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.