Protecting Your Wealth From Inflation & Investment LossesPage 2 of 3 - Go To Page 1 3
In order to be better prepared for future periods of economic contraction, which may trigger a bear market in U.S. stocks, it is prudent to identify asset classes that performed well in the last bear market. In our approach, a model economic contraction portfolio was built which can be used as a reference point when it appears that the U.S. economy may be entering a period of slower economic growth or a period of economic recession. Figure 15 below shows the asset classes that serve as the building blocks for the CCM Model Economic Contraction Portfolio (or simply model economic contraction portfolio). Each investment in the chart below was able to produce positive returns in the most challenging environment for U.S. stock investors.
In a similar vein, we also want to be prepared to invest effectively when the economy appears to be entering a period of prolonged expansion. Figure 16 below shows winning asset classes during the current bull market in U.S. stocks, which began when the stock market bottomed in October of 2002. These asset classes serve as the building blocks for the CCM Model Economic Expansion Portfolio (or simply the model economic expansion portfolio). Using the results below, we know it may be prudent to slowly increase exposure to commodity stocks, foreign real estate, and emerging market stocks, as the economy appears to be moving into a period of improved performance.
Economic Expansions & Economic Contractions
The model portfolios can help us adjust our real world portfolio in periods where the economy moves from an economic expansion to an economic contraction, and then from the economic contraction back to an economic expansion. Client portfolios are allocated using elements of both the model economic expansion portfolio and the model economic contraction portfolio. The idea is to slowly shift or tweak the portfolio based on all the information available about the health of the economy and financial markets. Our ultimate goal is to produce superior returns over a complete economic and financial market cycle (through both a bear and bull market).
The model portfolios are created using proprietary allocations to a hedged U.S. stock investment, U.S. bonds strategically weighted between short, medium, and long duration investments, emerging market stocks, China regional stocks, foreign bonds of varied durations, physical gold, physical silver, gold stocks, U.S. commercial real estate, foreign real estate, timberlands, physical commodities (such as oil, wheat, corn, etc.), commodity stocks (such as energy, base metals, and mining), U.S. small cap stocks, Australian stocks, Canadian stocks, and U.S. dividend paying stocks.
To give you an idea of how we can move closer to achieving satisfactory returns while having a low probability of a portfolio loss in any given year, the charts below show the hypothetical historical performance of the CCM Model Portfolios vs. the S&P 500 Index. The returns for the S&P 500 Index in all the charts are the actual returns of the Vanguard 500 Index Fund. The Vanguard 500 Index Fund is a low-expense index fund, which invests in the 500 companies that make up the S&P 500 stock index. Dividends are reinvested for both the CCM Model Portfolios and the Vanguard 500 Index Fund. Within the context of this study, the terms S&P 500 Index and Vanguard 500 Index are for the most part synonymous since their investment returns will be very similar over any given time period.
Figure 18 below shows the hypothetical growth of $100,000 based on the historical performance of the CCM Model Economic Contraction Portfolio during the last bear market in U.S. stocks. The actual daily historical values for each component investment, weighted according to the model, were used to produce this chart. As you can see, by having exposure to asset classes that have either a negative or very low correlation to the S&P 500, it is possible to protect and grow your assets even during very difficult periods.
You may be thinking, how much risk is there if you are invested in the model economic contraction portfolio in a period where the economy is strong and U.S. stocks are going up. Stated another way, what happens if the portfolio manager is wrong about the economy and the direction of the market. This is a fair question and one that we will explore later in this study.
The chart below shows the hypothetical historical performance of the CCM Model Economic Expansion Portfolio during the current bull market in U.S. stocks, which began on October 7, 2002. The CCM Model Economic Expansion Portfolio has exposure to, in alphabetical order, Australian stocks, Canadian stocks, China regional stocks, commodity stocks, dividend paying U.S. stocks, emerging market stocks, foreign real estate, foreign bonds, gold stocks, hedged U.S. stocks, intermediate U.S. bonds, physical commodities, timberlands, U.S. commercial real estate, and U.S. small cap stocks. The model portfolio's weightings are based on historical performance of each asset class and adjustments for differences in today's environment versus the past.
The CCM Portfolio Management Strategy
"Best-Case" Full Cycle Scenario
Figure 20 below shows the hypothetical "perfect world" implementation of the CCM Portfolio Management Strategy. We examine the perfect world or optimum results in order to better understand the possible effectiveness of the basic portfolio management strategy presented here. Our real world goal is to capture a portion of the perfect world results. The chart below shows the hypothetical growth of $100,000 under the following extremely unrealistic circumstances:
Portfolio Manager Invests In The
CCM Model Economic Contraction Portfolio
During A Bull Market
Since one of our primary objectives is to minimize, as best as possible, the probability of incurring portfolio losses in any given year, it is prudent to explore the possible outcomes if we are 100% wrong about the direction of the U.S. stock market and the economy. Figure 21 below shows the hypothetical historical performance of a $100,000 investment in the CCM Model Economic Contraction Portfolio during the entire bull market (wrong portfolio at wrong time). The assumption is that we invest $100,000 in the CCM Model Economic Contraction Portfolio on the exact wrong day, when the market bottomed on October 7, 2002, and incorrectly stay in the CCM Model Economic Contraction Portfolio for the entire bull market in U.S. stocks.
Portfolio Manager Invests In The
CCM Model Economic Expansion Portfolio
During A Bear Market
Next, we will examine the other possible 100% wrong hypothetical scenario. In this case, we assume that $100,000 is invested in the CCM Model Economic Expansion Portfolio at the exact wrong time; just before the bear market began in earnest on August 30, 2000. We also assume that we incorrectly stay invested in the CCM Model Economic Expansion Portfolio for the entire bear market in U.S. stocks. Under these assumptions, the results are still very positive when compared to the relative performance of the S&P 500 Index.
Combination of Case One and Case Two
Manager Is In Wrong Model Portfolio For Entire Study Period
To examine the strategy's margin of safety over a full economic and market cycle, the scenario below combines the portfolio manager's mistakes made in Case One and Case Two above. In this third hypothetical scenario, the portfolio manager is 100% wrong 100% of the time in terms of his or her economic outlook and choice of which model portfolio to utilize. The results are shown in Figure 23 below:
Assumes Investment In Static, Mixed Model Portfolio
In the next hypothetical scenario, we will remove the portfolio manager and invest in a static, buy-and-hold portfolio based on a simple 50%-50% split between the CCM Model Economic Contraction Portfolio and the CCM Model Economic Expansion Portfolio. For example, if the CCM Model Economic Expansion Portfolio calls for a 12% allocation to diversified foreign real estate and the CCM Model Economic Contraction Portfolio calls for a 7% exposure to diversified foreign real estate, the model static mixed portfolio would use the average of the two allocations, which is a 9.5% ([12%+7%]/2) allocation to diversified foreign real estate.
The charts below (Figures 24, 25, 26) show that a hypothetical $100,000 invested in the model static mixed portfolio outperformed a $100,000 investment in the S&P 500 Index over all three periods (the bear market, the bull market, and the entire cycle).
Obviously, the next bear market and subsequent bull market in U.S. stocks will be different from the most recent cycles. The CCM Portfolio Management Strategy was developed with a respect for Mark Twain's way of looking at history: he stated,
The future will not be exactly the same as the past, but there will be meaningful similarities. The CCM Portfolio Management Strategy is based primarily on how asset classes, not individual stocks, performed under different economic and market conditions. This should make the results more relevant than if we studied how Microsoft's stock performed under the same conditions since individual stocks can be influenced by company specific outcomes (earnings disappointments, fraud, credit ratings, analyst recommendations, etc).
While the future will be different from the past, many of the asset class correlations presented here should remain relevant in future economic cycles. For example, the odds are extremely high that bonds will be more desirable in an environment where the Federal Reserve is lowering interest rates (the Federal Funds Rate). Conversely, in the future, the odds are good that bonds will be less attractive under conditions where the Federal Reserve is raising interest rates. The odds are also reasonable that commodities will be more attractive in periods of economic expansion and they will be less attractive in periods of economic contraction.
The Present and The Past
A portfolio manager must be able to put what happened in the past into the context of what conditions are present today. Using interest rates as an example, since inflation is presently above the Federal Reserve's stated comfort zone and the U.S. dollar has been weakening, it is prudent to assume that the next rate reduction cycle by the Federal Reserve will most likely be shorter in duration (number of months) and lesser in magnitude (rates won't fall as far as they did in the last cycle). While headline inflation numbers will show some improvement during the next economic contraction, future economic stimulus in the form of lower interest rates will be more likely to rekindle inflation. Said another way, the Federal Reserve most likely has less wiggle room to tinker with interest rates on the downside than they did during the last cycle of accommodative policy. Lower interest rates will also put some additional downward pressure on the U.S. dollar. A weakening U.S. dollar also makes U.S. Treasury Bonds less attractive. In the current context, the portfolio manager may consider cutting their exposure to long duration U.S. Treasury bonds earlier than the historical data from the last economic contraction would suggest. This is just one example of how a portfolio manager might tweak the portfolio's allocation using more information than just historical precedent.
One scenario that would require adjustments to the Model Economic Expansion Portfolio and Model Economic Contraction Portfolio would be if we entered a period of deflation in the United States. However, the same basic portfolio management theory would still be relevant using the updated model portfolios. Understanding the history behind inflationary and deflationary environments is important to any investor. More information on this topic can be found here:
Like many individual investors, large institutions, such as college endowments and pension funds, are concerned about inflation and investment losses. These institutions have conducted exhaustive research to find better ways to improve their probability of achieving satisfactory returns while significantly reducing the probability of incurring losses over any reasonable time frame. Managers of pension funds and endowment funds understand the importance of investing in a wide variety of asset classes that have either low performance correlations or negative correlations to U.S. stocks as measured by the S&P 500 Index. With the availability of vastly improved investment offerings to both personal money managers and individual investors, it is now possible to for almost anyone to successfully implement an institutional quality investment strategy, which includes the use of hedging.
The portfolio management strategy described above was developed over time to attempt to best meet the needs of many wealthy individual investors. As an individual investor, you may find that:
While the financial markets have proven time and time again that there is no magic formula for investment success, the concept of diversification into a wide array of asset classes, including some with low or negative correlations to U.S. stocks, combined with the concept of "tweaking" the allocation based on the outlook for the economy and financial markets, appeals to an experienced investor's common sense.
On page 3, we will begin to explore investment hedging strategies in the context of the CCM Portfolio Management Strategy.
Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com