The dramatic turnaround of the stock market from last Wednesday's all-time high through the steep losses of the past three days is complicating the release of the March issue!

Everything was ready to go for tomorrow, but in light of the evolving market situation — particularly as that impacts the potential for changes to our Upgrading strategy — we're going to hold off one more day and plan to release the March issue on Thursday instead.

I'll go into more detail in the new issue email (and perhaps a brief "market commentary" to be added to the March issue itself), but here are a few quick thoughts on what's been happening this week.

The stock market has been on quite a tear over the past few months. The S&P 500 index is up +11.3% since the third Fed rate cut happened last October 30, a span of about 3.5 months. It's up a whopping +17.2% since the October 8 low, right before the Fed ramped up its "not QE" Treasury Bill buying program alongside providing huge overnight liquidity to the Repo market, both of which continue to this day.

Let's take a quick look at how those numbers compare to similar situations in the past. There have been four other times in the past 25 years when the Fed has cut interest rates at least three times. The last two, in 2001 and 2007, the economy worsened and fell into recession, and the stock market tumbled. After the third rate cut in 2001, stocks fell -12.6% over the following year, while after the third cut in 2007 stocks plummeted -42.4% over the following year.

However, the two cases prior to those worked out quite well for both the economy and stock investors. In 1996 and again in 1998, a series of three rate cuts helped sustain the economic expansion, propelling it to become the longest (at the time) expansion on record (it has since been eclipsed in length, though not magnitude, by the current expansion). Stocks were up +24.8% following the third cut in 1996, and +19.4% following the third cut in 1998.

So the big differentiator between these two very different experiences was whether or not the economy slipped into recession, necessitating further cuts. The good news on that score is there is little to indicate the U.S. economy is in any imminent danger of slipping into recession. The not-so-good news on that front is the Fed Funds market currently shows a 70% chance of further cuts by September. Time will tell whether that comes to fruition.

I've written increasingly over the past 18 months or so about similarities the current market has with the market of the late 1990s. No two periods are ever exactly the same, but when you've done this long enough you start being reminded of certain things you've seen before.

That's happening to me more and more often. Mark Twain is credited with having said, "History never repeats itself, but it does often rhyme."

Yesterday I responded to a pair of readers who were feeling frustrated about the recent performance/behavior of SMI's Dynamic Asset Allocation (DAA) strategy. That response is buried 20 comments deep in an article published a week ago, so I thought it might be worthwhile to expand on those thoughts a bit here for a wider audience.

I'm sure they aren't the only ones wondering about DAA and whether they should continue to use it.

There are two changes to the DAA lineup for February. 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 when evaluated over full market cycles, demonstrating the power of "winning by not losing."

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

There is no change to the official SR recommendation for February. Read on for the details.

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.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” – Chuck Prince, ex-CEO of Citigroup, July 2007

There seems to be something about market highs that makes people want to dance. Or at least talk about dancing.

Twenty years ago, near the end of the dot-com stock market bubble, Warren Buffett likened the state of the market to Cinderella’s Ball in his annual shareholder letter. He wrote that investors — despite knowing that “overstaying the festivities...will eventually bring on pumpkins and mice” — nonetheless refused to leave the party until just seconds before midnight. He concluded, “There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

Fast forward to the period just prior to the housing bubble bursting in 2007 and we find the quote atop this article. In words that sound eerily familiar to today’s Fed-liquidity driven market, then-Citigroup CEO Chuck Prince uttered his infamous explanation of why his bank continued to lend aggressively despite obviously risky conditions.

It didn’t age well: just four months later, Prince was forced to resign because of massive losses from the bank’s mortgage holdings. Within a year, the whole global financial system would be engulfed in the flames of the subprime mortgage crisis.

More recently, the head of the world’s largest hedge fund started feeling that familiar beat. Here’s Ray Dalio, July 2017:

For the last nine years, central banks drove interest rates to nil and pumped money into the system creating favorable carries and abundant cash.... That era is ending.

[The central bankers will now] try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn. Recognizing that, our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.

Dalio was exactly right. As 2018 drew to a close, the Fed had taken eight baby steps toward higher, normalized interest rates. The ninth hike, in December 2018, would prove too much, sparking an immediate stock market correction of nearly –20% and intensifying concern over a global economic recession that has only recently begun to abate — as a direct result of the Fed reverting to spiking the punchbowl!

These quotes illustrate how market risks can rise to a point where it becomes uncomfortable to continue investing, even for top professionals. A few, like Buffett, simply refuse to play in that environment and wait it out. That’s easier to do when you’re already a billionaire; it’s not a practical option for most investors. Others, like Prince in 2007, ignore the growing risks and carry on unphased. While history looks unkindly on Prince, this is exactly what many index-fund investors are doing today, whether they realize it or not.

The last option is to follow Dalio’s approach: continue to invest, but make adjustments to account for the higher-risk environment. Sounds great, but how should a person actually go about doing that?

SMI’s approach to “dancing with one eye on the door” begins with the underlying construction of our strategies. All of them, other than Just-the-Basics, are trend-following strategies (and trend-following defensive signals can also be applied to JtB, if desired). This means we can have confidence the SMI strategies will never stay on the wrong side of the market’s dominant trend for long. When the market is moving sharply higher, as it did last year, SMI’s strategies will keep us dancing. But when the market weakens, they will force us to become more conservative (and in some cases, exit stocks altogether).

The past 18 months provide an extreme illustration of this concept in action. When the market dropped sharply at the end of 2018, our strategies responded by rapidly becoming more conservative. As we discuss in our 2019 Year In Review, that shift “cost” us additional gains last year, because the correction didn’t morph into a full-blown bear market — this time. If it had, our strategies were already positioned to stop the bleeding. When the market trend abruptly shifted higher, our strategies followed suit and still managed to post strong gains in 2019.

The most important step to take as market risk increases is to make sure your blend of SMI’s strategies (and overall portfolio stock/bond allocations) are appropriate. If they are, you can continue investing with confidence, knowing your portfolio won’t stay on the wrong side of the market’s trend for long. Given that no one ever knows what the market will do next, that’s reassuring.

As the calendar flipped from 2018 to 2019, few imagined the dramatic turn the financial markets were about to take. The stock market had fallen nearly -20% during the last quarter of 2018 and fear was palpable as 2019 began. But a dramatic shift in Fed policy — from nine interest rate hikes in 2016-2018 to three rate cuts in 2019, coupled with massive Fed stimulus late in the year that re-inflated the central bank’s balance sheet at a breathtaking pace — provided a steady dose of rocket fuel that propelled financial markets to new all-time highs.

JFK famously said, “A rising tide lifts all boats,” and that was certainly true of financial markets in 2019. Asset prices rose sharply across the board.

SMI’s model portfolios reflected these strong gains as well. Despite starting 2019 with very conservative allocations and fund selections (the result of following the rapidly falling market trend during the dismal fourth quarter of 2018), all of SMI’s model portfolios except one still managed to produce new all-time highs during the year. Ironically the one that did not, Sector Rotation, has been the standout performer throughout this long bull market — reinforcing the idea that little is predictable when it comes to investing. Hence, the best course is to diversify and maintain a long-term perspective!