Portfolio Shield – September 2022

Looking back over the last month, Portfolio Shield™ correctly identified that momentum was on the side of equities and dropped its bond hedge for August.

While both stocks and bonds were down the last month, stocks were down the least.

The Bear market rally that started in mid-July appears to have ended in mid-August. When Bear market rallies end, the corresponding move lower in price is usually rather strong.

A further decline in stock prices does not necessarily mean bond prices are going to suddenly rally. The market believes the Fed is far from done, even though the inverted yield curve suggests otherwise, which is keeping long-term bond prices from rallying for the time being.

Seasonality is also in play, as every year since 2015, starting around August, yields tend to rise through September. This year appears to be no different.

As I mentioned last month, the probability the formulas would recommend hedging the strategy in September was low. Sure enough, the move lower in equities was not enough to trigger the formulas to hedge.

Looking forward to October’s rebalance, which will happen shortly after the next Federal Open Market Committee meeting, the probability the strategy will hedge is very high. Looking past September, the probability the strategy will remain hedged in November and December is favorable.

Jeff Snider, our Chief Strategist, and I are fully aware the returns are below where we would like them to be. As I mentioned in prior updates, the outsized move lower in bond prices while the strategy was attempting to hedge the decline in stocks earlier this year was the primary reason for its underperformance.

Rather than play chase, by taking on excess risk in the hopes to recover some of those losses, we are choosing to remain defensively positioned by holding the two Simplify funds with the embedded downside put options. In the coming months, conditions are likely to be more favorable for the strategy where it has the potential to recover its losses.

Investing is a marathon and not a foot race. When investing over long periods, there are certain times when taking risks makes sense and there are times the prudent move is just to be patient.

With most of the Treasury yield curve inverted and the Eurodollar Futures curve inverted, the bond market is indicating there are likely more favorable conditions ahead for Portfolio Shield™.

Curve inversions, notwithstanding the extreme size of the current inversions, suggest that there is a high probability that at some point in the future that interest rates are likely to begin a larger move lower.

For Portfolio Shield™, which hedges with long-term bonds, an inverted yield curve is the precursor to favorable conditions for the strategy. When the strategy is hedged with long-term bonds, which is it likely to do starting in October, and yields are falling, the bond allocation has the potential to make a positive contribution to returns.

It is this positive contribution that can quickly reverse prior losses, especially during periods of falling equity prices. Knowing that the high probability of lower Treasury yields is on the horizon, along with a recession, we remain confident that the strategy will soon enter favorable conditions where it can unwind a significant portion of its prior losses.

With the knowledge that Portfolio Shield™ has a high probability of hedging in October and that it is likely to remain hedged for the months following means, the strategy will be well positioned for rates to fall once the Fed changes its tune from max hawkishness to max dovishness as Jeff indicates is very likely based on his macroeconomic outlook.

Forecasts of the upcoming intermediate-term period had previously coalesced into two camps. In the one, favored by politicians and most mainstream commentators around the world, the economy last year was red-hot and is now transitioning, on its own as well as by force of coordinated central bank rate hikes, into a more normal state. The US “technical recession” in the first half of the year was nothing more than this transitional phase which welcomes central bank “tightening” to speed up the process of normalizing.

The other view – the dominant market view – is that economic growth in 2021 wasn’t actually growth rather little more than a struggling recovery still trying to overcome the long run damage created by imposed restrictions and the deep recession in 2020. Despite limited progress, consumer prices accelerated wildly (supply shock) setting the stage for the inevitable potentially severe backlash.

Russia’s invasion of Ukraine in March spilled over immediately into already-painful oil then gasoline prices worldwide, eventually food prices, too, which by nearly all accounts and evidence seems to have provoked the start of that backlash.
In this other scenario, America’s “technical recession” in the first half of 2022 was instead the opening phase of a much deeper contraction (not just in the US, globally), the combined product of lack of recovery and the negative pressures surrounding last year’s supply shock.

With macro data worldwide tilting further and further in that direction each passing month, a wide variety of statistics and accounts already at 2020 levels, now the mainstream view is beginning to shift in order to accommodate (pun intended) the growing likelihood of a more severe downside. Analysts recently have begun to suggest this previously “unexpected” weakness was actually part of the plan, the Fed ditching the Goldilocks “soft landing” in favor of going full-blown Volcker.

It seems more projection of the first viewpoint onto a situation that is becoming harder to reconcile with the broad cross-section of evidence, including China’s entire-too-brief-and-tiny reopening rebound.

From this broad view, even incorporating the August US payroll data, the reason the market is potentially positioned for a rapid decline in short and long-term rates at some point is crystal clear. In a more severe downside case, which even the other camp is having to seriously consider, it’s not just the unwinding of hawkish rate hikes that would drive bids on fixed income instruments, there would be material risks of deflationary outbursts capable of depressing rates on their own, raising prices especially of the most liquid (and safe) assets.

By unanimous decision, Jeff and I agreed to maintain the additional downside hedging on the two equity funds for September due to the increased risks of further equity weakness as the global economy slows.

There were very slight changes to the Portfolio Shield™ allocation for September.

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 where applicable, the advisory agreement terminated.

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

Thank you,

Steven Van Metre, CFP®
Jeffrey Snider