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2022 has been a rough year so far. Bonds and equities are falling in tandem, meaning a traditional 60/40 equity-bond portfolio has had a brutal year. Therefore, I have been investigating new ways to structure a long-term passive portfolio to survive any market environment.
Fade the Hype
With the rise of social media today, there have been many Furu’s and Guru’s advising young investors to buy the S&P 500 Index, and they would be guaranteed a great return. Let’s investigate these claims.
It is true that on average, the S&P 500 Index has returned around 9% per year. However, that has not come without periods of inferior performance.
S&P 500 index 1922-1955, Source: TradingView
From the peak of the market in 1929, it would have taken 23 years for investors to see positive returns once again. Investing just isn’t that easy.
Also, having read Ray Dalio’s book, ‘Principles For Dealing with The Changing World Order’, I have learned that the average lifetime of an empire is about 100 years. The British Empire and several Chinese Dynasties are examples of this. The US Empire of today has been around for over 100 years now. I am by no means suggesting that the US will fall tomorrow. However, I am suggesting that we should consider as investors that there is a chance after 20 years of US outperformance that there could be a period of poorer returns in the future. In my opinion, it would not be wise for a young person today with a 50-year investment horizon to put all their eggs in one basket, and buy the S&P 500.
Broadly speaking, there are four main regimes that investors need to consider. This was highlighted in one of my past articles. Accounting for these categories, I would build an equal weight multi-asset portfolio designed to perform in any environment. (Don’t worry, this portfolio was designed by someone a lot smarter than me – see more here).
Regime 1: Inflation
Inflation usually arrives as we come out of an economic downturn. Demand picks up as consumers become more confident about their financial position. This causes prices to rise as people buy homes and spend on goods and services. This environment usually benefits commodities, which have historically performed well in times of heightened inflation or ‘reflation’ as the economy kick-starts again. An example includes November 2020, when the news of a vaccine broke.
For this environment, I would add 10% to diversified metals and mining trusts such as BlackRock World Mining Trust, 5% to a commodity trading adviser like Mulvaney Global Markets Fund, and 5% to stable individual miners that are likely to survive for many years to come. Examples I can think of include Alcoa and Glencore.
Regime 2: Dis-inflationary boom
In the second environment, inflation is slowing but demand is still strong. The consumer is spending and banks are lending, so money flows through the system smoothly. Generally, people are optimistic about the future. The end of 2020/the first half of 2021 would be a good example.
For this environment, I want to own equities. I would allocate 5% to 3 index funds. S&P 500, MSCI World Index and Vanguard Emerging Market ETF. This would give me exposure across the globe. With the other 5%, I would add individual stocks at attractive valuations, in the hope of outperforming further – this is often referred to as a ‘core and satellite’ strategy.
I have decided to add a fifth segment into my equal weight portfolio called ‘momentum’. About 86% of the time, stock markets are rising, so I believe having a larger weighting toward stocks will benefit a long-term investor with a long time horizon (me). A momentum strategy buys winners and hopes they continue to win. Such strategies were dominated by companies like Amazon which have been proven to win over many years but have recently flipped to add in oil companies which are now outperforming.
Momentum outperforms it all - Momentum (Blue), S&P 500 (Orange), FTSE100 (Yellow), Gold (Purple), and MSCI World Index (Turquoise), Source: TradingView
For this environment, I would add 20% to a low-cost ETF such as iShares World Momentum Factor UCITS.
Regime 3: Stagflation
Arguably the worst environment is stagflation. This is when growth is slowing/low, and unemployment and inflation are high. This is difficult because central banks are stuck between raising rates to kill inflation and taming policy to reduce unemployment and/or improve growth. Does this sound familiar? This is the environment we currently find ourselves in. Central banks are aggressively raising interest rates to tame inflation and are willing to sacrifice the economy to get there.
In this environment, precious metals perform well. Relative to other asset classes, gold has been performing excellently, especially for UK investors due to recent falls in the pound. If central banks did not raise rates or decide to pivot before inflation is brought back to the 2% target, precious metals will skyrocket. This is exactly what happened in the 1970s. I would add 12% to WisdomTree Physical Gold, 5% to WisdomTree Physical Silver, and add 3% to Bitcoin. I hope this protects my money from currency devaluation in the long run.
Bitcoin & Gold allocated based on volatility outperforms, Source: ByteTree Asset Management
Regime 4: Deflation
The final environment comes as times get tough. People spend less, banks aren’t willing to lend, and the economy slows. A recession is imminent/present, and growth is nowhere to be seen. **Inflation is falling or negative (deflation)!** 2008 is a good example.
In this environment, I want to invest in secure assets that pay a safe yield. I would allocate 5% to a capital preservation trust such as Ruffer Investment Co, which can actively manage my money. With the final 15%, I would allocate capital across various duration bond ETFs, such as iShares TIPS ETF, iShares Treasury Bond 7-10yr ETF, and iShares 20yr+ Treasury Bond ETF (5% in each).
Now, back to the starred & underlined part…
Many investors have got the regime incorrect this year, and have purchased bonds to hedge falls in stocks. As you can see below, this is detrimental to portfolio returns.
Buying bonds at the wrong time can seriously damage your portfolio returns. US 20+yr bond (Blue) and S&P 500 Index (Orange) Return Year-to-Date, Source: TradingView
There have only been several other occasions when bonds and equities have fallen substantially together. The most recent time (apart from this year) was in 1969, when Americans experienced runaway inflation resulting from a combination of loose monetary policy, generous fiscal stimulus and energy supply disruptions. This sparked a decade of higher inflation. Sound familiar?
This makes me wonder whether we are entering a new regime, where we experience structurally higher inflation and a positive correlation between bonds and stocks. If so, this is very worrying, since the financial system is built on this correlation holding (e.g. UK Pension Fund panic two weeks ago).
Are we entering a new (old) regime? US 10yr Note Yield (Inverted - Orange) and S&P 500 Index (White). Correlation on bottom chart, Source: Bloomberg
For this reason, it is a good idea to invest across duration and asset, to protect against any potential regime shift. After all, the point is to have a passive, no-thought portfolio!
In investing, nothing is guaranteed. However, from the research I have conducted, this seems like the most balanced way to obtain growth in any investment environment.
But How Do You Know
For those of you who are interested in a more active investing approach, identifying the regime and allocating capital accordingly, below is a list of indicators I use to identify the current investment environment. Links to where you can find each indicator is linked in the name;
10yr-2yr government bond yield curve: How a central bank’s hiking cycle is affecting the economy. If it’s below 0, a recession is more likely
10yr-3mth yield curve: Good indication of banks’ willingness to lend. Banks borrow on the short end and lend on the long end. The lower this spread, the less likely banks are to lend to people and therefore the less money flowing through the system
ISM Manufacturing PMI: How businesses are coping in the current environment. Below 50, the manufacturing sector is entering a contraction
Forward US CPI expectations: How the market is pricing US inflation at present. If I disagree with current pricing, I can make investments accordingly
Implied Fed funds rate: How harsh is the Federal Reserve priced to hike interest rates in the future? Is this too high or too low? Once again, I can then make investment decisions accordingly
New home sales: Indication of how credit is flowing through the system, and banks’ willingness to lend. Be aware this is a lagging indicator. The Fred website attached for this indicator is great for finding any US data including; Retail sales, The Feds balance sheet, Mortgage applications, Auto sales and many more indications of the shape of the US economy.
These are just a few of the many indicators that I use to monitor current economic conditions. If you would like me to write a full article on lots of indicators (or any other topic for that matter) to help you build your market knowledge then let me know by emailing me at thesparknewsletter@gmail.com.
The Spark Portfolio
There have been no significant changes to the portfolio in recent weeks, aside from the sale of Meta Platforms (META) and Airtel Africa PLC (AAF). These positions were closed mainly to reduce volatility and protect capital in the portfolio. I am finding it increasingly difficult to find places to put cash at present. It seems cash is king in the current environment.
On a final note, for any new reader wondering how I disclose position changes, for full total transparency, every opened/closed position is posted on a weekend, with the price bought/sold taken from the close of markets on Friday. If you would like to receive live updates of portfolio changes, then please sign up to our mailing list.
Portfolio Return Year-to-date: -4.8% vs S&P500: -25%
Total Return since inception (20/09/2021): 1% vs S&P500: -18%
Let me know your thoughts by emailing me at thesparknewsletter@gmail.com
See you next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.