The Sleep Well Portfolio at a Glance - 1/18/22

Listening to the Market

SPY (Large Caps)

  • We have been calling for a slowdown in equities since September of 2021. Wow were we early. Everything else collapsed around the SPY and we are now flat for the SPY since September of 2021. The data is now coming in for the 4th Quarter of 2021 and it looks like we were right fundamentally. Sales and profits slowed. Trigger Fed tightening at the same time, and we have a perfect storm for Q1 and Q2 of 2022. Currently, we have strong support at current levels. Triple bottoms rarely hold… Likely to see a bounce, follow-through will likely be lacking unless the Fed reverses course.

  • One Month Risk Calculation – Risk Increasing


TLT (Bonds)

  • This week we saw more selling in bonds and the yield curve flattening. We have a way to go for an inversion, but we are seeing the writing on the wall… Bonds are expensive. If the Fed does get to tighten, the ensuing collapse in Q2 will likely call for a reversal of the Fed’s stance. What is more important, the stock market and economy or inflation? We wait for Bonds to achieve equilibrium with stock risks before moving into a long bonds/long dollar position. Yet again we see that Bonds are not the friend they once were. Inflation kills bonds’ correlation to stocks. Gold?

  • One Month Risk Calculation – Risk Decreasing



GLD (Consumer Goods Inflation)

  • After a long year of correlation breakdown in gold, we are finally getting back to a normal gold relationship with TIPs. My favorite asset is gold this quarter. Q2 will likely still have a strong allocation to Gold. We learn some things in selloffs and we learn more in rallies. Gold is telling us “I’m Back”.

  • One Month Risk Calculation – Risk Decreasing



UUP (US Dollar Relative Deflation)

  • Still negative risk for the Dollar in the first quarter. With the recent selloff in the dollar, it started to look attractive in the short term. We wait until we get closer to Q2 when we get Global inflation/ Dollar deflation/ growth slowing. Right now we still have our models saying dollar inflation, this tells us to ignore buy signals in UUP.

  • One Month Risk Calculation – Risk Unchanged



IWM (Small Caps)

  • This is where risk management shows its strength. IWM is down over -20% from the highs set in Q3 when we said things were getting tougher for equities. Small caps are still a risky asset even at these levels. Moving into a slowing growth and deflation dollar Q2 we are going to remain skittish of IWM.

  • One Month Risk Calculation – Risk Unchanged


EEM (Emerging Markets/ Relative Inflation)

  • If we had a signal for investing in equities right now EEM would be the favorite. With a general sell-off in risk, EEM is out of favor for the portfolio. For all of those short-term traders out there, EEM is a great long in Q1 but only for some short-term swings to balance out any bear positions in small caps or tech.

  • One Month Risk Calculation – Risk Decreasing


Drivers for Current Portfolio Allocation

This is the beginning of a huge Federal Reserve mistake. Yet again the Fed is behind the curve. Begging the new year with the surprise aggressive hawkish tones, equities are telling the Fed that tightening in Q1/Q2 of 2022 will be painful.

All of Q4 The SWP was being very cautious due to what our models were seeing for Q1 and Q2 of 2022. Doing this during DDs of the SPY Q4 2021, created a temporary loss in the SWP. We were clearly too early for large caps but not for small caps and emerging markets. Our models were pricing in tapering for Q4 of 2021, with the Fed being sluggish, we had to adjust. Now every risk manager on earth sees the writing on the wall.

We will surely see bounces in stocks on the way down but it will get uglier as long as the Fed chooses to be hawkish while the economy has organic slowing growth.

Bonds are beginning to look attractive but are a long way from getting a positive allocation until we see some dollar strength. We are likely to see this in Q2 2022.

Gold is the “man” in Q1 and Q2. We just missed an aggressive allocation to gold this week. As long as gold holds its correlation to TIPs and rate-sensitive assets we will surely get an allocation to it next week. With Oil still shooting higher and rent YOY growth being at records, inflation will be elevated. Elevated inflation and yields dropping are strong buy signals for gold. Yes, rates haven’t dropped yet but they are likely to slow down or reverse as the Fed realizes that they skewed up. Future J Powell... "Just forget we ever said rate hikes and tapering, we are going to buy everything again".

Risk-off, until the Fed starts to change their verbiage, or we get to Q3 2022 first.

Weekly Topic of Interest

Cash is a position

I have been called out for not using a typical cash position in the SWP/AWAKE. The Idea of the SWP/AWAKE is to be in assets that have grown over the long run as much as possible. Being in cash doesn’t pay in the long term.

To push this to an extreme we can look at the opportunity cost of a cash position over the last 10 years. On average we have seen a loss of -2.47% per annum of purchasing power for the dollar (Fed calculated CPI). Invested in a savings account earning +0.50% that puts us at a loss of -1.93% per annum.

What if we put $100K in a savings account, what would it be worth today in purchasing power? We would have the equivalent of $78.4K. This is just the average purchase power loss. If we were saving for a house, it would be the inverse of growth in the housing market… closer to $48K equivalent. Dang, what a bummer for the savers out there!

This is why the Fed targets positive inflation. Positive inflation means investors can’t save due to purchase power loss. As inflation soars, the need for higher returning investments grows. Now we see why stocks have been pushed to the moon and every dip is bought.

Invested in a stable portfolio we could estimate a minimum of 10% return per annum. Quick math would leave us at $259K. To be fair we will remove the purchasing power as well from the 100K initial investment. That leaves us with $237.4K and a grand total return of +137.4%, all in a conservative portfolio.

When moving into cash, it is important to remember the opportunity cost if we are wrong. Cash is a losing position guaranteed, thanks to the Fed! So why do we ever move into cash?

It’s a rare thing in the world of SWP to be in all cash. In the AWAKE it is more common but still rare. Here are the dates of all Cash positions for AWAKE and the large-cap market returns over the following week…

  1. 5-27-2008 +0.17%

  2. 1-19-2010 -0.65%

  3. 4-9-2012 -0.85%

  4. 8-13-2012 +1.01%

  5. 8-10-2015 +0.01%

  6. 8-31-2015 -0.12%

  7. 9-8-2015 -0.72%

  8. 9-14-2015 +0.75%

  9. 12-7-2015 -2.62%

  10. 4-2-2018 +1.37%

  11. 9-27-2021 -3.16%

  12. 12-20-2021 +4.90%

  13. 1-10-2022 -2.03%

  14. Current

Average of -0.14% and a sum of -1.94% that is with the crazy rally we saw last month included. Without that one week, the numbers are far worse. If we were to look at all assets and average them together during these times, we get -0.19% and a sum of -2.48%. Over 13 data points in the last 14 years. It is very clear that cash has a less negative expectancy when our models are negative for all assets.
What causes all assets to trigger a no investment signal? Without getting into the model specifics, there are some commonalities during the times listed above.

  • All were times of elevated market volatility relative to short-term trailing averages.

  • All were times of dollar weakening.

  • All were times that Bond correlation to Stocks was positive over the short term.

  • All were times of slowing or tightening monetary policy

These times are particularly risky for the typical portfolio that depends on bonds for their risk reduction. In these typical portfolios Bonds are used to offset risk due to inverse correlations of stock/bonds, but in these times they begin correlating or losing at the same time as stocks.
The SWP/AWAKE will typically move to alternative assets like gold/emerging markets/dollar forex, but in the rare times that correlations converge and signal all positive relations to stocks there is no escape from the selling pressure.

In these times we will get the unique opportunity to hold cash in the short term until correlations diverge again, an opportunity presents itself again. Cash is a position, just not a great one unless everything else is worse.

Wrap Up

Gold is attractive right now and is the closest to breaking its correlation with stocks. As oil keeps rising the Fed will likely remain hawkish. This stance is very problematic for stocks and troublesome for bonds as well. Something to keep in mind… historically tightening fed = dropping bond yields. So far this has been false but will likely revert to true as the quarter progresses.

On the topic of Bonds… bonds become attractive at higher yields, with over 4 rate hikes this year already priced in, it is likely that bonds will bottom soon. Playing this all out in the medium term, gold will continue to rally, stocks will bounce but fail, and bonds will bounce and hold. Then later in Q1 2022, we will see the dollar strengthen. For the portfolio, we will likely see an all-alternative asset mix similar to late 2018, Covid 2020, late 2008, and mid-2011 until some broad buying or a weakening dollar pushes us back into equities.

May your assets grow and you Sleep Well,

Wayne Klump