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The Passive-Aggressive Investor for the Week of August 26-30

Summary:
Before starting please note that I am not the reader's investment advisor or lawyer.  This information is not meant for a specific individual.  Please read and then consult with your adviser.  This is not investment advice for any specific person. Let's start with a simple question: where are we in the economic cycle?  We're a lot closer to the end of the latest expansion.  I've got a 25% recession probability in the next 6-12 months, based on the yield curve and softness in several business related metrics.  While I don't think a recession is a foregone conclusion there is a broad enough swath of data to be concerned.   But as for the third quarter, the NY Fed's 3Q19 GDP prediction is 1.8%; the Atlanta Fed is predicting 2%; the blue-chip consensus is between 1.6%-2.4%.    The markets

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Before starting please note that I am not the reader's investment advisor or lawyer.  This information is not meant for a specific individual.  Please read and then consult with your adviser.  This is not investment advice for any specific person.

Let's start with a simple question: where are we in the economic cycle?  We're a lot closer to the end of the latest expansion.  I've got a 25% recession probability in the next 6-12 months, based on the yield curve and softness in several business related metrics.  While I don't think a recession is a foregone conclusion there is a broad enough swath of data to be concerned.   But as for the third quarter, the NY Fed's 3Q19 GDP prediction is 1.8%; the Atlanta Fed is predicting 2%; the blue-chip consensus is between 1.6%-2.4%.   

The markets have taken notice.  In my latest weekly Technically Speaking summation, I noted that the weekly charts are continuing to roll-over in a bearish formation.  I've also noted that the daily charts are trending weaker.  

Let's take a deeper look at the charts I follow for this column, starting with US equity indexes:

The Passive-Aggressive Investor for the Week of August 26-30

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The ETFs that track larger indexes (the SPY, OEF, and QQQ) are still in decent shape.  All recently hit highs but have since sold-off due to weaker economic news and trade-related concerns.  As the size of the issue decreases, however, the chart becomes technically weaker.  Mid-caps (IJH) are in fair shape, small caps (IWM) are technically more precarious and the micro-caps (IWC) are hanging on by a technical thread.

The Passive-Aggressive Investor for the Week of August 26-30

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Defensive sectors (the XLP, XLU, VNQ) are in solid uptrends.  The fourth defensive sector (the XLV) is under a great deal of political and legal weight right now.  The other more aggressive sectors range from fair (the XLK and XLY) to very weak (XLE). 

Let's now look at the international ETFs:

The Passive-Aggressive Investor for the Week of August 26-30
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Latin America (the ILF) has dropped sharply thanks to Argentina's and Brazil's weak performance.  Europe (VGK) and Asia (VPL) have both sold-off recently thanks to weaker economic data and concerns over trade-related issues.  The broader ETFs (developed and developing markets) are also weaker for the same reasons.

But the dividend paying ETFs are in slightly better shape:

The Passive-Aggressive Investor for the Week of August 26-30

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The international dividend ETF has sold-off with the markets.  But with a high yield (it's currently yielding 6.3%) it's reasonable to assume that it's hit a bottom for now.  Preferred shares continue to rally.  The broader market dividend ETF has sold-off a bit but is still trading at its 50-day EMA.

Now let's turn to the bond market ETFs, starting with the US:

The Passive-Aggressive Investor for the Week of August 26-30


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The US bond market is on a tear.  Both the treasury and corporate markets are rallying very strongly.


The Passive-Aggressive Investor for the Week of August 26-30

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We see the same pattern in the international bond markets, although international treasury bonds (left) are stronger than international corporate (right).

The Passive-Aggressive Investor for the Week of August 26-30

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Junk bond markets are actually doing pretty well, thanks to investors reaching for yield.

Let's add all this up:

  1. The economic back-drop is fair.  But while there are clear signs of economic weakness, a recession isn't a foregone conclusion.  
  2. Larger cap indexes are still catching a bid.
  3. The smaller the underlying equity issue covered by the ETF, the more precarious its technical position. 
  4. Bonds are very strong. 
If we just forming a portfolio in this environment, we'd have to make the following assumptions:
  1. The possibility of massive capital gains is very small, which means
  2. We should look for assets that have, at minimum, a certain level of income.
    1. While I didn't cover them above, a number of Dividend Aristocrats are currently yielding far above the 10-year treasury, making them potential candidates in future issues.
  3. We should probably shy away from higher risk (higher beta) assets due to the modest possibility of a recession in the next 6-12 months.
And that leads to a discussion of one of the investment world's most basic portfolios: the broad market (S&P 500 represented by the SPY), long treasury bond (20+ year treasury represented by the TLT) combination.  This is about as simple as you can get -- you've only got two assets, after all.  And they're almost always negative correlation -- when one rises the other is likely to fall.  Here's their rolling 60-day correlation for the last 10-years:

The Passive-Aggressive Investor for the Week of August 26-30 
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Let's look the historical performance of three possible allocations:

portfolio 1: 25% stocks/75% bonds
portfolio 2: 50% stocks/50% bonds
portfolio 3: 75% stocks/25% bonds

Let's first look at the historical return of this portfolio (January 1978-August 1979)

The Passive-Aggressive Investor for the Week of August 26-30
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There's not much difference between the standard deviation (risk) of portfolio 1 and 2.  But portfolio 3's risk increased a lot for a .55% increase in the compound annual growth rate.  In addition, the Sharpe and Sortino ratios decline a bit between portfolio 2 and 3.  There's also a large increase in the drop during the worst year between portfolio 2 and 3.  The bottom line is that portfolio 2 looks to be a decent mix for the risk, whereas somewhere between portfolio 2 and 3 the investor winds up on the losing end of the risk-reward trade-off.

Finally, let's run a monte carlo simulation of the 50% SPY/TLT allocation model:

The Passive-Aggressive Investor for the Week of August 26-30

Here's the end result of the analysis (emphasis added):
Monte Carlo simulation results for 10000 portfolios with $1,000,000 initial portfolio balance using available historical returns data from Jan 2003 to Dec 2018. The historical return for the selected portfolio for this period was 8.50% mean return (8.30% CAGR) with 8.03% standard deviation of annual returns. The simulated inflation model used historical inflation with 2.08% mean and 1.37% standard deviation based on the Consumer Price Index (CPI-U) data from Jan 2003 to Dec 2018. The generated inflation samples were correlated with simulated asset returns based on historical correlations. The available historical data for the simulation inputs was constrained by iShares 20+ Year Treasury Bond ETF (TLT) [Aug 2002 - Aug 2019]. 
Here are a few observations from the above data:

  • With the exception of one scenario, all returns are positive
  • By year 3, it's reasonable to assume an annual return of 5% 
  • By year 10, it's reasonable to assume an annual return between 5% and 7.5%

 

 




  


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