Portfolio Shield – August 2022

The good news is all models rose in July. However, as I mentioned in last month’s note and prior month’s notes, should equities rally we would lag to the upside due to the strategy’s dual hedging. And we did.

Due to the relative outperformance of equities in July and over the lookback period, the strategy decided to drop its bond hedge for August.

For those worried about missing out on a bond rally at this point, I’ll cover more of my thoughts on that, when I think the strategy will hedge again, and how much of this year’s losses it can unwind later in this note.

Despite sentiment surveys indicating that both investors and money managers are bearish on the economy, money continues to pour into the stock market. They have been told by experts and pundits that the worst of the slowdown would be over by the end of summer which would create a buying opportunity for stocks.

The hope, for these bearish-yet-optimistic investors and money managers, is that the worst is behind us and that the economy will accelerate into the second half of the year along with stock prices. History suggests otherwise.

Once the Fed begins a tightening cycle and stock prices start falling, they historically do not bottom until the Fed has reversed its position and has gone full dovish. History suggests we are more likely in the early stages of a Bear market rather than near the end of one.

However, we may see both stocks and bonds rally over the next couple of months. Algorithmic trading machines, or CTAs, have been short both equities and bonds, and volatility-controlled strategies have also reduced their equity and bond exposure.

Should these machines hit their trigger points to exit their short positions and then begin accumulating long positions, both stocks and bonds could rally. The deterioration of the economic fundamentals will eventually outweigh this potential for short-term buying as our Chief Strategist Jeff Snider weighs in on his outlook for the rest of the year.

While there have been some upside surprises in recent economic data, notably European GDP for the second quarter, nearly all those surprises have been backward-looking. At the same time, there were far more downside results, including the “technical recession” striking the US part of the global economy during the first half of this year.

This is already a serious downgrade to expectations. Hardly anyone (outside of those following market curves) late last year or early this year was thinking about any kind of recession, but now it’s at least arguable one has already happened.

The potential for even more serious macro deterioration, however, remains in front of us. While real GDP in the US was declining (or European GDP rising) in the first half of 2022, curve positions and shapes only grew worse during it meaning that markets aren’t worried about what had already occurred, they continue to hedge for perceived more serious risks yet to come.

There are strong indications that Treasury yields have peaked and bond prices have bottomed, which is consistent with what happens following a yield curve inversion. This doesn’t mean yields will soon come crashing down.

Looking back at prior bottoms in bond prices, it usually takes about six months for the bottoming process to complete. Based on my assessment, this leaves a little over two more months before a bottom is complete before we see a larger move higher in bond prices.

Looking forward, the probability the strategy will hedge in September is somewhat low compared to October which is much higher. Should equities make an outsized move lower or bonds an outsized move higher, the probabilities of the strategy hedging next month will increase significantly.

Several have asked how much of this year’s losses can the strategy reverse should we see yields crash and bond prices rally as we have seen following prior yield curve inversions.

Assuming the strategy is hedged with a similar percentage of bonds that it held in July, should bond prices rise back to their one-year high, the hedge would recover a good chuck of this year’s losses. Should bonds move back near their two-year high, they would recover most of this year’s losses.

A move to new all-time highs, which is consistent with where bond prices go following a yield curve inversion, well, let’s just say we will all be very happy.

I have begun a review of the hedging formulas as this past year has revealed some weaknesses in the original design. I have begun tracking two additional conditions that should two of the three be met, the strategy will hedge.

I believe this will alleviate the strategy of attempting to hedge during a rising rate environment, reduce the frequency of the hedging to times it has a greater potential to create excess returns, and improve the overall long-term returns of the strategy.

No changes to the formulas will be implemented until Jeff and I have sufficient reason to believe these changes will improve the performance of the strategy. I will keep you appraised of my thoughts as I test my proposed changes.
For those in Balanced, Income, Conservative, or bond-heavy models, hold tight – your day is coming soon.

Thank you for your continued trust in allowing us to manage your money with Portfolio Shield™.

By unanimous decision, Jeff and I agreed to maintain the additional downside hedging on the two equity funds for August. While we fully acknowledge the strategy will lag to the upside should stocks rally, with the Eurodollar Futures curve inverted along with the front and back end of the Treasury curve inverted, we both feel the downside risks outweigh the upside potential.

Portfolio Shield™ increased its allocation to SPD & QQD and removed its position in TYA across all models for August.

As a reminder, all strategies are rebalanced on the first trading day of each month and at that time, any new monies are invested according to the model strategy you are in.

For those who want to change between strategies, changes will occur at the next rebalance on the first trading day of each month.

Zero balance accounts that have had a zero balance for six months or more will be closed and the advisory agreement terminated, where applicable.

There is only a 0.3% allocation to cash in each model. Due to a misreporting between Morningstar® and the ETF providers, the Asset Allocation box on the fact sheets may show a higher cash position than is actually in the model.

If you have any questions or would like to change which Portfolio Shield™ strategy you are invested in, please let me know.

Linked below are the latest Morningstar® Investment Detail Reports for the Portfolio Shield™ family.

Thank you,

Steven Van Metre, CFP®