The Big Fed Miss - 6/14/22

The Sleep Well Portfolio at a Glance
SPY (Large Caps) 
After delaying their interest rate hikes in 2021, the Fed is now in the position of choosing between crashing the markets or fighting inflation. A quick history check… The fed is mandated to maintain stable prices and employment; their job is not to prop up the stock market. Stocks are pushing to their relative lows and volatility has spiked to record levels again. The S&P is now down more than 20% from its highs and is currently sitting at oversold levels short-term again. 

One Month Risk Calculation – Risk Decreasing
TLT (Bonds)
You know what will drive bonds into the gutter?  Over 90 billion US treasuries being sold on the open market every month. That’s exactly what the Fed is doing right now. Sucking cash out of the financial system and flooding it with cheap assets. As inflation slows, bonds are more attractive, but the opposite is true as well. We just printed a 8.6% YOY inflation.  This is a very bearish sign for bonds and the economy medium-term. 
One Month Risk Calculation – Risk Unchanged

GLD (Consumer Goods Inflation)
What was once our friend is now just another asset dropping. We scaled out of gold in April and haven’t looked back. When the Dollar begins to relatively inflate again and cpi inflation remains elevated, gold will come back online.  
One Month Risk Calculation – Risk Unchanged

UUP (US Dollar Relative Deflation)
We had the potential to have a bottom in stocks and a slowing of the dollar. After the CPI print of 8.6% YOY, that went all out the window. Now the dollar is back in play and rates are likely to continue to rise. The one thing that can change this is the Fed. We will find out more tomorrow if the Fed is going to stay on its warpath. If they do, we will get more of the same. If the Fed does not accelerate its tightening, we could get a rally in markets. 
One Month Risk Calculation – Risk Increasing

IWM (Small Caps)
A positive note is that this recent drop has impacted large caps more than small caps. This is an early sign that risk managers have cut small caps to a relatively even level with large caps. If this pattern continues, it will provide some bullish signals for IWM in the coming weeks. 
One Month Risk Calculation – Risk Decreasing
EEM (Emerging Markets/ Relative Inflation)
Emerging markets are in a very good position for a bullish move when global growth reaccelerates. That time is not now, but we could see this asset pop up in the latter half of 2022 or the beginning of 2023 as the recession matures. 
One Month Risk Calculation – Risk Decreasing
Drivers for Current Portfolio Allocation
Rates are the key driver in the portfolio this week. As we get higher rates vs other counties, the dollar gains strength. It has been our call that the dollar was going to strengthen on a relative basis since last year. The Fed was wrong and is now trapped in a corner. If they choose to overcompensate now, it will turn us into a tailspin like in 1973-1975. They could slow down their rate hikes and let inflation run higher and longer, but that will cause the full collapse of worldwide currencies, not just the dollar. It’s clear what they must do… tighten at the cost of the global economy to reset the stage and deleverage the financial system. 
Weekly Topic of InterestAverages LieI started out my career as a retail investor before working for a fund. There are so many nuggets of wisdom that I learned by managing money on a professional level, and they have given me a unique perspective when looking at a new strategy. There are countless trading strategies out there. Some are amazing and many are…not amazing.  There is a lot of trickery used out there to excite buyers and unfortunately, it can lead to honest strategies being looked at as having inferior returns. Today we are going to dig into one statistic that is misleading when determining the efficacy of a trading/investing strategy. Most promotional material in the retail investor space uses “average annual return” (AAR). While this is one statistic that can give us an indication of profitability, it can easily deceive us as well. The math of averages naturally limits the effect of outliers and overweights repeating numbers. Below are examples of averages lying to us. On the surface, these returns look positive and are in the double digits on a yearly basis. The error is most magnified when we have volatile yearly returns. For example, below is a better measure, the Compounded Annual Growth Rate (CAGR), for this strategy.Here we can see that the CAGR is 4% lower than the AAR. The CAGR is much more representative of how we feel as investors on a yearly basis. This is because there is a compound effect on capital in losses and gains. The equation for CAGR is… Here’s another example. It’s amazing how much this illusion can bend results. Here is an example of the AAR being positive but the CAGR being negative, with a massive net loss at the end. “But wait, you said it has a positive annual return on the brochure…”This is a staggering misrepresentation of investor expectations! After being asked multiple times to provide Average Annual Return, I’ve started using it for publicly displayed results, but CAGR is always more accurate. Food for thought for next time you evaluate the next new strategy. Of course, you have to have long-term historical results to have stable statistics. A strategy that is only tested or run for 1 or 2 years is not proven and will likely break down without significant foresight on the strategy engineer’s part. 
Wrap UpThe Fed holds all the cards! They can crash it or they can crash it. Whether it is this quarter or Q1 2023, the deleveraging will have to take place if they want to save inflation. Historically the Fed chooses price stability over the economy; I doubt this time will be different. As they tighten, so too will the consumer. The consumer is the lifeblood of the economy. Without increased spending and positive growth prospects for the average individual, the economy is sure to slow. Looking at the consumer sentiment index, we can see that the squeeze is on. All is not lost though… Being invested in the proper assets for the macroeconomic cycle can provide returns until opportunities in growth assets come back. #UUP/GLD for the win, this year so far. Who knows, we might even get some #EEM for some real growth in the portfolio later this year. 
May your assets grow, and you Sleep Well,
SWP Team


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