The Good Harbor U.S. Tactical Core strategy lost 0.5% after fees in June compared to a gain of 4.1% for the S&P500 Total Return Index, ending the second quarter of 2012 with a loss of 0.3% versus a loss of 2.8% for the index. This brings the year to date total for the Good Harbor U.S. Tactical Core strategy to a gain of 6.5% compared to 9.5% for the index. The Good Harbor U.S. Tactical Core strategy maintained a largely defensive allocation during the quarter after ending a three month run in equities in April and moving to a 100% treasury allocation for May and June. While the defensive move in May proved significant to the portfolio performance, with U.S. Tactical Core registering a 2.6% gain versus a loss of 6.0% for the index, the treasury allocation proved to be a laggard in June, giving back some of May's outperformance. Overall for the second quarter the U.S. Tactical Core approach gained 2.5% on the index.

June data present a mixed outlook for stocks. Equity momentum improved across the month, particularly for the small cap index. However bond momentum remained relatively steady, registering a slight decrease for the month but maintaining a positive level. The VIX spot index decreased significantly in June, falling nearly 30% to end the month at 17.1. The futures complex reflected similar sentiment with the near term contracts falling 20%-25%. Credit spreads widened slightly while on the economic front, the U.S. economic output level and growth rate decreased. On the yield curve side, rates increased across the board as did our slope measures.

While close to being a 50/50 mix between stocks and treasuries, the model ultimately moved into a full allocation to equities. Twice in the last three months the portfolio allocation has fallen near the 50/50 state, only to move marginally into one of the fully allocated modes. This highlights one of the potential drawbacks to limiting the portfolio states as we do with the U.S. Tactical Core approach. However, recall the motivation for using limited states is to impose large changes on the portfolio - something we believe is necessary in order to have a material impact on portfolio performance. Minor allocation adjustments, in our opinion, tend to offer little value to portfolio returns. As such, per the Good Harbor U.S. Tactical allocation model we have moved to a 100% equity allocation, moving from treasuries into an even mix of small cap and large cap exposure. Interestingly, this allocation does suggests some caution. A small/large allocation is fairly rare, happening only about 15% of the time when we are fully allocated to equities. The persistent strength in large cap momentum we've seen throughout the year may be a sign investors are still taking a somewhat cautious approach to equity risk - something to monitor going forward. Regardless, as usual, we caution our positive outlook on equities based on our tactical model does not mean equity indices are guaranteed to increase over the coming weeks. There are many economic and geopolitical factors that can certainly disrupt the equity markets in either direction with little to no warning. However, our research suggests when we see the kind of moves we're seeing in our risk premium measures, it is better to maintain equity risk. This has been our process over the last nine plus years and it is the consistent application of this process that is most critical to implementing a sound investment strategy.

The Good Harbor U.S. Tactical strategy is a tactical asset allocation program that attempts to align with the stock market when it's rising and move defensively when weaker equity prices are anticipated. One of the main tenets of the strategy is that U.S. treasuries outperform stocks during weak economic environments, and as such are a useful defensive investment vehicle. In previous commentaries we explored the usefulness of an investment in treasuries during recessionary environments. We also analyzed the effectiveness of the "safe haven" quality as a function of yield levels, showing that U.S. bonds tend to perform well as a defensive allocation during both low and high interest rate markets. In this segment we take a closer look at treasury performance during various inflationary environments.

Figure 1 below illustrates the Year-over-Year (YoY) change in the Consumer Price Index (CPI) going back to 1914 (source: Bloomberg). As shown, over the last one hundred plus years the markets have gone through various periods of inflation and deflation.

Figure 1: Year over year change in CPI. (Source: Bloomberg) 

Ranking the changes in CPI from lowest to highest and grouping into deciles provides a view into the performance of treasuries during deflationary periods (i.e. negative CPI growth) and inflationary periods (i.e. positive CPI growth). Since the goal is to establish whether treasuries are a useful safe haven from equities, it is useful to isolate the performance of treasuries during negative S&P 500 months. The idea being that it is during negative S&P 500 months when the U.S. Tactical Core strategy should be more likely to have a defensive portfolio. Table 1. below details the results.

Table 1: Treasury performance across varying inflationary environments.

Figure 2 below further summarizes the results by plotting the average change in CPI by decile against the average outperformance of treasuries.

 Figure 2: Regression of treasury outperformance against CPI decile.

From the data it is clear that while the amount of treasury outperformance does decline as inflation increases, treasuries are still useful as a defensive investment. In all deciles treasuries have outperformed stocks during negative stock months and in all but two deciles have maintained a positive average return during negative equity months. It is this combination of outperformance and positive return capability that make treasury indexed products a useful tool in the U.S. Tactical Core investment universe.