Protecting Your Wealth From Inflation & Investment Losses

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Isolating The Best Bear Market Performers

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.

Figure 15

Asset Class Correlations All Weather Investments



Isolating Bull Market Winners

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.

Figure 16

Asset Class Correlations All Weather Investments



Using Model Portfolios During
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.

Asset Class Correlations All Weather Investments



The CCM Model Economic Contraction Portfolio

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.

Figure 18

Asset Class Correlations All Weather Investments


A great deal of effort has been expended to create a portfolio that has a high probability of protecting principal during bear markets in U.S. stocks. The importance of attempting to protect against significant and prolonged portfolio losses can be emphasized with a simple example using the chart above. The $100,000 investment in the S&P 500 made on August 30, 2000 declined to $53,664 at the end of the bear market (October 7, 2002). That represents a loss of 46.33%. If we are able to earn 46.33% on that $53,664, that only gets us back to $78,526 or $21,474 short of our original investment. To get the $53,664 back to the original investment of $100,000, we would have to earn a return of 86.34%.

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 CCM Model Economic Expansion Portfolio

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.

Figure 19

Model Economic Expansion Portfolio



Hypothetical Test Of
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:

  1. A $100,000 investment was made in the CCM Model Economic Contraction Portfolio on August 30, 2000 (just before the bear market in U.S. stocks really began)
  2. That investment hypothetically would have grown from $100,000 to $132,090 during the bear market, which ended on October 7, 2002
  3. During the same period, a $100,000 investment in the S&P 500 Index would have been reduced to roughly $53,664
  4. On the first day of the new bull market in U.S. stocks, October 8, 2002, we take the $132,090 and make the necessary adjustments to move from the CCM Model Economic Contraction Portfolio to the CCM Model Economic Expansion Portfolio
  5. During the current bull market, the $132,090 hypothetically would have grown to $360,435 (from October 7, 2002 to October 12, 2006)
  6. For comparison purposes, the $100,000 original investment in the S&P 500 Index would have been worth roughly $99,627 at the end of the study period (based on actual historical returns for the Vanguard 500 Fund found on Yahoo! Finance).


Figure 20

Asset Class Correlations All Weather Investments


The point of the exercise is not to suggest that the above scenario is even remotely likely to happen in the real world, but to illustrate the theory behind our portfolio management process. The exercise also shows that if we can even capture a reasonable portion of the potential returns, we will be greatly satisfied as investors. To build a balanced review of the CCM Portfolio Management Strategy, we will now examine investment returns under less than ideal conditions.


Margin Of Safety - Manager Error - Case One:
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.

Figure 21

Investment Performance With Portfolio Manager Error


The results (see Figure 21) are encouraging. Even with significant implementation errors, the CCM Model Economic Contraction Portfolio was still able to beat the S&P 500 Index over the entire bull market cycle. How is this possible? The portfolio is well diversified and contains all weather investments that can perform well in both up and down periods for stocks. The hedging strategy utilized is based on historical models, which call for a reduction in hedging when economic and market conditions are improving or are favorable.


Margin Of Safety - Manager Error - Case Two:
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.

Figure 22

Performance With Portfolio Manager Implementation Errors



Margin Of Safety - Manager Error - Case Three:
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:

Figure 23

Investment Performance With Portfolio Manager Errors



Margin of Safety: Removing The Portfolio Manager
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).

Figure 24

Buy And Hold Investing Model Mixed Investment Portfolio


Figure 25

Buy And Hold Approach Still Beats S&P 500

Figure 26

Buy And Hold Approach Still Beats S&P 500


Historical Performance vs. The Real World

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 past does not repeat itself, but it rhymes."

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.


Accounting For Differences Between
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.


The Possibility Of Future Deflation - Adjustments To CCM Model Portfolios

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:


This Basic Approach To Portfolio Management Is Not New

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.


Wealthy Investors and Pension Funds Desire Similar Outcomes

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:

  1. You are concerned that inflation may erode your purchasing power and wealth
  2. You do not want to lose money, especially in large amounts for long periods of time ("wait it out" strategies failed in 2000-2002)
  3. You cannot afford either mentally or financially to go through another period of painful losses like 2000-2002
  4. You want to accept the proper amount of market risk based on your financial situation and personal preference. You may even want to assume below average risk in terms of the probability of incurring losses in any given market cycle. Said another way, many wealthy people can afford to be conservative since they are not depending on stellar returns to make their financial projections balance.
  5. You also want to have a reasonable probability of achieving above average returns while knowing that there some margin of safety built into your portfolio.
  6. You want to be confident in your research (or your money manager's research) and be ready to proactively take action with your assets when market conditions warrant
  7. You want to be well read and search for the best investments available based on current global trends (or have your manager do it for you)
  8. You do not like frequent trading or rebalancing, but understand the need to make some prudent moves a few times a year, especially when the economic outlook is changing.
  9. You want to pay reasonable fees and minimize transaction costs. You may question why many hedge funds charge 2% per year plus 25% of the profits only to deliver average (or below average returns)
  10. You know there is a better way to build and maintain an investment portfolio and you have an interest in finding it

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.

Click Here To Continue - Asset Allocation Study


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Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Based on market conditions, CCM may use inverse or short funds to hedge long postions. The information contained herein (including historical prices or values) has been obtained from sources that Ciovacco Capital Management (CCM) considers to be reliable; however, CCM makes any representation as to, or accepts any responsibility or liability for, the accuracy or completeness of the information contained herein or any decision made or action taken by you or any third party in reliance upon the data. Some results are derived using historical estimations from available data. Investment recommendations may change and readers are urged to check with their investment counselors and tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS ARTICLE. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.Legal Restrictions and Terms Of Use