The Sleep Well Portfolio at a Glance
Over Reaction and Rebalancing
SPY (Large Caps)
This week we see the SPY test the bottom of its upward trending channel for the 3rd time in the last month and a half. There is an old saying on the street, “Triple bottoms rarely hold”. The first time I heard that was in 2015 when the Fed raised rates for the first time after the great recession. The market then rallied to new highs before eventually having a small correction in august of that same year. After the Fed minutes were released last week, it was made clear that the Fed is not only going to raise rates but also going to actively tighten monetary policy. Historically this is a bearish thing for stocks. Right now, short term we are oversold and ready for a bounce in equity markets. In 2015 small caps eventually corrected ~20% while Large caps were able to only modestly correct ~9%. Currently, we are only ~4% off the highs.
One Month Risk Calculation – Risk Unchanged
TLT (Bonds)
Now that Bonds are pricing in 4 rate hikes this year, they look significantly more attractive. Short-term oversold and not fairly priced for the slowing growth in Q2 of 2022, Bonds are a great buy. We will let the market lead the way, but bonds are on the radar now.
One Month Risk Calculation – Risk Decreasing
GLD (Consumer Goods Inflation)
Our favorite asset for high inflation/slowing growth/dropping rates. Gold is going to get a lot of attention as Q2 gets nearer. This week we saw a gold sell-off in tandem with all assets. When we get this rare signal it typically leads to a genera selling frenzy and panic. We will let the panic cool off and get ready to chomp on the tasty prices gold is flashing.
One Month Risk Calculation – Risk unchanged
UUP (US Dollar Relative Deflation)
Just in case I was too vague in the monthly meeting… The dollar is set to weaken in the first quarter of 2022 before deflating in Q2 and Q3. This can help stocks shake off some risk until Q2. Right now I would rather be in euros vs dollar until march.
One Month Risk Calculation – Risk Increasing
IWM (Small Caps)
Now that the cat is out of the bag and both SWP and AWAKE have been faked out, we scale out of IWM. Small caps had the volatility we were looking to sell coming into the new year. With acceleration, attractive pricing and high volatility small caps looked like a great deal a week ago. Now that we know the Fed finally realizes that they were supposed to taper back when our models said in Q3 of 2021, they are behind the curve. When the Fed aggressively tightens it is extremely bearish for small caps.
One Month Risk Calculation – Risk Unchanged
EEM (Emerging Markets/ Relative Inflation)
For the first time in 3 quarters, we will get a weakening dollar for a quarter. EEM is super attractive this quarter. After our US rate freak out EEM is a favorable diversifier. Yet again we will let the market confirm our models but my hope is that we will get a buy signal in EEM with Gold leading us into Q2 of 2022. We have a few months before that happens but we can see the buying action already in EEM this week.
One Month Risk Calculation – Risk Decreasing
Drivers for Current Portfolio Allocation
In the new year, portfolio managers and institutions must rebalance their portfolios. After having a huge year stocks are likely to be on the selling side for a brief minute. I will admit that the portfolio right now is in perfect inverse rhythm to the equity markets. Mondays have been the day for freakouts and bottoms. This has left the portfolio taking risks off at exactly the inopportune time.
While I wish this wasn’t true, it is. The exact situation happened to the SWP in 2015. After all, the only way to have a drawdown is to be wrong. Wrong and early we have been, in the words of Yoda. Soon we will resync with markets and break new ground to the upside in the portfolio.
Our models showed that the Fed was likely to taper in Q3 of 2021 and that time came and went. Every month after they have postponed their tapering cycle. We could have had a soft landing if the Fed could have been ahead of the bond market. Now that longer-term bond yields are significantly elevated vs the risk-free rate it creates massive inflation in the dollar and forces the Fed to act quickly.
When the back end of the yield curve is significantly elevated the fed is forced to buy excessive amounts of US treasuries every month. Add that to an already existing QE program it equals… “behind the curve”.
Now that the Fed is officially behind the curve, it means we will now need to accelerate tapering and tightening. All of which will partially reverse the positive effects that loose policy had on stocks.
If history is a guide, the last time we had cost/push inflation, tightening monetary policy, and slowing growth 1969-1970, 2007-2008… volatility and general selling ensued. We are still a few months from this specific combination crystalizing. We can see portfolios getting ready for it, with the fast downside action in the major indices. Next, we should see buying in Bonds and Gold with remained stagnation in stocks. There is a small potential that the excessive printing done by the Fed, due to the differential of rates will create a pop in stocks before we get the reversal.
One thing that is missing from a full-out doomsday is a yield curve inversion. Without a bond yield inversion, the downside is limited in equity markets due to the inflationary pressure. I look forward to a Fed that is more in line with inflation models and listens to the market. It has been a big failure, that the Fed is late to the party and we will see how they remedy this situation. If we are to believe what they say, It will be possible for them to stop buying assets, raise rates and tighten policy within 1 quarter (the fastest tightening cycle in history), and have no effect on the overall economy. Hmmm, that will be like hitting a grand slam in the bottom of the 9th inning and our team is down by 3 runs. Not impossible but it's a long shot.
Weekly Topic of Interest
"Behind the Curve"
This topic is likely to surface in the coming months as the Fed backpedals itself out of a policy mistake. So, what is “behind the curve” and how does it play out in history?
Behind the curve is a saying on the street when the bond market is dramatically leading the Fed target rate. The Fed target rate is the yield at which short-term bonds are targeted to have. The Fed uses open market actions (buying/selling) US treasuries to manipulate the short end of the bond market. Left side on the picture above. When institutions are convinced that an event or inflation rising is likely to transpire they begin to position their portfolio for it, the bond market reacts in kind to their selling or buying demand. In 2008 the bond market was inverted. This is when medium-term rates are lower than the Fed target rate. During this part of the business cycle, the Fed is actively tightening credit and slowing the economy further than bond participants call for. Basically, the supply and demand pressures of the bond market are at odds with the current Fed policy. This is when the Fed is behind the curve as deflation is imminent.
In an aggressive inflation environment, we see the opposite crystalize. The medium- and long-term bond yields crank up and signal inflation is too high and monetary policy needs to be more hawkish. People have attributed this type of yield curve as a good thing. When inflation is high it typically means business is good and the economy is running hot. Corrections in this environment are less severe or shorter in duration than in deflationary environments. Still, the act of tightening monetary policy is difficult for some businesses and especially harsh on individuals.
Corrections like in the 70s under a high inflation environment leads to a dwindling middle class and a rise in crime. The purchasing power is eroded for workers and a slowdown in the economy is especially hard for hourly workers.
A little difference is normal due to the shape of risk premium demanded for time in bonds but when this difference in yield is excessive it creates a flood of cash into the system.
When we have large amounts of government debt like we have today, the Fed needs to provide the excess purchasing power to keep yields artificially low. As the back end of the yield curve rises, more and more purchasing power is needed to maintain the target rate. Every unit of purchasing power is more dollars coming into existence. As more dollars are created it creates more inflation. More inflation leads to higher interest rates, which leads to more purchasing power needed. To stop this inflationary death spiral, the Fed needs to raise its target rate and be more in line with bond market demands.
Now we can see why the Fed is so quick to change its policy in recent months. As bond yields have spiked and continued to spike the Fed is now injecting an obscene amount of cash into a system that is saying there is too much already. They must act fast and aggressive to catch up and stop the runaway train.
What does this mean for financial markets? In high inflation and slowing growth, gold is a very nice asset to have. When bond yields approach the earnings yield of stocks money begins to flow out of stocks and into bonds or yield producing assets.
https://www.multpl.com/s-p-500-earnings-yield
https://www.marketwatch.com/investing/bond/tmubmusd20y?countrycode=bx
If the curve remains aggressive it also signals the aggressive devaluation of the currency that the bonds are denominated in. In short, hard assets are king and growth-sensitive assets will reflect true growth with added downside volatility. Keep in mind though, stocks are an asset and inflation has a positive relationship over time with stocks. Inflationary corrections are fast and quick with a limited negative effect on asset holders. The pain is normally targeted at the middle and lower class of society. As investors attempt to offset this purchasing power erosion is spurs on risky behavior and leverage.
The opposite is true for deflation. Correction in deflationary times can bolster the middle class as long as unemployment doesn’t get too high. Allowing the purchasing of assets at discounted dollar values and lifting many out of the slog. These corrections last longer and are problematic for the upper class and asset investors.
Today we are in the first situation. Inflation is high and leverage is higher. Investors are yield starved and leveraged. Tightening monetary policy and slowing growth will likely lead to a correction and a difficult time for the working class.
Wrap Up
Looking back at the last four Mondays (when we take our market measurements) we have had a bipolar Mr. Market. On the 27th we had elevated volatility and a fast-dropping market with a strengthening dollar, followed by a quick and fast return to new highs and a weakening dollar, and now back to elevated volatility and accelerating downside volatility with a weakening dollar. That will make your head spin!
The culmination of these events has led us to perfectly time quick bottoms and short tops. Something that is frustrating for any short-term investor/trader. It is entirely possible for any system to inversely sync up with its counterparty. The last few months have been exactly that for the SWP. Just like all things in nature, it is inevitable to revert to synchronicity with the larger power (The Macro Environment).
Being wrong on direction, timing or asset weightings is what causes portfolios to drawdown. The funny thing is, when we look at an equity chart of any portfolio’s history, we tend to forget the “why” in those dips we see in the graph. With an uncorrelated strategy like the SWP and AWAKE, it is highly likely that the dips came from being early or overly sensitive to the assets it holds. Better to be early than late, but dang it sucks to be wrong on timing in the interim.
The portfolio is going to shift and adapt to the current environment that is global inflation decelerating/ Dollar inflationary/ growth slowing, before our final shift into Q2 of 2022 that will global inflation decelerating/ Dollar deflation/ growth slowing. This week is the moment that is the turning point for the SWP/AWAKE to return to their perpetual ascension.