increasingly nimble in non-taxable accounts.
As shown below, international equities have underperformed US equities for the better part of 14 years—the longest such stretch in more than 50 years.
Longtime clients and readers know our team uses objective indicators to help make allocation decisions, so a choice to boost international exposure would not be based solely on a mean-reversion study. With the help of NDR, we designed an indicator intended to identify when it would make sense to move to an overweight position in non-US equities. That indicator, which tracks the relative health of international markets vs. US markets, flashed a buy signal late last year and has now clearly moved into the bullish zone, as shown below.
This bullish signal, combined with lower valuations, more accommodative central banks, and recent relative outperformance, led us to make the adjustment. While we are not currently calling for an end to US outperformance, we believe it is prudent to follow the weight of the evidence by moving to a slight overweight position in non-US equities.
Watching for an equity downgrade
While a comprehensive review of the evidence leads us to remain overweight equities, we are getting closer to an equity downgrade. Our models have deteriorated with the recent correction, but not quite enough to call for a cut to stocks, despite the interest rate moves and geopolitical events.
We believe volatility and declines are part of investing in equities, but if we can make adjustments that allow us to avoid a 20% decline, we then have capital to put to work at lower levels. This is no easy feat, so we closely monitor multiple indicators to guide our decision. We’ve been paying particularly close attention to the NDR Bear Watch report, which attempts to forecast when a decline greater than 20% is in the making. Specifically, we watch the percentage of indicators in the “bearish” zone. A reading over 40% alerts us that we might have to act. As shown below, we are still shy of this threshold.
Furthermore, the NDR Daily Sentiment Indicator has crossed well into the “extreme pessimism” range, as shown below. Considering past performance, this positioning has usually flagged a good entry point—not necessarily a time to sell.
In conclusion, it is not always easy to make tactical investment decisions, which is why our approach is focused on the weight of the evidence. For now, we believe our indicators support further reducing sensitivity to interest rates and increasing international exposure without tax consequences. We have a close eye on our current equity position and will adjust, if needed, should we see a decisive breakdown in our readings.