A Portfolio To Maximize Returns And Minimize Risks

Includes: ANF, EWW, SLV, WFC
by: Charlie Zhou

I am bearish on the stock market. I don’t believe that the market will make new highs when corporate profit margins are at all time highs and they historically revert back to the mean. I don’t believe President Obama has the political power to push through another meaningful stimulus package, but I am worried about the Fed. Chairman Bernanke isn’t scared of expanding the Fed’s balance sheet to sky high levels. There is no doubt that he will pursue another round of QE if deflation/recession risks increase. What the Fed would do makes shorting very risky without some protections. I constructed a portfolio that will make money in either a slow or a bad economy with or without Fed intervention. Here are my picks:

iShares MSCI Mexico Index ETF (NYSEARCA:EWW)

Since I’m bearish on the U.S. market, it makes sense to short something that is closely tied to the U.S. However, individual companies have acquisition risks, so I picked EWW. It moves almost in sync with the U.S. indexes but with greater volatility. If the Dow moves by 1%, you can expect 1.5% to 2% moves in EWW. Instead of shorting the Dow, I decided to short EWW for the extra volatility. Mexico can’t grow if the U.S. doesn’t grow. On top of that, Mexico has plenty of its own destabilizing problems.

Abercrombie & Fitch (NYSE:ANF)

I follow leading indicators closely and believe that leading indicators see things before CEOs and Wall Street analysts do. Most of the leading indicators, such as the ECRI, are pointing to a significant slowdown in the economy in the coming months. Such risks haven’t been priced into the market. If the economy does slow, high-end retailers with high valuations will be hard hit. Abercrombie fits that profile. It is a high-end clothing retailer that owns Abercrombie & Fitch and Hollister stores. Its revenue has been flat in the past 3 years, but the company started expanding into Europe last year and has been generating decent revenue growth in the past few quarters. However, Europe is a mess, its economy will be in a recession next year. I just don’t see how Abercrombie can justify the 30x PE if its primary growth market slows. Abercrombie is still very small in Europe so it might not be negatively impacted, even if its growth continues. Abercrombie's peers are trading at 15x PE. The stock is pricing in 100% profit growth. I believe most of the gains have been priced in while any risks can be devastating to the stock. It is a good short to play the economic trend.

iShares Silver Trust ETF (NYSEARCA:SLV)

Since I’m unsure what the Fed would do, I need some insurance against Chairman Bernanke. One trend I noticed about Silver is that whenever the Fed decides on a new QE, Silver shoots up. SLV has pulled back 35% from its peak and it serves as an excellent hedge against the Fed. The only bad environment for Silver is if the Fed starts reducing its balance sheet, something I can’t see happening anytime soon. I’m going long SLV in my portfolio.

Wells Fargo (NYSE:WFC)

What if the economy unexpectedly booms or the Fed boosts stock prices? I need a high quality stock that can participate in the run up. Wells Fargo seems to be that candidate. Warren Buffett owns it, that’s a big stamp of approval on its management. It has pulled back from all time highs and its lending units will benefit from any boom in the U.S. economy. I’m long WFC shares in my portfolio.

My Portfolio

With these combinations of stocks, how can I maximize my return yet lower my risks? As it turns out, by varying the weights of these stocks in my portfolio, I can do just that. I created a model that takes into account different economic scenarios in the U.S. along with the probabilities of each scenario. I then estimated the percent moves in each stock under each scenario. Finally, I used Excel Macro to vary the weights of each stock in the portfolio from $0 to $10000. After checking all 100,000 combinations, this is the return/risk graph I generated. As you can see from the scatter graph, for each risk level, you have different returns simply by having different weights on each stock. As an investor, you definitely want to have the highest return for a given level of risks.

In my model, I used Excel macro to vary the amount of stock in my portfolio. As you can see in the screen shot, for $9000 Dow short and $10000 Silver long, the expected return is 12.01% and variance/risk is 2.292. If you want a copy of my model, please email me.

Click chart to enlarge:

My model

This is the Return and Variance graph after trying all 100,000 combinations

variance and return graph

Disclosure: I am short EWW, ANF.