The Sleep Well Portfolio at a Glance
Diversification
SPY (Large Caps)
Equities remain risky but have risk-on characteristics over the last week. Overall we are still cautious about US equities in the first half of 2023. Inevitably this will shift but not before earnings crater. We got our first taste of earning season after Goldman Sachs posted its largest earnings miss in over a decade. This will be the story all the way through this earning season. YOY earnings are going to be significantly lower. To some extent, we could argue that earnings expectations have been revised down but are still high for many companies that will have to report the reality of contracting economics.
One Month Risk Calculation – Risk Unchanged
TLT (Bonds)
The back end of the curve sinks further. What does this mean? Lots of media will tell you this is because a recession is coming. While that is mostly true, the real reason is due to longer-term expectations of inflation being less than shorter-term ones. This typically precedes a recession because a monetary tightening cycle is coming. Well unless you have been on planet mars for the last year we knew that already. The collapse stage is when the back end of the yield curve drops and the front end of the yield curve drops simultaneously. This would tell us that inflation is turning into disinflation or deflation. Unlike what the media would like us to think, disinflation is bad for risk assets historically as capital flows from risk assets to fixed assets.
One Month Risk Calculation – Risk Decreasing
GLD (Consumer Goods Inflation)
Gold is still surprising to the upside. Well, the USD is tanking and the Fed is planning on letting Inflation run hotter in this next recession. When the reserve currency is allowed to inflate and there is slowing growth we have a perfect storm for Gold. Now it's not a perfect asset and unlike the moves, it has had to this point, it doesn’t go straight up. As the Fed does tighten one more time or even a few more, gold will have some dips. We have started to scale out, more in AWAKE than SWP but still, we are at the point where we will prefer to move into other assets.
One Month Risk Calculation – Risk Unchanged
UUP (US Dollar Relative Deflation)
The USD is still losing ground vs other currencies. This is what happens when we have a Fed that is scared of deflation. I talked about the Fed attempting to stay behind the curve on purpose and erroring on the side that the bond market would come back to them on our monthly meeting. That is exactly what we have now. The Fed is already talking about slowing down their interest rate hikes even more and we still have above 6.5% inflation YOY. As other central banks have to deal with even higher inflation they do not have the luxury of being easy. Due to this relationship, we will have a Dollar that errors on the side of down with only small blips up during this collapse stage.
One Month Risk Calculation – Risk Unchanged
IWM (Small Caps)
Do not be fooled by this week's allocation. Financials are a very bad place to be during the collapse stage and IWM is heavy in small banks. Also, IWM has more volatility than SPY. This makes the risk off nature more detrimental to IWM vs SPY. Overall we will still err on the side of caution even though we see remnants of risk on behavior. The underlying reason for the risk on improvement for equities has been the debasement of the dollar. Well, the Dollar is not going to zero, so as soon as it stops we will see the asset recession continue.
One Month Risk Calculation – Risk Unchanged
EEM (Emerging Markets/ Relative Inflation)
EEM has been on a tear with Gold and Bonds Correlating strongly. This is yet another sign of easing monetary policy leading into the Collapse stage. The Fed is early on this round which has given artificial hope to risk assets. Inevitably reality will sink in and risk assets will fall again. As long as the Fed is killing the Dollar though, EEM will be the least risky equity exposure.
One Month Risk Calculation – Risk Decreasing
Drivers for Current Portfolio Allocation
Finally some diversification for our portfolio. AWAKE is almost into a 60/40 Equity to Alternative mix and SWP is just fading out of Gold. As the volatility of assets took a nosedive this week last week we are more willing to scale into them. That of course comes with the caveat of a volatility event will scale us back out. This is the likely scenario over the coming weeks as we inch closer to the Fed meeting.
We have fully priced in a 25 basis point rate hike in the next meeting. Any deviation from that will be a surprise. Inflation is falling faster than our models were predicting and that will likely give hope to the bond market. History tells us that inflation is not fleeting and will only be subdued momentarily during the collapse stage. As the economy heats back up and onshoring picks up, inflation will likely roar back. This second surge of inflation will be the headwind to the next bull market in US equities and will benefit emerging markets.
I will be covering the yield curve during collapse stages at the SWP QA at 3 PM Pacific today. The Collapse stage is set up and all that need to happen is capital flows moving into bonds with a strengthening dollar. This setup is how all crashes happen in recessions. For now, the dollar is getting pounded, but actually, bonds are seeing high capital flows. This is classic distribution and bottom fishing. The worst is yet to come unless the Fed coos like a dove. Our allocation in SWP is still very cautious and AWAKE is riding the edge with lots of diversification. Bonds and Gold are going to be the predominant assets for our risk of this year unlike UUP last year. I will be covering the yield curve during collapse stages at the SWP QA at 3 PM Pacific today as well.
May you ADAPT to markets and Sleep Well,
SWP Team
The content of this article is provided for informational purposes only and may not be construed as an offer, for sale or purchase, of any investment product or advisory service. Redistribution of any part of this information is prohibited without the express written consent of Sleep Well Investing LLC. Sleep Well Investing LLC is not responsible for any errors in or omissions to this information, or for any consequences that may result from the use of this information.