THE SITUATION

The current economy, marked by the combination of high and rising inflation, low unemployment, and the near-zero interest rate policy by the Federal Reserve is like none that investors have experienced, at least over the past 40+ years.  The uncertainty of the situation has resulted in falling prices of both stocks and bonds at the same time–also a first in a very long time.

 At this writing the aggregate U.S. Bond market (AGG) is down nearly 12% year-to-date, Treasury Inflation Protected Securities (TIP) down 8.4%, and U.S. stocks as measured by the S&P 500 (SPY) are down 22.4%, what is known as correction territory, defined as -20%.   

THE PROBLEM

If you are feeling uneasy about your investments, rest assured that you are not alone.

Now, most investors, and many professionals, follow the routine that has been popularized as asset allocation. You likely know the drill: own a basket of individual securities and / or funds of traditional asset classes such as cash, stocks, and bonds.   Allocate the entire portfolio across those asset classes and periodically rebalance the portfolio back to those prescribed allocations. In this strategy, you wash, rinse, repeat and your investment portfolio will be safe, or so it goes. The portfolio objective of this strategy is to achieve market-like returns within the particular asset classes while reducing volatility of the entire portfolio by holding securities that move counter-cyclically with each other. In other words, the theory assumes that total upside and downside volatility, not loss of capital, is the chief risk that we investors face.  But let me ask, won’t we accept, even desire, all the upside volatility we can find?  It’s the downside that keeps us awake at night, right?  But what happens when all the usual asset classes are declining at the same time?  Turn to cash?

Thanks to Federal Reserve policy, the interest rate on cash remains at nearly zero.  With inflation running rampant at about 8%, holding cash while we wait for the markets to settle down means that purchasing power is evaporating. 

Remember that the Fed only controls short term interest rates.  The bond market controls the rates of longer-term bonds.  The interest rate on a bond is fixed at the time it is issued. The bond market fulfills its function by bidding up or down the price at which it is willing to buy bonds.  As interest rates that the bond market considers attractive increase, the price of the bond must fall to provide that rate. That is why your portfolio of bonds decreases in value as interest rates rise.

I am sure that you probably think the current market only presents a problem.  However, we invite you to join us in seeing it as an opportunity.  Please look at your portfolio performance (both the percentage return and the number of dollars gained or lost) for the trailing twelve months.  Assess how you feel about that.  There is a strong chance that current stock and bond losses will get worse before the markets turn around.   If you are losing sleep now, just know that although not guaranteed, things can get worse and that you have a wonderful opportunity to accept or adjust your risk tolerance. Now is a good time to assess your risk tolerance and to inform your advisor so that he or she can take steps to align with reality.

OUR SOLUTION

In 2002, while still attending to the tenets of traditional asset allocation, we began to select stock and bond mutual fund investments based, in part, on momentum. Each asset selected for the portfolio was growing at a faster rate than its peers. We likened our analysis to watching a horse race and seeing a particular horse moving through the pack toward becoming the leader. (Just to be clear, we don’t invest in race horses or advise that our clients do that, despite being from Kentucky.) Often we found the need to get on a fresh horse (investment) at the quarter-mile pole. Initially, we invested in this way without imposing risk controls of selling those securities that lagged the others.  We called it our Momentum Growth Strategy. This subjected the portfolio to drawdowns consistent with the market.

In 2007, we became aware of the work of Dr. Mordecai Kurz at Stanford University.  Dr. Kurz posited that most of the risk in the market is endogenous to the market and not to some outside forces. This discovery has far-reaching significance. We then asked our clients with which they were most concerned: a) failing to achieve market returns or b) losing their capital.  Many responded that they were more concerned with the latter.  In response, we developed the Wealth Preservation Strategy just in time to prevent significant losses in the 2008 downturn for those clients who chose that strategy over the Momentum Growth Strategy.  This strategy also worked very well to protect capital in the downturns of 2011 and 2018.    

One aspect of the Wealth Preservation Strategy has been the use of technical analysis to determine the entry point for adding new securities to the portfolio mix. Attention to risk controls for each individual security and position sizing are other aspects of the strategy designed to control drawdown. We did not allow small losses to turn into big ones. The strategy also usually carried a rather significant allocation to cash. This works as long as inflation remains low or non-existent. But now we are at a different place and a different time.

As the markets’ access to free capital via the Fed’s zero interest rate policy kept driving up the stock market, it was quite normal for some investors to totally abandon Wealth Preservation for the sake of seeking higher returns. 

At times like the present, when all the usual asset classes are turning down, we instead hear investors clamoring for more Wealth Preservation. By the way, when it comes to investing, any inclination to either “throw in the towel” or “to go all in” is usually a mistake.

So, what is a person to do?

1. Invest the Wealth Preservation strategy to minimize volatility and in such a manner that will preserve purchasing power with capital appreciation at least as much as inflation.
2. Adjust Momentum Growth Strategy to a higher risk / higher return portfolio using technology and market trends along with fundamental analysis designed to pick top performers.
3. Blend the two strategies in proportions that will attend to your individual tolerance for drawdowns while seeking a return that addresses your objectives.

Rather than mandate the allocation to particular asset classes, i.e., stocks and bonds, we might allocate a portion of assets to each of the two strategies. The amount to allocate to which strategy will solely depend on one’s risk profile that has been mathematically determined i.e. tolerance times capacity. Regular rebalancing is also important and should be done quarterly or quantitatively when the total portfolio gets out of balance.  The more risk tolerant you are, the greater percentage of your overall portfolio should be invested in Momentum Growth.  Wealth Preservation will protect from further drawdowns. We have made a concerted effort to ascertain our clients risk tolerance on a 1-5 scale of Conservative, Moderately Conservative, Balanced, Moderately Aggressive, or Aggressive. 

We will also choose assets that we believe will perform well in the current economic environment.  Consequently, you will likely be able to retain some of your current investments, but we may also invest in ETFs that track commodities, precious metals, and real estate, rather than exclusively in traditional stock and bond ETFs. We may also recommend that, at times, you invest in a reverse-index ETF that moves in opposite direction of its index. Hopefully, these are not long-term investments as they are expected to perform well while the market is going down and inflation / interest rates are rising.  We can only hope that policy makers will soon get our economy back on track for sustainable growth.  Meanwhile, we must all dance to the music we hear.

You are likely to have questions about this and, as always, we welcome them.

May 25, 2022 and updated June 20, 2022