Portfolio Shield – November 2022

After putting in a strong performance for September, Portfolio Shield™ began hedging further downside risk into October. A late October stock rally and a further decline in bonds saw the strategy give back some of its hard-earned gains from the prior month.

Early-stage Bear markets are very difficult for momentum strategies. Momentum strategies perform optimally during markets that are either trending higher or lower, whereas early-stage Bear markets experience rapid moves lower followed by rapid moves higher.

Momentum strategies often perform poorly during early-stage Bear markets due to the look-back period. All momentum strategies run a momentum screen over a look-back period from which the strategy then makes its investment decision.

Each month it compares the momentum of the stock market to the bond market over the look-back period. When the momentum of the bond market is greater than the stock market, the strategy hedges, which is indicative of Bear markets.

When rapid price reversals occur, the strategy cannot adjust fast enough. Most investors believe that changing the look-back period and the frequency of the rebalancing would fix the problem but that is not the case.

Academic research and thorough backtesting show that reducing the look-back period and increasing the frequency of the rebalancing only leads to lower long-term returns.

Momentum strategies can be designed to capture most of the upside of a market but at the sacrifice of missing the bottom of a market. Alternatively, a momentum strategy can be designed to give back some of the upsides of the market in exchange for getting back into the market shortly after a major market bottom.

Academic research, and again thorough backtesting, shows that the optimal design for a momentum strategy is to capture as much of a Bull market as possible, give back some of the gains from the top, hedge the mid-to-late stage of the Bear market, and then buy back into the market when stocks are low.

This is what Portfolio Shield™ does.

Until the market makes a clear signal that it is going to enter a new Bull market or turn lower into a deep Bear market, Portfolio Shield™ will continue to struggle due to the rapidly shifting momentum of the market.

In the short term, the trend for the market is likely higher as seasonality is usually very strong going into the last two months of the year. Corporate share buybacks are expected to accelerate into the year-end as the blackout period ends and quantitative or systematic momentum strategies are likely to turn from net sellers back to buyers of stocks. The outcome of the midterm elections could also boost investor sentiment.

While Jeff and I remain cognizant of the downside risks to the market and the broad economy, we feel the upside potential is greater than the downside risks over the next couple of months. With the strategy dropping its hedge for November, we feel this is an opportunity to let the strategy run with the Bulls.

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

Dating back to last year’s stock market peak, the belief that the downside was entirely due to the Fed’s rate hikes has become widely held. Therefore, as the moment for the so-called Fed pivot draws closer, believing that the bear market has been caused by rate hikes whose end is in sight will lead many to buy shares – and do so heavily.

This is likely what has supported equities in recent weeks. The yield curve’s inversion has moved closer to the very front end, the spread between the 3-month bill and 10-year note having overturned decidedly in the closing weeks of October, meaning stock bulls are now on the lookout, just itching for more confirmation that the FOMC has indeed come within sight of its terminal point.

Should they get it, and we think they will over the weeks ahead, a potentially sizable rally seems a strong possibility.

However, at some point the reason for the Fed’s pivot – especially if involuntary – raises serious concerns about the fragility therefore durability of any rally across risk assets. There are really only two ways the Fed will abandon its rate hike stance: 1. The CPI and/or PCE Deflator materially improve and appear more likely to remain low; 2. Something happens (could be a combination of factors and events) which forces the FOMC to abandon its consumer price fixation regardless of the condition for consumer prices at that time.

In our view, the first option is the least likely. Consumer prices and really consumer price measurements have proved “sticky” for a number of reasons, from the politics of energy to how rents are calculated, none of them having much to do with the actual economy.

This leaves the second option triggered by a wide range of potential setbacks, from a sharp rise in unemployment (bad recession) to an outright outbreak of deflationary chaos and instability across markets and even countries (we got a taste of this to end last quarter).

Or, worst case, the combination of the two.

Should any of those prove to be the ultimate reason why the Fed stops hiking rates, what are the chances they would be stock price positive? A major financial disruption so severe as to override the CPI as the primary FOMC policy consideration is not going to support rising equity prices. Nor would, by mainstream account, an “unexpected” and nasty recession.

Unfortunately, those options appear far more probable as demonstrated by broad market behavior and recent experience. Throughout the last year the economy and monetary system have continued to move (deteriorate) in the manner money and bond curves had anticipated, and there is, right now, not a single reason to believe this has changed.

Money and bond curves today anticipate the worst is yet to happen.

By unanimous decision, Jeff and I agreed to remove the additional downside hedging on the two equity funds for November due to the seasonal tailwinds building behind the equity market that could lead to a short-term melt-up in stocks.

Portfolio Shield™ changed its allocation to the S&P 500 (SPY) and the Nasdaq-100 (QQQ) and removed its position in iShares 20+ Treasury Bond ETF (TLT) across all models for November.

Looking ahead to the December and January rebalances, the strategy will likely remain unhedged unless there is a large downside move in stocks.

Last month we implemented the new conditions for the equity strategy to hedge. In addition to the original condition being met, it would also require the 2-10s yield curve to be either inverted or steepening before implementing the hedge.

This additional condition will severely reduce the frequency of hedging during Bull markets and only attempt to hedge during times of equity market weakness.

While this time the hedging did not make a positive contribution to the strategy, we still feel the decision-making process was improved and will lead to a higher probability of the strategy hedging at more optimal times.

Last month we also entered a review period where we were 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.

With momentum turning positive for high-yield bonds, which tend to move in a similar direction to equities, we are going to implement a mild version of the proposal by reducing the allocation of aggregate bonds to add high-yield bonds to the strategy.

Portfolio Shield™ added an allocation to High-Yield Bonds (HYG) and reduced its position in Aggregate Bonds (AGG) across the Growth, Balanced, Income, and Conservative models for November.

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