The Word from Main Street

Market Update for the Week of April 22nd, 2024


Trend-following is a strategy that has been around for decades. The basic idea is by buying when price is moving up and selling/hedging when price is moving down, one can outperform a buy and hold strategy. Typically, it is thought of as a stock-based strategy, but it has been applied to many other asset classes including Fixed Income (bonds). In fact, we often find outperformance can be more consistent in Fixed Income due to the nature of Fixed Income index construction. Most indexes are market-cap weighted, meaning the most indebted areas of the market get the highest weight. This tends to become a problem when these areas start to have issues (e.g., being overweight mortgage-backed securities in 2008). Because of this issue, passive Fixed Income benchmarks tend to perform worse relative to active management (see below). We believe this provides an opportunity for trend-following approaches which, in theory, should be able to rotate out of poorly performing areas when passive indexes cannot.

 

Source: Nasdaq Dorsey Wright

Fixed Income markets have seen historic declines since the Federal Reserve began raising interest rates in early 2022. In fact, 2022 was the worst year for bonds in at least 250 years. Why was it so bad? How could calamities such as the Great Depression, World War II, and the Civil War not cause more substantial issues for the market? Part of it comes down to the convex nature of bond pricing. When rates are low, more of a bond’s return comes from the return of principal at maturity vs. coupon payments made along the way. This naturally lengthens the duration of bonds (making them more sensitive to changes in interest rates) with greater price changes occurring the lower interest rates get (see below). Given that the period leading up to 2022 saw the lowest interest rates in recorded history, this had a major effect on bond prices and explains why similar rate changes in the past didn’t have the same impact on prices we saw here. Additionally, the Aggregate Bond Index is also more weighted towards U.S. Treasuries now which further increases its interest rate sensitivity. All of this, combined with the speed of the rate increase led to the historic decline.

Source: Nasdaq Dorsey Wright

If the market only went down, a trend-following approach likely would have done well as it could have allocated more of the portfolio toward the short end of the interest rate (yield) curve and sidestepped steeper declines in longer dated bonds. However, along with the increase in rates, we also saw a sustained increase in bond volatility. One way to measure this is through the ICE BofA MOVE Index, which is like the VIX index for stocks in that it uses options to calculate the implied volatility for treasury bonds. The average value of this index over time is 93. The average value since the beginning of 2022 is 119 (almost 30% higher). This is a difficult environment for a trend-following strategy as, by definition, it requires the markets to form stable trends in one direction or another to succeed. In volatile markets, even if the markets trend, the countertrend moves are often significant enough to cause the strategy to generate false signals. It also doesn’t help when the period of high volatility is sustained as it has been. In fact, the MOVE index recently traded below the long-term historical average (93) for the first time in two years (see below). Looking at historical data, levels of sustained high volatility like this have only been seen before this in 2008/2009 and 1994/1995. The good news is that we seem to be moving back to a more normal environment which should allow trend-following-based approaches to resume their previous success.

Source: Nasdaq Dorsey Wright

The current reading for the Nasdaq Dorsey Wright PR4050 Cash Trigger is: Money Market = 4.23% & U.S. Equity Core = 97.89%. For the PR4050 indicator to trigger and alert us when we should consider moving to cash, Money Market must be 50% or above and U.S. Equity Core must be 40% or below.

Source: Nasdaq Dorsey Wright

Below is the most recent D.A.L.I. (Dynamic Asset Level Investing) Indicator showing Domestic Equities in the top spot, while Commodities have closed the gap with International Equities.

 

Source: Nasdaq Dorsey Wright

P.S. If you believe this information would be of benefit to anyone you know, please share this communication with them. Also, if you, or someone you know, would like to be added to the weekly market update, please click here to provide us with the e-mail address.

Main Street Wealth Advisors
33801 1st Way South, Suite 271
Federal Way, WA 98003
Office: (253) 944-1047
Fax: (253) 944-1075
www.mainstreetwa.com

ART-568370

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

These views are those of the author, not of the broker-dealer or its affiliates. This material contains an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. All investments involve risk, including loss of principal. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. All indices are unmanaged and may not be invested into directly.

Technical analysis is based on the study of historical price movements and past trend patterns. There is no assurance that these movements or trends can or will be duplicated in the future. Nasdaq Dorsey Wright developed the indicators described above. They have been prepared without regard to any particular investor's investment objectives, financial situation, and needs. Accordingly, investors should not act on any recommendation (express or implied) or information in this report without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions.

Nasdaq Dorsey Wright’s “DALI" employs relative strength-based analysis to rank macro asset classes based on developing leadership trends within the global capital markets. The objective guidance within DALI provides the tools necessary to properly allocate portfolios across all major asset classes in an effort to emphasize strength wherever it exists. Domestic Equities, International Equities, Commodities, Currencies, Fixed Income and Cash are evaluated daily to identify dynamic developments across investment genres, as well as within them. This tool provides the tactical precision that allows investors to adapt as the market leadership changes.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

The Bloomberg U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.

The CBOE Volatility Index® (VIX®) is meant to be forward looking, showing the market's expectation of 30-day volatility in either direction, and is considered by many to be a barometer of investor sentiment and market volatility, commonly referred to as “Investor Fear Gauge”.