Portfolio Theory & Sample Portfolios

In the 1950s, economist Harry Markowitz came up with the idea of "modern portfolio theory" and won a Nobel Prize as a result. Over time, this has come to be known as "traditional portfolio allocation", and is to this day, the basis for most people’s pension portfolio’s.

This allocation model balances a portfolio between publicly traded equities and bonds based on someone’s age. The typical standard allocation is 60% stocks and 40% bonds. The proportion of stocks to bonds typically will reduce as someone approaches retirement to lock-in the gains made by high allocations to riskier stocks in the accumulation phase.

Model Your Portfolio Allocation Returns

Before we get into the portfolios below, there are a couple of web resources available for free whereby you can 'back-test' the portfolios against their historical returns. The first is Portfolio Visualizer which is US based, but as we are typically invested in standard global asset classes and funds you can use these US based tools. Fast forward to 20 minutes in this video to see a demo of using this tool to model returns.

The second is Curvo which is UK based, but the same principle applies in terms of simulating global fund returns

Below we will kick of with a sample implementation of the 60/40 portfolio an then expand out into other well known portfolios just to give you an idea about these portfolios, but the are NOT recommendations.

60-40 Equities/Bonds & "Portfolio-Shield"

This is a classic portfolio consisting of two funds: –

Total stock market fund (to drive returns over the long term) Vanguard FTSE All-World / VWRL
Intermediate bond fund (to reduce volatility) - iShares 3 to 7 year Treasury bond – IEI. Alternatively Vanguard Total Bond Market ETF / BND

This portfolio is generally credited to John Bogle, the Godfather of Index Investing. The percentage of stock can vary with age with say 80% equities for younger investors but John was also a fan of sticking with the 60/40 split.

60/40 Equity/Bonds Portfolio Alternative

The traditional 60/40 portfolio has come in for a lot of criticism of late with bonds being so out of favour and indeed providing no protection at all from crashing stocks in the 2022 sell off. A newer and more innovative and tactical use of bonds and equities can be seen in Steven Van Metres' Portfolio Shield strategy/portfolio that dials up bonds when the economic factors signal to do so. This strategy has produced better returns than the S&P500 over a number of years. This tactical strategy points to a more modern, intelligent. data science based version of the 60/40 portfolio.

Portfolio Shield uses four liquid, low-fee ETFs and performs a monthly rebalancing of bonds to equities. The 4 ETF's are: -

SPDR S&P 500 ETF (SPY)
Invesco QQQ Trust ETF (QQQ)
iShares Core Aggregate Bond ETF (AGG)
iShares Trust iBoxx High Yield ETF (HYG)

The Stagflation Friendly 75/25 Portfolio

The reason the 60/40 portfolio has not done well recently is down to the fact that we are in, or heading into, a 'stagflationary' economic environment with high inflation and low growth. One analyst I follow... John Butler, recommends a 75/25 portfolio: 75% tangible, cash-generative, high-dividend, low-value stocks; 25% gold, other precious metals and major miners. In this way, investors can still achieve some diversification, yet overweight those assets that have a strong track record of outperforming in a stagflationary environment, while underweighting those, such as bonds and growth stocks, that don’t.

The Deflationary Depression Portfolio

A word of warning... Recent times have left many investors (and investment professionals) only ever knowing about inflationary pressures and shocks. But Deflation is arguably a bigger risk in terms of a black swan that could do some serious damage to portfolios.

Once again, as DIY investors we have the choice as to what to own in a deflationary depression.

Inflation Friendly Market Sectors & Portfolios

The table below comes from a 'consensus view' report that holds that if inflation ranges in a 3-5% holding pattern, equities should outperform bonds. But once above 5% for any period of time, both stocks and bonds suffer with bonds outperforming stocks.

The hard way to implement an inflation based asset allocation in a portfolio is to buy ETF's in the sectors that have historically done well in high inflation market conditions. According to Schroders research below quantifying sectors in inflationary markets since 1973 energy, real estate investment trusts (Reits) and consumer staples businesses are the way to go.

But even then, will you know when to get back out of these sectors? Will you know how much of your portfolio to allocate to them? Unless you are a professional investor who does this for a living it's not an option.

Interestingly, the Schroders report says ‘utility stocks display a somewhat disappointing success rate of 50%. As natural monopolies, they should able to pass on cost increases to consumers to maintain profit margins. However, in practice, regulation often prevents them from fully doing so.

‘What’s more, given the stable nature of their business and dividend payments, utility stocks are often traded as “bond proxies,” meaning they might be bid down relative to other sectors when inflation takes off (and bond prices fall).’ Save yourself the bother, consider these....

All-Weather & Other Lazy Portfolios

This well known portfolio has been popularised by billionaire hedge fund investor Ray Dalio. Dalio has pioneered his own diversified approach selecting stocks and different global asset classes that provide returns over the longer term no matter what happens in the wider economy.

The following ETF implementation captures the portfolio in a simplified collection of ETF Funds.

The overriding aim is to set and forget for the longer term rather than attempting to chase slightly higher returns in the shorter term. The main portfolio design is based on the fact that stocks have 2 to 3 times more volatility/risk, so they are heavily counterbalanced by bonds

Tickers are highlighted in bold below. UK alternatives are given after.

30% stocks
(Vanguard US Total Stock Market – VTI or a FTSE 100 or FTSE All Share tracker in the UK)
40% long term US bonds
(iShares 20year+ Treasury bond – TLT or Vanguard Long Duration Gilt Index fund in the UK)
15% intermediate term US bonds
(iShares 3 to 7 year Treasury bond – IEI or Vanguard UK Gilt in the UK)
7.5% Gold
(SPDR Gold Trust – GLD or iShares Physical Gold)
7.5% Commodities
(iShares S&P GSCI Commodity Index (Goldman Sachs) – ticke GSG or UBS BB Commod CMCI HDG to GBP)

Bogleheads Lazy Portfolio's

PORTFOLIO REVIEW

Simple 3 Fund Retirement/Drawdown Portfolio (UK & Global)

Retirement & Drawdown portfolio to grow your assets for the long term. (It could also be argued that any of these portfolios could make a good 'accumulation' phase portfolio too)
Diversification is of the utmost importance as nobody knows which asset classes will lead and which will lag.
Vanguard ETFs provide an easy route to diversification.

If you’re 10+ years from retirement, a more aggressive equities based portfolio might be appropriate. As retirement approaches, dialling back equities is still the preferred option for many, but even then you still might not want to forgo the stock market.

New ideas are emerging whereby equity investing is fully utilised as retirement advances. This is called the “reverse glidepath” strategy. Michael Kitces and Wade Pfau pioneered this idea in an article on the Nerd’s Eye View entitled, “Should Equity Exposure Decrease In Retirement, Or Is A Rising Equity Glidepath Actually Better?”

A UK & Global Focused 3 Fund Portfolio

40% equities, 40% low-risk corp bonds, and 20% EM GOV BONDS.
Aimed at drawdown phase with bonds providing an income. However 5 year total returns on bonds have disappointed raising the question “Are bonds worth the reduced risk and volatility?
Portfolio copied from a highly qualified source.

Here we have an example of why it might be best to just keep things simple and invest in the Life Strategy 60 equities 40% bonds fund (LifeStrategy 60). Over the past years or two the EM Bonds have tanked due to the inflationary pressures of a high US dollar. The corporate bond fund should over the longer term remain a decent long term hold providing steady income, but these also feel significantly in 2022.

If an IFA has designed a 'simple' portfolio such as the below for me then I would expect them to monitor these funds and advise me to sell when they deem it appropriate. When speaking to an IFA, these are the kinds of questions that need to be asked.

UK Vanguard Life Strategy 100 (40%)
OCF %: 0.22
RISK (max = 7): 4
Div Yield: (-)
5 Year return: 63.1%
Annualised return: 12.6%
Annual Performance 2021: (-) 2020: 7.7% 2019: 21% 2018: -5% 2017: 13.3% 2016: 26.1%

UK Investment Grade Corp Bonds (40%) TICKER: VIUKGB
OCF %: 0.12
RISK (max = 7): 4
Div Yield: 2.14%
5 Year return: 30.4%
Annualised return: 12.6%
Annual Performance 2021: (-) 2020: 7.9% 2019: 9.3% 2018: -1.7% 2017: 4.2% 2016: 10.7%

USD EM Gov Bonds (20%) TICKER: VEMT
OCF %: 0.25
RISK (max = 7): 4
Div Yield: 4.3%
5 Year return: 34.4%
Annualised return: (-)
Annual Performance 2021: (-) 2020: 6% 2019: 13% 2018: -2.7% 2017: 8.1% 2016: 10.%

UK/Global Focused 3 Fund Portfolio (take 2)

This portfolio has a UK home bias. Simply replace the UK Equities fund with an S&P500 fund (E.g SPY) and the Bond fund with a US or global bond fund as in the other portfolios on this page for a US bias.

Vanguard FTSE All-World ETF / VWRL (Global Equities fund)
FTSE 100 + FTSE 250 / VUKE + VMID (UK Equities fund)
UK Government Bonds / VGOV (Bonds)

US/Global Focused Portfolio

Vanguard Total Stock Market ETF (US) / VTI (see below)
Vanguard FTSE All-World ex-US ETF (large caps only) / VEU OR Vanguard Total Stock International Index ETF (large caps and small caps) / VXUS

Vanguard Total Bond Market ETF / BND (see below)

Lets take a look at these stellar, well know Vanguard ETF's in a bit more detail...

Vanguard Total Stock Market ETF (US) (VTI) Expense Ratio: 0.03%, or $3 per $10,000 invested annually...

U.S. equity market investing has been a sound investment strategy whilst rates were low but will this continue with higher rates? Probably not in my opinion.

This U.S. stock market fund tracks the performance of the CRSP US Total Market Index. The benchmark includes companies spanning the mega-, large-, small- and micro-capitalization field and represents nearly 100% of the U.S. investable equity market.

This fund comprises around 3,500 stocks with about a quarter of the assets in the 10 largest holdings at the time of writing. The fund uses a market cap weighting (returns are influenced by the momentum growth of the biggest firms with approximately 25% in the technology sector, 17% in financials, 15% in healthcare and 14% in consumer services.)

The returns are in line with its index with a 10-year average annual return of 12.8%.

Vanguard FTSE All-World ex-US ETF (Expense Ratio: 0.08%) ...

A passively managed, large-cap international fund investing in developed and emerging market global companies by tracking the FTSE All World ex-U.S. index.

A riskier alternative that captures small-cap growth would be the Vanguard Total Stock International Index ETF (NASDAQ:VXUS).

(41% invested in Europe. 23% in Emerging Markets. 29% in the Pacific. The rest are in North America and the Middle East.)

The top holdings are well-known global names such as Alibaba (NYSE:BABA), Nestle (OTCMKTS:NSRGY) and Tencent Holdings (OTCMKTS:TCEHY).

Vanguard Total Bond Market ETF (BND) (Expense Ratio: 0.035% Number of Bonds: 9,568 Average Duration: 6.4 years / Yield: 1.4% ...

The rationale for holding bonds is that eventually, interest rates will rise along with bond yields.

BND is heavily weighted to U.S. Government bonds, at 61%, and then 19% is in BAA rated bonds. 12.6% in A bonds and a small allocation to AAA and AA rated bonds. The 0.035% expense ratio is negligible.

Bond allocation should be based on attitude to risk and investment volatility. The general rule of thumb is for a greater percentage in the stock market if you’re younger. Retirees who will have hopefully gone through this accumulation stage in the stock markets in their earlier years need to consider the use of bonds to protect or lock-in that growth and capital and need to consider their short and intermediate cash flow needs such as keeping at least one year’s living expenses in the highest yielding cash account available.

Simple 5 Fund Accumulation/Drawdowm Portfolio

Retirement & Drawdown portfolio to grow your assets for the long term.
Diversification is of the utmost importance as nobody knows which asset classes will lead and which will lag.
ETFs provide an easy route to diversification.

Expanding on the Simple 3 fund portfolios, the Simple 5 fund portfolios are aimed at providing a more diversified ‘fine tuned’ allocation such as the explicit inclusion of Gold and Silver or a focus on particular bonds.

US/Global Focused Accumulation Portfolio

All Cap + EM + Gold & Silver (accumulation stage portfolio)

FUND & Costs/Returns: iShares MSCI World Small Cap (UCITS ETF USD (Acc)) OCF: 0.35% Annualised return: 6.4%
Allocation: 20%
TICKER: WLDS.L
RATIONALE: The investment objective of the Fund is to seek to provide investors with a total return, taking into account both capital and income returns, which reflects the return of the MSCI World Small Cap Index

FUND & Costs/Returns: Invesco MSCI World UCITS ETF Large Cap OCF: 0.19% Annualised return: 9.5%
Allocation: 45%
TICKER: MXWS.L
RATIONALE: This is a Synthetic ETF so US dividend withholding tax does not apply so full US divs are paid. The Fund aims to provide the performance of the MSCI World Total Return (Net) Index. The MSCI World Total Return (Net) Index is a free float-adjusted market capitalisation weighted index that is designed to measure the equity market performance of developed markets.

FUND & Costs/Returns: iShares Core MSCI EM - (UCITS ETF USD (Acc)) OCF: 0.18% Annualised return: 9.6%
Allocation: 20%
TICKER: EMIM.L
RATIONALE: Large and small caps. The investment objective of the Fund is to provide investors with a total return, taking into account both capital and income returns, which reflects the return of the MSCI Emerging Markets Investable Market Index (IMI).

FUND & Costs/Returns: iShares Physical Gold ETC 10% OCF: 0.15% Annualised return: 9.7%
Allocation: 10%
TICKER: SGLN.L
RATIONALE: The investment objective of Gold is to protect capital in times of high volatility. Equity market crash insurance

FUND & Costs/Returns: iShares Physical Silver ETC 5% OCF: 0.2% Annualised return: 8.7%
Allocation: 5%
TICKER: SSLN.L
RATIONALE: The investment objective of the Fund is to seek to provide investors with a total return, taking into account both capital and income returns, which reflects the return of the MSCI World Small Cap Index

Long term 5 fund portfolio performance:-

MSCI World Index (Large Cap) Compound Annual Growth Rate:-

9.7 % over past 51 years

6.4 % over past 20 years

MSCI World Small-Cap Index Compound Annual Growth Rate:-

9.5 % over past 20 years

MSCI Emerging Markets (IMI) Compound Annual Growth Rate:-

5.4% over past 27 years

9.6 % over past 20 years

LMBA Gold prices returned Compound Annual Growth Rate:-

5.0 % over past 53 years

9.8 % over past 20 years

LMBA Silver prices returned Compound Annual Growth Rate:-

4.7 % over past 42 years

8.7 % over past 20 years

UK Focused Portfolio

40% equities 60% low-risk corporate and GOV bonds. This could be viewed as more of a late accumulation / early retirement stage portfolio as the bond allocation is 60%. The tickers below can be looked up on any online broker platform (or even google or yahoo). Note that this portfolio forgoes Internation stocks which may not be optimal in this day and age.

FUND / TICKER / RATIONALE

US EM GOV BOND (20%) / VEMT / Higher risk but potentially high return EM Bond fund.
EUR COPR BOND (20%) / VECP / EUR companies are traditionally strong, but that doesn't mean they will always be a safe bet.
UK GOV BOND (20%) / VGOV / Capital preservation & diversification from equities and volatility. In a market sell-off it should hold value or even rally.
FTSE DEV EUR EX UK (20%) / VERX / ex UK developed equities.
FTSE 250 (20%) / VMID / UK developed equities.

The UK Replication of X% Bonds Y % Equities with home bias UK equity ETF with a FTSE100 or FTSE250 fund (or combination of the two), or alternatively a FTSE All-share ETF/Index fund will implement the equities side. However, the problem with the approach above is that you would then need to periodically 'rebalance' the percentage allocations or each fund which even with the reduced number of funds is going to be a headache.

This is why a number of online brokers and investment manager firms have come up with simple 'one fund' globally diversified portfolio funds such as the LifeStrategy fund range. These replicate the equity/bonds percentage splits also do all of the rebalancing and allocations to the various underlying global equities and global bond funds that spreads your risk on a global basis. All this for a low cost to boot.

A Global Replication X % Bonds Y % Equities) would be to simply hold a global equities fund and a global 'aggregate' bond fund. The aggregate bond fund holds a mix of government bonds from around the world spreading risk. The Bond fund "devils advocate" ... in 2022 bond funds crashed due to execessive inflation. This was inevitable in an inflationary shock so selling down the bond fund and sitting in cash was an entirely feasible decision for an active DIY investor to make.

Harry Browne’s Permanent Portfolio & Other Portfolios

Prior to the global financial crisis, I was influenced by Harry Browne’s so-called Permanent Portfolio. This was designed to provide a more or less bullet-proof and largely passive way of immunising your savings against the widest possible number of potential threats.

The Permanent Portfolio concept splits your investible assets equally into four compartments:

Cash, as a safety net against deflation and sundry crises.
Bonds, as a relatively safe source of income generation.
Stocks, as a claim on the real economy and a hedge of sorts against inflation.
Gold, as the ultimate inflation and crisis hedge. The concept then simply requires you to rebalance your portfolio annually back to those 25% / 25% / 25% / 25% allocations.

At the time of writing, both cash and bonds have little fundamental allure. Cash yields next to nothing, but also comes with potential counterparty and inflation risk. The same holds for bonds. This is a problem given that cash and bonds account for fully half of the Permanent Portfolio. An award winning defensive portfolio manager in the city of London I used to follow designed his strategy to improve on the Permanent Portfolio with three core allocations, namely: -

Defensive, “value” stocks and diversified equity funds
Uncorrelated, ‘absolute return’ funds.
Real assets, notably the monetary metals, gold and silver, and related equity interests trading at undemanding multiples with little or no associated debt but with compelling cash flows.

Whilst interest rates on cash are low, it has no real investment function or fundamental attraction, except as a source of liquidity and “dry powder”. It does, however, give you optionality and it buys you some time out of the market (and in the short run it shelters you from short-term price volatility in the likes of precious metals.

Given the heightened risk of inflation and also financial repression over the medium term, gold is a viable option. Given the challenging global situation, the fundamental belief of the award winning defensive manager was that we therefore "simply can’t be too diversified. If in doubt, diversify some more!

Why “absolute return” funds? The investment world has got more risky, not less, since the global financial crisis. Global politics are a mess, and a rising interest rate cycle will play merry hell with traditional portfolios, and not least with bonds. Managers pursuing an absolute return thesis will be more appropriate than plodding index-trackers. The time to use index-trackers will be after the next major correction, when markets are once again objectively cheap.

Why “real assets” and the monetary metals? Because they are 'sound money'. Gold and silver have always been “money good” – nobody has ever been forced to use them as money; their use arose spontaneously in free markets and economies over thousands of years.

Other Well Known Portfolio's

The links below link to M1 Finance (US based) implementations of a range of the most well known portfolio's constructed by clever portfolio managers of recent decades (they are not affiliate links). If you switch each to the 5 year charts you will see that the total return is actually remarkably similar (with the exception of one or two that are overweight bonds).

The overriding conclusion here is that no matter how hard we try to allocate into different asset classes, it really is hard to 'beat the market'. I just invest in a 'total stock market' fund and I'm done with it all. (Note: ... deciding what your 'lower risk' bond allocation should be if you are approaching retirement and want to de-risk from a 100% equities fund in the biggest decision retail investors need to make.)

The Portfolio Allocation and Returns "Blog Roll"

Check out these portfolio sites/blogs for further information on portfolio construction and their returns. The top link (portfolio vizualizer), is the 'top' like and is my goto free resource for comparing return of portfolios...

https://www.portfoliovisualizer.com/

The following page from Portfolio Charts is a great deep dive into how different portfolios behave during recessions

Portfolios Charts Recessions & Portfolios

The MULTI-ASSET FUND Approach

As the name might suggest, 'Multi-Asset' funds investing in multiple assets, the aim of which is to provide a 'Total Return' over the longer term that may be less prone to the wider stock market (equities) volatility. This is why these funds are also called 'Total Return' funds.

Pick a Fund allows you to select from the available 'Multi-Asset' funds using a simple selection from a few drop-downs on their selection page.

The 'Best Asset Now' Approach

Chris Vermeulen Over at the Technical Traders has developed an innovative strategy aimed at only holding assets that are rising in value.

Hold the 5 asset classes below and trade in and out of 5 big liquid ETF’s that implement these asset classes. Not the Correlation factor for each that is correlation to stocks (SPY = 1.0). The other asset classes can be moved into when and different stages if they are bearish or bullish.

In 2022 when you have high inflation and SPY and TLT were both heading down then UUP (dollar) and sitting in cash/short term bonds (BIL)/money markets was a winning trade

The Covid crash is a good example of utilising these un-correlated asset classes to protect against the downside of both bonds and stocks when they are both in freefall due to either a global phenomenon such as a global pandemic or extreme spike in inflation as seen in 2022.

The 5 uncorrelated asset classes are held:-

SPY (sp500)
QQQ (nas100)
TLT (US BONDS)
UDN/UUP/DXY (Dollar Index/ETF both long and short):-

UUP goes long the US dollar and shorts the currencies of major US trading partners using USDX futures. Specifically, the fund is shorting the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.

UDN is more of a bet against the dollar than a bet on any particular currency. It shorts USDX contracts, which means that it's shorting the US dollar and long six G10 currencies: the euro, Japanese yen, British pound, Swedish krona, Canadian dollar and Swiss franc.
BIL (US T-Bills)
(Short term US GOV bonds)

Method: -

MAX 3 open positions
5 to 12 trades per year
Consider monthly and seasonal patterns in these assets

The chart below shows the dollar (UUP) and BIL moving up whilst SPY and TLT are moving down...

Risk-on vs Risk-off & The Merrill Lynch Investment Clock

This Approach is related to the best asset now approach above. Merrill Lynch's investment clock is based on the economic cycle and segments it into four stages: -

Reflation
Recovery
Overheat
Stagflation.

Risk-off: Preserve Capital During Stagflation & Reflation

The purple line in the image below is the direction of 'growth' relative to it's trend. And by 'growth' it means the overall economy, but for us globally diversified investors it also essentially means the direction of the stock market. So in the first quarter of the chart ("Reflation"), higher inflation is now coming down, with central banks cutting interest rates, and so bonds tend to rise in value whilst stocks tend to decline...

But this is actually the 2nd phase of "Risk-off" where the Capital Preservation satellite comes into play. The 1st Risk-off phase is the 4th quadrant of the chart ("Stagflation") where central bank interest rate hikes, designed to put the brakes on an overheating economy, has taken it's toll and, as you can see in the chart, inflation is rising whilst growth is coming down.

So that is the Risk-off cycle where I'm dialling up my Capital Preservation satellite and dialling down my Core globally diversified portfolio as well as probably not employing much of the Growth/Factor satellite at all.

Risk-on: Grow Capital During Recovery & Overheat

When central banks have completed a rate cutting cycle and have possibly started Quantitative Easing (a.k.a. money printing), stocks and the economy start to grow again and this is where we look to start re-allocating to our Core globally diversified stock fund and growth fund.

Profit From Investment Clock Asset Allocation

Although there might be a 'best asset class' or each stage/phase that doesn't mean that the whole portfolio is invested in the one asset class. All we are doing here is making a probability based decision on a higher weighting of the asset class(es) that are more suitable for the stage of the cycle we are in: -

Stagflation: The top of the cycle with high inflation. Other clues include reports of wage-price spirals and then rising unemployment starts the break of the cycle
Reflation: Due to Stagflation, growth slows and inflation comes down from its cycle peak. Clues include reports of overcapacity in the economy, and/or declining demand, which lowers commodity prices and pulls down inflation. Stocks down, Bonds Up
Recovery: Inflation is now well on its way down but there is still 'excess capacity in the economy. Central banks aid Growth recovery with QE, Stocks Recover.
Overheat: Inflation is now rising again as the economy turns on the heat. Cue central banks to start 'hiking' rates up again. Bond prices start suffering when this happens as bond yields go up. Stocks start to become less attractive again and commodities may do well in comparison to stocks and bonds.

The Market Sector Business Cycle Portfolio

Investment giant State Street have crunched the numbers on which sectors outperform depending on which stage the business cycle is in. To implement the strategy they buy the relevant sector ETF's, Index funds, or investment trusts and monitor where we are in the cycle. (The 2 green plus signs are the best sectors and the two red minus signs are the worst): -

The sector returns based on Inflation and Growth (which helps determine where we are in the business cycle) shows the historical outperformance of sectors based on these two major market factors.

Prevailing Market Narratives & Considerations

Macro-economic conditions act as guidelines for professional fund managers/investors informing as to what asset class is likely to outperform for each particular condition. Whilst this is the realm of professional capital allocators, it does no harm to gain an understanding as a retail investor.

Inflation Increases Significantly - Sell Bonds/Equities & Buy Gold (and maybe REITS)

When inflation increases there is a greater chance for higher interest rates which would mean lower bond prices and therefore bonds selling off. If inflation is really high then central banks may be forced to raise central interest rates in order to bring that high inflation under control.

You might need to really wait it out before rotating back into equities. Central banks would need to see headline inflation come right down before 'pivoting' and reducing interest rates. So depending on how 'sticky' the inflation is, it could be an uncomfortable wait before the light at the end of the tunnel. Note to gold bugs... gold does not like high interest rates and can just as easily sell off in this scenario.

Potential action... if it is thought that the inflation might be 'sticky' and persist then rotate some bonds in a portfolio into inflation protection assets such as REITS or gold. Research by Schroders has shown that since 1973 energy, real estate investment trusts (REITS) and consumer staples businesses have been the best sectors to invest in in high inflation environments.

Inflation Decreases - Buy Equities & Buy Bonds

The general rule of thumb here is that when inflation cools, stock markets should rise. In particular, for our globally diversified retirement fund (or funds), as the US government Treasury bonds 2 year and 10 year interest rates (or yields) reduce, stock markets should rise in price. In particular, the direction of the 2 year yield is a strong indicator for the short to medium term direction of stock markets. It has to come down for stocks to go up.

When inflation decreases there is a greater chance for lower interest rates which would mean higher bond prices and so bonds and bond funds should attract buyers again.

Potential action... Increase equities and bond holdings. If it is thought that the deflation might be 'sticky' and persist then rotate even more into bonds.

Slowing Growth, Recession (or a Decline in Earnings)? - Sell Equities & Buy Bonds

Oil and inflation fall during recessions which is bad for equities and good for bonds. During a recession equities will tend to drop to a low point before reversing and starting a new bull run. This point is the best time to buy equities but purchasing in or around the low point and on the way down are tactics to use to buy when prices are at the discount. It is very hard to time the 'real bottom' in markets, so getting close to the bottom is a better strategy. Trying to be too clever about this will probably backfire.

In particular, the worst types of recession for stocks are 'earnings based' recessions. The dot-com bust in 2000 and the Great Financial Crisis in 2008 were earning based recessions. This is where we see the more significant price destruction in comparison to a more temporary market correction.

If inflation is really high and central banks start tightening, it increases the chances of seeing company earnings coming down so we need to be particularly vigilant in this scenario.

Potential action... de-risk by rotating some equities into bonds and/or selling down some equities to cash near the start and buying back in at a lower price nearer to the end of the recession.

EARNINGS IN DECLINE & BOND MARKET YIELD CURVES

This is just to re-iterate that we aim to track stock market wide company earnings forecasts as well as analyst reports of the percentage of companies with earnings beating the forecasts. If this percentage heads south it's further confirmation that economic growth is slowing and equities are not necessarily the best home for our investments.

Another big clue that economic growth is heading into secular decline is the general direction of the bond markets and the yield curve.

The US Dollar rises - Sell US & Global Equities

A strong US dollar is bearish for equities, not just the the US but globally. In particular for emerging markets as much of their debt and trade is conducted in the dollar as the worlds global 'reserve' currency.

Volatility Trading (& institutional algorithmic trading) - Sell Equities & Buy Bonds

For shorter term trading style investments the VIX is a decent indicator. When the CBOE volatility index hits 36, all of the automated products (pension funds, insurance funds etc) start selling. It's at the point of maximum selling you will see a reversal and bargain hunters come in and buy up the discounted assets.

As you can see on the chart below, the VIX tends to ping off the 36 level and revert to mean. So when I see the 'ping' and the VIX heading back to normality, that is when I want to be buying. Conversely, selling when the VIX is below 20 is a much better probability trade/investment than when the VIX is at, say, 28 or above.

The VIX is also our big warning sign for a black swan financial crisis style event. When it heads above 36 and keeps going as happened at the start of the dot-com crash and the GFC then all bets are off and equities will probably crash.

Potential action... Timing of equity selling and purchasing as described above. If it is thought that volatility will remain high then rotate some equities in a portfolio into bonds.

When the Fed 'Pivots' then money will flow back into stocks... right?

Not necessarily. When the Fed (central bank of the US) 'pivots' (starts reducing their interest rate) then it is likely because something has 'broken'. More often than not, the pivot is accompanied by a recession with stock prices coming down also...

However, although the previous big market drawdowns/crashes actually happened after a fed pivot, there is a theory stating that this is already priced into the stock market declines that were seen throughout 2022 for example. So the logical boost to stocks when the fed does pivot could be seen. This is a "but it's different this time" theory and they tend not to pan out.

Personally I will be waiting to see how the stock market starts to react to the pivot and then make a call to allocate or de-allocate equities...

The Periodic Table of Asset Classes gives us a nice birds-eye level view of all of the variosus asset classes there are available to investors today. They are color-coded for risk level and the border thickness denotes liquidity...

The Asset Class Investment Universe

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