Three Secrets to Create Investment Portfolios That Make Money in Any Economic Environment By, Chuck Whitman

One year ago, we began to pound the table that Modern Portfolio Theory was broken. The traditional 60% Long Equities/40% Long Fixed Income was setting up to cause losses that investors were unprepared for. In fact, people were incentivized to take on even greater risk by assuming larger equity allocations because fixed income interest rates were so low.

One year later, our prediction has proved to be prescient. The model, which is diversified between 60% equities and 40% bonds, is getting killed. In fact, 2022 is one of the five worst starts to a year for stocks and bonds since 1939, with both stocks and bonds down double-digits. While the 60/40 Portfolio is -12.8%, our High Yield Portfolio is +4.8% on the year.

Why is this? While US Bonds did well as a hedge against equities in the coronavirus crash, we now have an inflationary backdrop that is bad for both stocks and bonds, often at the same time.

Today, we are going to share with you Three Secrets to Create Investment Portfolios That Make Money in Any Economic Environment. The secrets we will discuss today is why our High Yield Fund beats the 60/40 Portfolio by +17.6% YTD.

Wouldn’t you like to have access to strategies that benefit from inflation when inflation flares, and yet still have a better reward/risk than stocks alone when inflation is not flaring? We are going to show two of many such strategies today and how you can access them.

Before we get into the specific strategies, it is important to highlight the Three Secrets.

Secret #1 – Strategy Allocation vs. Asset Allocation. While there are benefits to an Asset Allocation approach, (i.e., diversification within an asset class), there are even greater benefits to a Strategy Allocation approach by diversifying strategies within an asset class.

In the Strategy Allocation approach, risk is managed at the individual strategy level and not aggregated to the portfolio level. Additionally, open protective and trailing stops are used for each instrument based on the characteristics of that specific instrument.

The Strategy Allocation Approach allows us to be more nimble as well, as a strategy can allow us to participate more substantially when strong trends develop, while cutting back exposure when strong trends are not proliferating and reduce drawdowns.

Secret #2 – Diversify Across Three or More Strategies. Ray Dalio says, “If we can invest in three uncorrelated strategies, we reduce our risk by 50%. If we can invest in fifteen uncorrelated strategies, we can reduce our risk by 80% and improve our return/risk five times.”

Note that Ray describes three uncorrelated strategies, not asset classes.

Secret #3 – Create a Blend of Strategies That Make Money Across All Four Economic Seasons. We want to create a portfolio of strategies that each do well under different economic conditions. In the quadrant below, we can see the Four Economic Seasons in a Matrix. The four seasons are: Inflation, Deflation, Economic Contraction, and Economic Expansions. If we use the Dalio approach and combine it with Strategy Models that give diversification for the different economic seasons, we create a portfolio that should be robust through all economic seasons.

Our Portfolio Strategy Letter (PSL) follows this approach by allocating to different strategies. The strategies implemented exploit multiple asset classes and benefit from different economic seasons. By taking this approach, the portfolio avoids underperformance due to individual asset class price fluctuations. Instead, the portfolio includes asset classes mainly when they benefit from the current economic season (i.e., take advantage of dislocations in markets with a strong reward to risk opportunity). Ultimately, Strategy Allocation reduces drawdowns and makes it easier for investors to stay with the strategy.

In the Strategy Allocation approach, risk is managed at the individual strategy level and not aggregated to the portfolio level. Additionally, open protective and trailing stops are used for each instrument based on the characteristics of that specific instrument.

This approach allows us to be nimbler as well. A strategy can allow us to participate more substantially when strong trends develop, while cutting back exposure when strong trends are not proliferating, and reduce drawdowns.

For example, our Uncorrelated Fund Strategy is one of our many commodity strategies in the PSL and has been in existence in real-time for just over 18 years. Because our aggressive commodity Uncorrelated Fund Strategy exploits strong trends in commodities and commodity-related investments in either direction, it can actually make money, whether commodities are trending higher or lower, as long as some commodities are trending. This makes the strategy profitable during both economic expansion and economic contraction, and during both inflation and deflation or disinflation. This is not just a theory. The strategy produced gains in 17/18 years (94%) and was down less than 5% in its negative year, while producing over 800% returns during those 18 years on a lower than 18% maximum drawdown.

The reason the 60/40 Portfolio is getting killed right now is because it does not have any exposure to investments that can benefit from inflation. Commodities benefit from inflation, but to turbocharge your gains and slash the risk of investing in commodities, you can invest in one or a group of commodity strategies.

A lot of investors and traders do not pay enough attention to commodity prices. At key inflection points, they are incredible leading indicators and can give important clues. The March 2020 lows were a great example. We highlighted major basing patterns in the CRB Commodity Index, in oils, and in base metals that have met objectives and confirmed broader economic upside that vaccines have turbo-charged.

Back in October 2020, during the biggest correction commodities have had in this recovery, we wrote in our On the Horizon column about a potential commodity super-cycle higher, something we also discussed as being likely eventually back in 2018. We were already getting more and more signals that this scenario is indeed developing, but the Russian-West conflict has sent the commodity super-cycle into instant overdrive.

The first head & shoulders base breakout in the CRB was in our PSL in June 2020. A larger base breakout occurred in November and again in June 2021. The original upside objective has already been hit in the CRB around 300, but larger bases now project a further run to new all-time highs in the CRB eventually, above 467.

Commodities are over-extended, into resistance, and could correct sharply at any time. The move illustrates the importance of having consistently applied commodity strategies that get one into commodities early enough that you do not miss them when they explode higher.

The CRB index has hit minimum upside targets already and has accelerated sharply higher on the Russian conflict – larger pattern targets are now at new all-time highs above 467 eventually – although a sharp correction could develop anytime, and next resistance has been reached.

Courtesy StockCharts.com

We look for substantially more upside and relative strength from commodities ahead in this recovery, but we may have to endure more volatility in what is becoming a roller-coaster ride. A prolonged Russia-West conflict could send commodities sharply higher, far above the 2008 all-time highs, although we suspect that is not the most likely scenario ahead. A peace agreement over the coming months is more likely, which could lead to a correction in some commodities, but the super-cycle bull market is likely to obtain until recession becomes imminent.

Big bull markets often start with a bang, and the highest rate of change in decades for the CRB, off the 2020 bottom, certainly qualifies as a bang. The trend is up for commodities and a sustained period of relative strength may lie ahead. Although, corrections and consolidations may happen at any time in these over-extended markets, while a global recession could eventually make matters worse for commodities.

Our commodity strategies did reasonably well in 2019 and 2020 and made some gains in 2021 as well. 2022 is starting out with continued nice gains so far, and commodities have been a primary holdout to the overall stock correction underway this year. This crucial diversification into commodity-related strategies has been a key to consistent gains for our portfolio overall since 1992 and has really saved our overall PSL portfolio so far this year in 2022.

Our Commodities strategies have provided needed diversification for us during past global equity bear markets (overall) in particular, providing a nice buffer and alternative long-term gaining strategy for us. Although in sharp corrections (the non-bear-market kind) they often do not provide much smoothing, However, in the current major equity correction they have proven to be a valuable offset.

Maintaining this diversification into commodity strategies is rather important. If a renewed downtrend develops again, or if inflationary concerns continue to flare more sustainably, that importance will grow. Bonds do not hedge against rising inflation (or concerns about rising inflation), but commodities strategies usually do. And bonds are wildly overvalued currently because of central bank intervention, so they may not provide as much of a cushion in the next bear market in stocks as they have in the past. Notice that bonds have not been a cushion in the equity correction so far, while commodities have.

US Bonds did well as a hedge in the coronavirus crash, but German and Japanese bonds (where rates were lower) did not provide a hedge. With rates so low in the US now, they are not likely to provide as much of a hedge in equity-bearish periods ahead, particularly in periods where inflation is also a concern.

It’s likely the problem isn’t over either. The Fed is historically lagging beyond inflation and the neutral rate, which probably means much more rate-hiking and Quantitative Tightening. As rate hikes get going, historically, it gets to be less fun for stock markets. Normally, the Fed must hike until a riot-point in stocks, bankruptcies, the labor market, or in weakening economy increasing recession risk. Eight of the last nine times the Fed raised rates to fight inflation, recession eventually followed.

Aggressive Model Commodity Portfolio

Here is an example of one of our many commodity strategies, and one strategy that tends to improve gains during inflation and recession historically: Aggressive Model Commodity Portfolio.

Each month we apply a number of trend-following patterns to ETFs in the major commodity markets, and producers and commodity-related industries, including grains, meats, softs, precious and industrial metals, energies, indexes, currencies, stock indexes, bonds. A strong trend rating and a high reward/risk pattern leads us to enter with Open Protective Stops and a trend following methodology using trailing stops. We use relative strength, WAMRS, various trend following methodologies, pattern recognition, runaway trend characteristics, support-resistance, and other tools to assess each market and scan for solid reward/risk patterns for rule-based trades.

We have published our model Aggressive Commodity Portfolio for 217 consecutive months in our PSL. The portfolio started with $50,000. We traded our own best long-term commodity trend trades, as well as a diversified portfolio of seasonal trades we have been trading since the early 1980s, is now worth $453,071 at new equity highs and up +0.25% since the last PSL. 2020 had a +13.35% return in our aggressive strategy. 2008-19 and 2021 have shown average gains of around 5%-6%, 2007 and 2021 were slightly up-flat but 2006 gained 7.5%, 2005 gained 4.9%, 2004 up 9%, 2003 up 21.3%, 2002 +19.4%, 2001 +26.6%, 2000 +50.5%, and +40.2% for 1999 (on around a 16% drawdown). Remember that drawdowns around 20% can happen in this portfolio from time to time and must be endured at some point. Nonetheless, we expect continued gains on an annual basis in this model portfolio.

In summary, to create robust portfolios that you can invest with confidence, remember the Three Secrets:

  1. Choose Strategy Allocation instead of Asset Allocation
  2. Invest in at least three (the more the better) Uncorrelated Strategies
  3. Add strategies that show diversification through all Four Economic Seasons.

These Three Secrets help you avoid years like 2022 where everything in your portfolio is a loser!

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