After nine long years of Federal Reserve policies dominating the economic and investing landscape, it's understandable if many readers are experiencing acute "Fed fatigue" and have largely tuned out news relating to it. The economy has been muddling along reasonably well for years now, and prices of financial assets are booming, so it seems reasonable that the Fed's role in directing the economy and markets has diminished.

That view is seemingly backed by the fact that the Fed has now raised short-term interest rates four times in the past 18 months, and the economy and markets have mostly stayed on track.

However, a new wrinkle emerged last week as the Fed provided some detail regarding their plan to finally begin shrinking its $4.5 trillion balance sheet. You'll recall that the Fed built up this massive balance sheet during its Quantitative Easing programs earlier this decade. Basically, each time the Fed bought a bond as part of its QE program, it created new money that went into the bond seller's account, expanding the money supply (and in theory, giving the economy a boost as that money could be lent, spent, etc.). The bond went onto the Fed's balance sheet. As those bonds matured, the Fed reinvested the proceeds in new bonds. The initial purchases account for how its balance sheet got so huge, and the reinvestment aspect is why it has stayed so huge all these years later.

The details of the Fed's plan to begin winding-down its balance sheet are as follows. At some point in the near future (this year), they are going to gradually stop reinvesting some of the proceeds of the maturing bonds on its balance sheet. Initially, the Fed will allow $10 billion each month to be "retired," rather than reinvested. The plan is for this to expand by an additional $10 billion every three months until they reach the point where $50 billion is being "retired" each month.

This is long overdue and arguably should have been started long ago (like 2013). So it's a good thing that it's happening. Less intervention by the Fed is almost always a good thing, particularly given that there's precious little evidence that its intervention has actually aided the U.S. economy.

But just as these bond purchases injected liquidity into the U.S. economy when they were made, so will these new steps take money out of the system as these maturing bonds are retired without their proceeds being reinvested. It's a boost on the way in, but then it's a drag on the way out.

Remember, all of this is "extra" or "new" Fed policy that was put into practice for the first time following the Great Recession in 2008. Normally, adjusting the Fed Funds interest rate has been the normal accelerator/brake that the Fed has used to try to influence the speed of the U.S. economy.

So what this means is that in addition to the typical pumping of the economic brakes that the Fed has begun by raising short-term interest rates from 0% to 1-1.25%, the Fed is now taking the additional step of finally reversing the economic support provided by its QE policies.

Timing

It's an interesting case of timing, given that the economic data in recent months has been less than robust. Over the past 12 months, inflation (core CPI) fell to 1.7% from 1.9%, though Fed Chair Yellen made a specific point of trying to explain why that was just a blip due to non-repeating short-term factors. Still, those figures are below the Fed's 2% inflation target. Others aren't so sure these soft economic readings are temporary, particularly in light of reduced GDP expectations, a slowdown in housing starts, and some weakness in recent employment numbers. Perhaps not surprisingly, the Consumer Sentiment Index has dropped significantly this month.

The longer-term bond market certainly isn't buying the "growth and inflation are heading higher" story that the Fed is using as its rationale for continuing to raise rates. The 10-year Treasury yield actually fell last week after the Fed's rate hike. While the Fed controls short-term interest rates, the market sets longer-term rates, and recently the yield curve — the difference between short and longer-term rates — has been flattening. That's typical of slower growth, and should that curve invert and short-term yields actually go higher than long-term rates, that would be a classic recession indicator.

While conspiracy theorists might argue that the Fed is out to get this president, I don't honestly believe that's the case. I do think the Fed probably cares less about sparking a downturn in asset prices now that Trump is in office, knowing that an eager press will be quick to lay any blame at his feet. But I don't think they're trying to orchestrate a recession or a stock correction.

Instead, I think the Fed realizes (and has for some time) that it's way behind the curve in terms of where interest rates are and where the economy/markets are in their respective cycles. Analysis done by Gene Epstein of Barron's (as well as numerous other people) indicates that the Fed Funds rate would historically have been 2-3% higher than it is today given similar employment/inflation figures in the past.

Given that the market and the economy seem to have absorbed the past three rate hikes without any significant damage, we should expect that the Fed will continue to press their normalization plan forward. As they should — there's no reason for interest rates to be so low or for the Fed balance sheet to be so bloated nine years into an economic recovery, no matter how anemic that recovery has been.

Impact

Unfortunately, the Fed's track record in engineering "soft landings" to past market cycles has been horrible. Ultimately, the Fed's tightening produced both the dot-com crash in 2000-2002 and the Financial Crisis in 2008. In both cases, markets continued to rise as rates rose initially. But eventually, the markets reacted violently.

Long-time readers of SMI know that we've been watching monetary policy (the Fed's impact on interest rates and the money supply) as THE key risk factor that is likely to ultimately bring about the end of this bull market. So when the Fed started hiking interest rates, our antennae started quivering. Last week's announcement of the plan to shrink their balance sheet, while appropriate, is just another domino falling in that regard.

That still doesn't give us anything tangible to work with from a timing standpoint. This process could unfold quickly or slowly. As has been the case since 2008, the lack of historical precedent for the Fed's recent actions makes it pointless to try to guess what kind of timeline is likely. In addition, the Fed isn't the only Central Bank in play, and the other big ones (Europe and Japan) are both continuing their significant interventionalist policies, with the Bank of Japan going as far as directly buying stocks. These policies continue to support global financial markets.

That said, as you see the likely prerequisites for an event being checked off one by one, it should start to heighten your anticipation and preparation for that event. Preparing for the next market downturn is no different. If you haven't thought through your plan/approach for the next bear market, it's certainly time to do so.

Last week, I returned from a week in the Dominican Republic as part of a team with GO Ministries. This was the second year I've been able to take this trip with my 18-year-old daughter, Nicole. It's a precious thing to watch your child minister to others in Jesus' name! This year's trip was extra special given that I had the chance to coach Nicole's volleyball team this year, and we had 5 other players with us from that team. So it sort of felt like I had half a dozen of my kids along with us this time!

I'd heard of various "sports ministry" groups/trips before getting involved with GO, but hadn't really understood how they worked. So for the benefit of others with similar questions, here's a quick explanation of how a bunch of gringos teaching volleyball for a week in a poor Dominican town can become something productive for the Kingdom of God.

DAA is a core portfolio strategy that is designed to help SMI readers share in some of a bull market’s gains, while minimizing (or even preventing) losses during bear markets. The strategy involves using exchange-traded funds to rotate among six asset classes, holding three at any one time. DAA is a defensive, low-volatility strategy that nonetheless has generated impressive back-tested results, demonstrating the power of “winning by not losing.”

Sector Rotation is a high-risk/high-volatility strategy. While its peaks and valleys have been more extreme than SMI's other strategies, it has generated especially impressive long-term returns, as discussed in Sector Rotation is Risky, But Highly Rewarding.

Sector Rotation continues to amaze so far in 2017, up 24.0% after just five months.

There is no change being made to Sector Rotation for June. Here are the details.

Why Upgrade?

SMI offers two primary investing strategies for “basic” members. They are different in philosophy, the amount of attention they require, and the rate of return expected from each. Our preferred investing strategy is called Fund Upgrading, and is based on the idea that if you are willing to regularly monitor your mutual-fund holdings and replace laggards periodically, you can improve your returns. While Upgrading is relatively low-maintenance, it does require you to check your fund holdings each month and replace funds occasionally. If you don’t wish to do this yourself, a professionally-managed version of Upgrading is also available.

SMI also offers an investing strategy based on index funds called Just-the-Basics (JtB). JtB requires attention only once per year. The returns expected from JtB are lower over time than what we expect (and have received) from Upgrading. JtB makes the most sense for those in 401(k) plans that lack a sufficient number of quality fund options to make successful Upgrading within the plan possible. Here are the funds and percentage allocations we recommend for our Just-the-Basics indexing strategy.

The first significant volatility the stock market has faced in months has finally pulled the trigger on the annual seasonality sell signal today. This signal had been getting close to being triggered in recent days, and today's action has pushed it decisively over the edge.

To avoid any confusion, I'm speaking of the MACD signal (read on if you don't know what that is), which gives us slightly different entry and exit points than the traditional "Sell in May and go away" dates.

As this old Introduction to Annual Seasonality article explains, the stock market has historically tended to perform much better on average between November-April than between May-October. This is, of course, an average based on many years of observation, and any specific year can vary dramatically from that long-term trend. But it is a pattern that has persisted long enough, and across global markets as well as here in the U.S., so as to have attracted quite a bit of attention over the past two decades.

The basic idea of annual seasonality, then, is to sell stocks at the end of April and buy back in at the end of October. (“Sell in May and go away.”) SMI makes a further refinement to this basic seasonality approach by looking to "fine tune" the buy and sell signals based on a mechanical indicator called MACD.

Questioning the value of investing seasonality

However, there have been two significant developments in recent years that now lead us to question whether acting based on this seasonality signal information is the best approach. First, our investigation of the impact of the election cycle on annual seasonality found that there is actually only one (out of four) unfavorable periods during which stocks have, on average, lost money. That is the May-October period leading up to the U.S. mid-term elections (which last happened in 2014 and will happen again in 2018). The other three unfavorable periods, including the one we’re entering this year, have still been positive on average. Which leads one to question the wisdom of making significant changes to an otherwise well-designed portfolio during these other unfavorable periods.

In other words, even those who want to apply annual seasonality as part of their investing plan would have a compelling case to only alter their base asset allocation during the mid-term election year unfavorable period (and potentially the following favorable period, which has been abnormally strong, on average). The other three years, they would leave their allocations alone and ignore annual seasonality.

Improving on investing seasonality

The second reason to question the value of continuing to apply annual seasonality signals stems from the research we did that led us to launch our Dynamic Asset Allocation (DAA) strategy in 2013. This strategy has a timing element built into it that triggers changes between six asset classes all year long, irrespective of the annual seasonality cycle.

When owning stocks while applying annual seasonality is compared to simply owning stocks year-round, it’s easy to make an argument in favor of incorporating the annual seasonality modification. However, when comparing the relatively blunt-instrument approach of annual seasonality to the more specific signals generated by Dynamic Asset Allocation, the results aren’t even close. Dynamic Asset Allocation has provided much better signals of when to be invested in stocks and when to be out of them than annual seasonality.

How much better have DAA's signals been than annual seasonality's? We haven’t done exhaustive research on this, but a quick analysis done a few years ago indicated that over the prior two dozen years, using DAA would have produced better than triple the returns of applying simple annual seasonality to stocks. (That's using the standard April 30 and October 31 exit and entry points, not the MACD refinement.)

To be fair, no one ever claimed annual seasonality was a finely-tuned timing instrument. It’s a blunt, simple device to improve on buy-and-hold stock market investing. DAA is purposely designed to give us more specific signals and it requires a lot more — someone has to calculate and track the momentum scores and potentially alter their holdings every single month instead of just twice a year.

But for the SMI member, the issue is quite a bit simpler. The DAA information is available every month in a very simple format. Given that these signals have been significantly better than annual seasonality’s, and they are so easy for SMI readers to obtain, it’s hard to imagine why someone would continue to use the blunt instrument approach of annual seasonality any longer.

Unless, of course, they're applying it to an account where using DAA isn't feasible. It's primarily for these readers that we continue to report on the seasonality MACD buy and sell signals. But for everyone else, we believe DAA offers better timing cues than annual seasonality.

If you do use investing seasonality

Even before the creation of DAA, SMI always maintained that annual seasonality should represent a relatively small refinement to your existing long-term plan, rather than being used as an "all in" vs. "all out" tool. We've seen annual seasonality be painfully out of synch with the market at times. As such, we've recommended making measured changes to your stock/bond allocation, if you choose to implement annual seasonality at all.

For example, someone who would otherwise have a 70/30 stock/bond allocation might choose to lower that to 60/40 during the unfavorable summer period, then raise it to 80/20 during the favorable winter period. That would give them an average allocation close to their ideal, optimized to correspond with the market's long-term statistical pattern. (Some readers have found that using automated versions of the strategies involved makes this semi-annual switching process easier.)

Another idea that has been popular with readers in the past is to switch a portion of their portfolio back and forth between a more aggressive strategy, like Upgrading, and a more conservative one, like DAA. Along those same lines, some might choose to pare back their Sector Rotation allocation during an unfavorable period such as this.

However you approach it, keep in mind this often-overlooked point about annual seasonality: the main objective of annual seasonality is not to improve returns. Rather, the primary objective of annual seasonality is to reduce risk. The data indicate that the overall returns of a portfolio invested in stocks only during the favorable period each year (and in bonds the rest of the year) has produced very similar total returns to a portfolio that was fully invested in stocks year-round.

Confused? Ask a question and we'll try to clarify anything that isn't clear. But bottom-line, if you don't have a compelling reason and desire to use annual seasonality, you can safely skip right by it and pretend it doesn't even exist.

Two random observations to pass along today. They're not related (at least directly). I'm just throwing them into this post together.

Market Breadth Narrowing Again

Much has been written about the "FAANG" stocks — Facebook, Apple, Amazon, Netflix, and Google (Alphabet) — as this tech quintet has dominated this long bull market. While this is anything but a new story, what is new is the fact that these 5 stocks have been about the only ones continuing to advance over the past 10 weeks (since the beginning of March).

The S&P 500 as a whole has gone nowhere since the 1st of March, closing that day at 2,395.96. Yesterday's closing level was 2,397.88. But as the chart below from John Alexander at MacroCharting shows, the FAANG stocks have continued to rise, while the other 495 stocks in the index have declined by a corresponding amount.

There's no specific take-away from this information, although it's generally considered to be a warning sign when the market's breadth (i.e., the percentage of stocks continuing to advance) narrows. As I mentioned, this FAANG phenomenon is nothing new, as these 5 companies have been dominating for several years now. But it's worth noting that the last time the breadth story became enough of an issue that SMI was discussing it was in late 2015. Perhaps coincidentally, perhaps not, that was about the time the market went through a pair of 12% corrections within a span of 7 months. However, there's no particular reason to think the timing of those corrections was specifically tied to any particular measure of market breadth.

If anything, seeing the continued focus of the market being channeled into such a narrow list of really expensive stocks makes me think how vulnerable the indexes generally (and index fund owners by extension) are to adjustments in the pricing of these handful of stocks. Amazon is a phenomenal company, and with a P/E ratio of 180 it had better be! We love the Netflix product too, but a P/E over 200? Wow.

Valuations Look Better Overseas

Sticking with the valuation topic, I'm seeing more and more written about the disparity in valuations between U.S. and foreign markets. This MarketWatch article is a good example, providing the following chart that shows how dramatically the performance of U.S. and Foreign markets has diverged since 2011.

Eyeballing this chart, it appears that over the past 10 years U.S. stocks have gained 62% while Foreign stocks have lost 16%, with most of that gap opening over the past six years. Clearly, owning foriegn stocks lately has been a drag on performance.

But it's worth noting these types of multi-year performance gaps between U.S. and Foreign stocks are common. Here's another chart that shows this clearly.

The upward spikes show the periods when U.S. stocks have had the upper hand, while the downward spikes show the periods when Foreign stocks have been the better performers. While this decade (2011- ) has been dominated by U.S. markets so far, the shoe was on the other foot for much of the prior decade (2001-2010).

Not surprisingly, when one market dominates the other for a period of time, as the U.S. has since 2011, valuations eventually get stretched between the two. This has definite implications for each market's future prospects.

Here are GMO's 7-year projected returns for various asset classes, based largely on today's valuations of those asset classes.

While all of these projections are depressingly low, on the stock side of the chart, you can clearly see how today's elevated valuations have impacted the likely future returns of U.S. stocks (both large and small). GMO projects U.S. stocks will be lower seven years from now than they are today (negative annualized returns). Their prognosis isn't great for International stocks either — slight losses for them as a group — although they expect slightly brighter skies for stocks from the Emerging Markets subset of the international group.

DAA investors have likely noticed that foreign stocks have been 2017's top performing group so far. There's no way to know whether that will continue in the short-term, but the longer-term trends seem to indicate that having the 20%-30% type of foreign allocation included in most of SMI's strategies will be a good idea in the years ahead.

It's May, the month when some investors point to the "Sell in May and go away!" playbook for investing instructions. As we explained a few years ago in Protecting Your Portfolio Against An Unfavorable Election Cycle, we don't think that old adage is worth following for SMI readers, with the possible exception of one out of every four years (which isn't this year). That said, we know some readers still have interest in it, so we continue to watch that "sell in May" indicator as we do every year, and will report on it when it signals that it's time to sell.

While annual seasonality may not be a pressing reason to sell stocks this year, investors have no shortage of other reasons to be nervous. As we've pointed out numerous times, the Fed's interest rate tightening agenda is the key signal we've been watching for as a risk warning for stocks. Investors have plenty else to be concerned about in terms of the market's high valuations, plus the more general concern that comes from the stock market entering the 8th year of this bull market.

There is one change to make to DAA for May. Read on for the full details.

DAA is a core portfolio strategy that is designed to help SMI readers share in some of a bull market’s gains, while minimizing (or even preventing) losses during bear markets. The strategy involves using exchange-traded funds to rotate among six asset classes, holding three at any one time. DAA is a defensive, low-volatility strategy that nonetheless has generated impressive back-tested results, demonstrating the power of “winning by not losing.”

The recommended categories/ETFs for May are (in order of current momentum):