Portfolio Shield – October 2022

Looking back over the last month, Portfolio Shield™ performed very well relative to the broad market.

The additional downside convexity in the Simplify ETFs added excess Alpha to the returns by reducing the downside move in the equity market.

I recently spoke with Paul Kim, the CEO, and co-founder of Simplify to get an update on the two Simplify ETFs currently utilized in the strategy.

Paul explained that Simplify has harvested some of the gains by exercising some of the embedded Put options in both SPD & QQD. They did this to avoid giving back all those gains should the stock market rally.

If the S&P 500 falls below 3,600 by late October, both funds will create further excess returns as the embedded Put options are currently well positioned to take advantage of a continued decline in stock prices.

Looking ahead to the November and December rebalances, the strategy will likely remain hedged unless there is a large upside move in stocks that is not followed by an equally large move higher in bonds. Assuming nothing changes between now and January, there is a high probability the strategy will drop its bond hedge in January.

Looking ahead on the global economy, our Chief Strategist Jeff Snider shares his outlook.

The global economic outlook hasn’t changed however, the market situation has, particularly toward the end of September.

First, the economy continues to move toward recession, in some places faster than others. Europe is being hammered by high energy prices while at the same time economic pressures have cut down on other rising input costs to a considerable degree. With the former being much more than the latter, the overall situation worsens while the possibility of another ECB rate hike actually increases.

In the US, the August CPI (and subsequent PCE Deflator) was interpreted as not having improved thereby raising the chances of another rate hike in the US. At the same time, economic data continues to point toward serious contraction, though not (quite yet) at a speed or to a degree that excludes all other possibilities, including the mainstream version of a red-hot economy helpfully cooling off and slowing down.

In China, that economy/system has failed its Shanghai reopening rebound, having fallen back on prospects of internal as well as external global contraction. In fact, the more the Chinese struggle, the less likely the world will be able to avoid some of the worst cases.

Policymakers everywhere have made it abundantly clear, reflected in markets and curves, they will, for the time being, focus exclusively on prices (“inflation”), an inappropriate adherence to the tunnel vision that has put them at odds with markets (inversions, including an unprecedented one in Germany) and reality.

In addition, warning signs are growing for a potential third deflationary “wave” to strike the global financial system. The first happened in February/March, the next June/July. These signals are too many to list, but we’ll add a few here anyway: German inversion for the first time; SOFR and T-bill rates well under RRP; substantial deterioration in interest rate swap spreads; a surging US dollar exchange value against nearly every currency, including CNY and INR (the latter forced from its “floor”); and on top of everything, the pound crisis, and gilt blowup.

Altogether, the chances of avoiding a recession/deflation scenario have diminished considerably, therefore the heightened market reaction to the Bank of England’s they-won’t-call-it-QE emergency program. In fact, the probabilities of any other outcome but more global QEs were never large to begin with, and with all these economic and deflationary developments continuing in the same direction as markets had previously priced, the only question left is when it all comes together.

By all accounts, that time is getting closer.

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

A few months ago, I wrote that we entered an evaluation period on an additional test that would have to be met before the strategy hedged with long-term bonds. This additional test would reduce the frequency of its hedging during Bull markets as it would also require the 2-10s yield curve to be either inverted or steepening before implementing the hedge.

The formula determined that both conditions (the original formula and the inverted 2-10s yield curve test) were met this month for the strategy to be hedged with long-term bonds.

Portfolio Shield™ reduced its allocation to the S&P 500 (SPD) and the Nasdaq-100 (QQD) to add long-term U.S. Treasury bonds (TLT) to the equity allocation across all models.

Due to heightened liquidity issues in the Treasury Bond market, we have opted to return to using the iShares 20+ Treasury Bond ETF (TLT), the original fund used to hedge the strategy.

We have also begun a review period where we are considering implementing a momentum-based screen for the bond allocation of the strategy which has from inception been a static allocation to the iShares Core Aggregate Bond ETF (AGG).

The proposed change would run a monthly momentum screen on a high-yield bond fund, an intermediate-term Treasury bond fund, a long-term bond fund, an investment grade corporate bond fund, and a Treasury inflation-protected bond fund.

The formula would then pick from two or three of the five bond funds that have the strongest momentum, risk-weight them, and hold them for the month. Each month, the screen would be run and the allocation adjusted accordingly.

If none of the proposed five bond funds have positive momentum, a short-term Treasury Bond fund would be used for the month.

We believe this proposal could increase the returns of the bond allocation over time while also reducing downside returns during periods of rapidly rising interest rates.

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.

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.

The latest Morningstar® Investment Detail Reports for the Portfolio Shield™ family are available on the Portfolio Shield™ website.

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

Thank you,

Steven Van Metre, CFP®
Jeffrey Snider