Following our January model updates and corresponding position changes, the Day Hagan Tactical Allocation strategy (DHTA) is now approximately 57.0 percent invested in equity and equity alternatives, 9.4 percent in fixed income and 33.6 percent in cash and cash alternatives. (Note: The fixed income and cash allocations reflect holdings within the exchange-traded funds we own. Therefore, individuals may look at their portfolios and see slightly different stock/bond/cash allocations.)

Based on the aforementioned allocation, DHTA is now nearly neutral with regard to our equity exposure. Further, we continued to underweight fixed income (though we increased exposure slightly this month as fixed income appears significantly oversold near-term) and overweight cash. Longer-term, our bond versus cash models continue to emphasize that longer-term interest rate risks remain elevated.

From a broader equity asset class perspective, DHTA favors U.S. equities over international equities, emphasizes value over growth and has returned to slightly favoring small capitalization equities over large capitalization stocks. From an equity sector perspective, the strategy's top three holdings remain Financial Services, Industrials and Technology. The sectors with the least exposure are Communication Services, Utilities, and Basic Materials, each with less than 4 percent overall exposure.

With the January model updates, we reduced our positions in our Large Cap Value (IWD) and Large Cap Growth (IWF) holdings and added to our Small Cap Value (IWN) holdings. Additionally, we added to our European exposure (VGK) as we simultaneously exited the majority of our emerging market exposure (VWO and AAXJ). We continue to hold a small position in the Gold ETF (GLD). (Please see our 1/4/2017 Trade Notification for more details.)

The changes primarily reflect strength in the U.S. dollar, which tends to benefit smaller capitalization stocks over larger capitalization stocks. Small cap stocks typically conduct business domestically, while the large cap stock universe has a more international scope. When the dollar is strong, it can negatively impact a U.S. company's international competitiveness as well as those company earnings that are derived overseas from countries with relatively weaker currencies.

The reduction in our exposure to emerging markets is due to a significant decline in the emerging equity market operating environment as higher interest rates in the U.S., along with the heretofore strong U.S. dollar, are creating relative problems for emerging economies that quasi-peg their interest rates and currencies to the U.S.

In our view, the models' and indicators' neutral readings for the intermediate- and longer-term horizons accurately reflect the dichotomy between the current readings of excessive investor optimism relative to the actual "results" that are likely to be realized.

For example, given the market's post-election rally, it is reasonable to assume that investors are already betting on significant tax cuts, larger government spending programs, widespread deregulation and the resulting stronger economic growth to boost corporate earnings.

  • Will tax cuts happen at the corporate and individual level? More importantly, how will they be implemented? Will the border tax take the wind out of large sectors of the market? Will one company's tax cut be another company's tax increase based on where they are sourcing their inputs?
  • Will large government spending programs be approved? And how long until the fiscal stimulus is unleashed into our economy? Where will the money come from, more debt issuance? Less spending elsewhere (a balanced budget approach)? Is it fiscal stimulus when no new liquidity is being added to the financial system as the government's spending change is a net zero percent?
  • Where will the deregulation be focused? The financial sector? Will deregulation in the financial sector be offset by new regulations around tax policy and trade restrictions (will China be labeled a currency manipulator)? The energy sector? Does this mean more supply?
  • Will economic growth accelerate? Will it just be in the U.S., or a globally coordinated move? While we have been noting better economic numbers from the U.S. overall, Q4 2016 GDP estimates have now declined to a 2% annualized rate, well below the 3.5% annualized rate that was achieved in Q3 2016.

So far, investors are ignoring higher interest rates, the potential changes to the deductibility of interest and the effect that would have on debt issuance for buybacks, for example. Investors are also ignoring relatively high valuations and overbought, excessively optimistic extremes. This suggests that investors believe the expected tax cuts, spending programs, deregulation and resulting economic growth will compensate them for the uncertainty posed by the unknowns around what the ultimate policy changes will look like. Keep in mind, the House Republicans have a very different view of what tax reform looks like—there is lots of compromising to be done.

The bottom line is that there are clearly more unknowns than knowns on some very big and important issues. But the market is being priced as though it knows what President-elect Trump's stimulative policies will end up looking like. While we expect improvements in each of the aforementioned areas, the extreme levels of optimism suggest that prices have likely gotten ahead of reality. Therefore, the recent shift to a neutral equity position dictated by our models is appropriate.

We will be looking for our models and the weight of the evidence to turn more positive before committing additional capital to equities. At this point, the competing number of bullish and bearish indicators illustrates that markets remain vulnerable and are likely to continue to meander until economic growth can find a more solid foothold and there is more clarity on the big issues. Our view is that taking big bets based on "hope and change" when the markets are expensive is risky.

If you have any questions or comments, please feel free to call any time.


Donald L. Hagan, CFA

— Written 1-06-2017
