Building Bear Market And Full Cycle Portfolios

|
Includes: FLPSX, FRIFX, FSCSX, FSMEX, IAU, VGHCX, VWINX, YAFFX
by: Charles Bolin
Summary

The S&P 500 has returned only 5.7% annually for the past 18 years, including dividends. A 40% stock/60% bond portfolio is likely to outperform in the coming decade.

Alternative investments are added to the August Model Portfolios during recessions to compare performance for Bear Market Portfolios.

The September Model Portfolio theme is low cost, low volatility funds. It is optimized over the past 12 years. A tactical update is provided for the past 12 months.

Introduction

The purpose of testing Bear Market Portfolios during the good times is to be prepared prior to the next bear market. This article looks at portfolios that did well during the past two recessions, adds bear market funds to these portfolios, and creates a low cost, low volatility Model Portfolio based on a full cycle starting in 2007.

Last month, Jim Rogers was on Bloomberg ETF IQ and made the statement:

The next bear market is going to be the worst in my lifetime.

In a mild recession like the one starting in 2001, an equity rotation strategy works well. It is an eye opener looking for long-only funds that did well in the 2007 Great Recession. Below are the drawdowns of a dozen funds similar to the ones that investors like myself are rotating into now seeking safer returns. Notice that some Defensive, Dividend, and Low Volatility funds had drawdowns of 30 to 50 percent. Morningstar has an excellent mutual fund screener with the ability to identify low volatility, low cost funds that did relatively well in 2008.

Source: Chart by the Author based on Portfolio Visualizer data

In last month's article, "Portfolios Of Funds That Do Well In A Bear Market", I created portfolios for four time periods including two recessions. The allocations of the Portfolios for the recessions and corrections, along with Vanguard Wellesley (VWINX) which was used as a baseline, are shown below. Almost all of the short positions are from PIMCO Global Bond Opps USG-Hdg (PAIIX) and Merger Investor (MERFX). These model portfolios and baseline funds did relatively well during corrections because stocks made up less than 40% of the portfolio and investments were rotated into business cycle late stage investments including health care, consumer staples, defensive funds, value and dividend funds, real estate, utilities, low volatility funds, and gold.

Source: Morningstar

The long-only, conservative portfolios are compared to the September low volatility, low cost Model Portfolio (blue line) with annual re-balancing. It took 6 to 8 years following the Great Recession for the S&P 500 to catch up to the Model Portfolios. The September Model Portfolio was optimized for the past 12 years and not for any bear market.

Source: Portfolio Visualizer

Investment Model

No one rings a bell at the top of the market, nor at the bottom. However, with the internet and availability of data, it is possible to measure the strength of the investment environment. "September 2018 Economic Forecast Index Value Marginally Retreats" at econintersect.com is an excellent summary of some of these indicators.

My Investment Model is based on 30 main indicators compiled from about 100 sub-indicators to account for risk, growth, valuations, monetary policy, etc. The dashed blue line in the chart below is the resulting indicator that is used to determine business cycle stages and a preliminary guideline for investment allocations in stocks and bonds. The dark blue line is an allocation guideline which ranges from 30% in Stage 4 (recessionary) to 75% in Stage 2 (expansionary). The red shaded areas define the time increments for creating the two bear market portfolios and the lowering of the allocation index in 2014 - 2016 defines the time period for the third portfolio to represent a minor correction.

The chart shows that the investment environment is fairly strong, but weakening.

Source: Author created from data mostly available at the St. Louis Federal Reserve FRED Database

Impact Of Inflation And Interest Rates

The return of the S&P 500 for the five year period from July 2007 until July 2012, including dividends, was about zero. The annualized return from July 2012 to July 2015 is 17.8%, and the return from July 2012 to January 2018 is 14.5%. The annualized return since February is 11.0%. Returns are respectable, but decelerating.

The following chart shows that the S&P 500 index continues to climb slowly in a topping process before it falls precipitously during recessions. It is during this topping process where many investors should consider reducing exposure to equities to the appropriate level for their risk appetite and to rotate into funds that do well in the late business cycle. This is the second half of "Buy Low, Sell High". For illustrative purposes only, 2018 is added to the chart.

Source: Chart by the Author based on the S&P 500

I am currently reading "Investing in Banks: Strategies and Statistics for Bankers, Directors, and Investors" by Richard J. Parsons. He points out that the historical risk premium for the S&P 500 over the 10 year treasury for the past 110 years is 6.25 percent. He wrote,

When rates are low, investors are more willing to pay up for stocks, which means higher price-to-earnings multiples. One reason the stock market was so skittish during much of 2015 is because fears that the Federal Reserve would increase interest rates. If the risk-free 10-year Treasury is at its historic average of 5.28%, the equity investments in large-capitalization firms need to return approximately 10.28%...

When interest rates in the U.S. rise, stock investors have the opportunity to shift investment capital to the now more attractive 10-year Treasury bond. Stocks face a double whammy when rates rise. First, for companies with debt, the cost of servicing the debt likely increases; as a result, profit margins erode and profitability falls. Second, the investor's 500 to 750-basis-point investment premium expectation does not go away just because rates rise.

The relationship of price to earnings (as measured by market capitalization to after-tax profits) versus 10 Year Treasury Yield for the past 60 years is shown below. Over the past 30 years, the 10 year treasury has fallen about 85% while the P/E has gone up 80%.

Source: Chart by the Author based on data from the St Louis Federal Reserve

A similar graph shows the relationship of Price to Earnings versus Inflation.

Source: Chart by the Author based on data from the St Louis Federal Reserve

If inflation and interest rates continue to rise, they will act to lower the valuations of equities as we are currently seeing.

Secular Markets

Below are the total share prices broken out by three secular periods, shown in months in the chart below. These secular markets often last over 20 years. The first Secular Bear Market (cyan line) starts in 1962 and includes high inflation, and rising interest rates. The Secular Bull Market (blue line) started in 1982 with the breaking of inflation, falling interest rates, increasing debt levels, benefits of technology, and culmination in high valuations of the Tech Bubble (high valuations). The returns for the Secular Bear Market (red line) that I believe we are now in compares to the one starting in the 1960's. While stocks have risen for the past decade, most of the gain was making up lost ground from the Great Recession and to inflated valuations.

Source: St Louis Federal Reserve FRED database

What causes these secular bull and bear markets? "Probable Outcomes" by Ed Easterling, or his article on Financial Physics at Crestmont Research point to extremes in valuation and inflation. The chart below shows valuation as measured by Market Capitalization to GDP (green line), Market Capitalization to Corporate Profits (red line), and Tobin's Q Ratio (blue line). During the 1960's Secular Bear Market, stock prices barely kept up with inflation for almost two decades because the price to earnings ratio (valuation) was falling. The dashed blue line shows that valuations are higher now than any time during the past 70 years except for the Tech Bubble. Lance Robert wrote a great article recently on profits and Secular Markets. Mr. Roberts adds, referring to earnings over the next year, that,

While anything is certainly possible, the risk of disappointment is extremely high.

Source: St Louis Federal Reserve FRED database

Much of the gain in this cyclical bull market is due to increases in valuation which has risen more than 35% in the past 5 years, as measured by the price to earnings ratio which includes the impact of stock buybacks. Notice that the P/E is declining since mid-2017. This is in part a reflection of rising interest and inflation rates. Earnings per share have been rising sharply for the past two years as well.

Source: StockCharts

Corporate after tax profits grew sharply between 2002 and 2007, but have been relatively flat for most of the last seven years, excluding the impact of share buybacks. There is a modest increase in the past two years which is likely due to tax cuts.

Source: St Louis Federal Reserve FRED database

The table below shows the data for the three secular markets. Profit and GDP are in annual growth rates adjusted for inflation. Inflation is the Personal Consumption Price Index average rate for the time period. Valuation is Warren Buffet's Market Capitalization at the start of the period. The 10 year Treasury yield is also shown at the start of the secular market. Stock market returns, including reinvesting dividends, have been low for the past 18 years, valuation is very high, and inflation is slowly rising and interest rates along with it.

Source: "S&P 500 Return Calculator, with Dividend Reinvestment" and St Louis Federal Reserve FRED database.

Secular Slow Growth With Higher Risk

The Congressional Budget released, "The 2018 Long-Term Budget Outlook" in June. They project that Federal debt held by the public increases as a percentage of GDP from 78% to 100% of GDP by the end of next decade and 152% of GDP by 2048 largely due to health care, social security and net interest on debt. The growing Federal debt will:

Increase the likelihood of a fiscal crisis, a situation in which the interest rate on federal debt rises abruptly, dramatically increasing the cost of government borrowing.

Large federal budget deficits over the long term would reduce investment, resulting in lower national income and higher interest rates than would otherwise be the case.

They add:

In CBO’s projections, the U.S. population increases from 332 million at the beginning of this year to 392 million in 2048, expanding by 0.6 percent per year, on average. That annual rate of growth is slower than the rate of the past 50 years (0.9 percent).

Over the next few years, the unemployment rate is expected to decline and inflation is projected to rise. CBO expects the Federal Reserve to respond to those developments by continuing to raise the federal funds rate to keep inflation close to the central bank’s long-term goal.

Six Bear Markets Since 1960

Stocks typically lose 15 to 20% during corrections. Bear markets which are typically associated with recessions average losses of more than 40% and last more than a year. A bear market (excluding smaller corrections) has occurred on average every 9 years.

Source: First Trust Advisors based on Morningstar Returns

Impact Of Secular Markets

The impact of secular markets is extreme on portfolios. Mark Bern describes in "Basic Guide To Successful Investing - Part II" as well as Lance Roberts in "The Longest Bull Market In History And What Happens Next" that it is a Wall Street myth that investors should be heavily invested in equities most of the time. One reason is that the investment accumulation time horizon of most investors is 20 to 40 years and not the past 120 years of the stock market. We are currently in a cyclical bull market within a secular bear market.

These concepts are illustrated in the chart below which includes the last two recessions. During this 18 year period, the Vanguard Balanced Fund (VBIAX) has outperformed the S&P 500 (SPY), and Vanguard Wellesley Income (VWINX) has outperformed both with less volatility. The gray line shows a simple market rotation strategy of being invested in the Wellesley Income Fund during Stage 4 (Recessions) according to the Investment Model and in Vanguard Balanced during all other times. I used a few of the market timing tools in Portfolio Visualizer that show promise, such as investing in VBIAX, but going to VWINX if the volatility exceeded a threshold value. During part of this time, we have been in a bond bull market which has helped the performance of Wellesley Income Fund.

Source: Chart by the Author based on data from Portfolio Visualizer

The data from December 2000 through August are shown below.

Source: Portfolio Visualizer

Alternative Investments In Bear Markets

In this article, I look at using alternative investments in a bear market portfolio consisting of funds including Bear Market, Long-Short Equity, Inverse Equity, Market Neutral and Multi-alternative funds. Portfolio Visualizer was then allowed to select the funds to be included in the Bear Market Portfolio. Allocations to these funds were limited to 15% of the portfolio.

The benefits during the two major bear markets are higher return, lower volatility, and lower drawdown. The benefit during the correction starting in 2014, which was not accompanied by recession, was negligible. The time periods start before the market peak and end after the market trough to be more realistic.

Source: Table by the Author based on data from Portfolio Visualizer.

The funds selected utilizing Portfolio Visualizer to be added to the Model Portfolios are shown below.

2000 Model Portfolio (1) and Bear Market (2) Portfolio (with Bear Market Funds)

Introducing bear market funds and long/short equity funds into the Model Portfolio shifted allocations from long term bonds and real estate to the alternative funds.

2007 Model Portfolio (1) and Bear Market (2) Portfolio (with Bear Market Funds)

September Model Portfolio

In Barron's "The Best Mutual Funds for Investors: Cheap and Boring" (recommended by Seeking Alpha Member "Exeditor"), Lewis Barham describes a study by Morningstar:

A study Morningstar released last year found that the average annualized return for investors in the cheapest 20% of diversified equity funds was 4.59% in the 10 years ended on Dec. 31, 2016, versus 5.83% for the funds—a gap exceeding 1.2 percentage points. Returns for investors in high-cost funds averaged just 1.78%, while those funds returned 4.34%—an almost 2.6-point gap.

The article goes on to say that investors tend to over trade and sell during the most volatile times. This leads to investors under-performing funds.

Funds were selected to be in the September Model Portfolio by having low expense ratios for their category, low standard deviation and draw down, and higher sharpe ratio. Portfolio Visualizer was used to maximize the return for 6% volatility since 2007.

The Provided Portfolio in the chart below is the September Model Portfolio with 6% volatility. By comparison, the standard deviation of the Vanguard Balanced Index Fund (VBIAX) is 9.0%. The maximum drawdown of the September Model Portfolio is 17.9% compared to 32.4% for VBIAX. It has taken nearly ten years for the returns of the Vanguard Balanced Index Fund to make up the higher losses in the Great Recession and catch up to the September Model Portfolio (which is similar to Vanguard Wellesley Income Fund).

The performance of the September Model Portfolio since 2007 is as follows.

The allocations and performance of the funds are shown below.

The following chart takes the September Model Portfolio (blue line) and maximizes return for 3.5% volatility for the past 12 months (red line).

Below is a comparison of the allocations for the September Model Portfolio and shorter term allocation based on the past 12 months. Allocations are shifted from the more conservative allocation funds, health care and gold, and into more aggressive allocation funds, inflation protected bonds, large cap growth and small cap value funds.

I made two changes during the process of using Portfolio Visualizer. Morningstar X-Ray-Interpreter advised adding a small cap value fund and so I selected Fidelity Low-Priced Stock (FLPSX), and I added Vanguard Prime Money Market (VMMXX) to have emergency funds. The results are shown below.

Source: Table by Author based on Morningstar Data

I added a token amount of gold to my portfolio in August as a protection from inflation and recession risk. The price has fallen for the past year, but recently started rising.

Chart IAU data by YCharts

Morningstar X-Ray Interpreter

Morningstar X-Ray Interpreter describes the September Model Portfolio as a Core Portfolio that is suitable for someone with a three to five year investment horizon. It is underweight in financials and energy and overweight in consumer defensive and healthcare. The stock exposure is 90% focused in the United States. The average expense ratio is 0.46%.

Model Portfolios (Results as of August 31st)

Each month, I build a hypothetical million dollar portfolio based on themes. They are independent from one month to the next. The primary strategy that I follow is "Maximizing Return For a Target Volatility" using Portfolio Visualizer. I use momentum and fundamental factors to select the funds to be optimized. I also use considerations for the business cycle such as the Morningstar Bear Market Rank and drawdown.


Source: Morningstar for Returns and Allocation. Portfolio Visualizer for Standard Deviation, Draw Down and Sharpe Ratio.

Funds from the Model Portfolios that have done well during the past 1 and 3 months are:

TECHNOLOGY

  • Vanguard Information Technology (VGT)
  • Amplify Online Retail ETF (IBUY)
  • Invesco Dynamic Software ETF (PSJ)
  • Fidelity® MSCI Information Tech ETF (FTEC)
  • Fidelity® Select Software & IT Svcs Port (FSCSX)

LOW VOLATILITY

  • Invesco S&P SmallCap Low Volatility ETF (XSLV)
  • iShares Edge MSCI Minimum Vol USA ETF (USMV)
  • Janus Henderson US Managed Volatility (JRSTX)
  • Invesco S&P MidCap Low Volatility ETF (XMLV)
  • Vanguard Global Minimum Volatility (VMVFX)

SMALL AND MID CAP FUNDS

  • First Trust Small Cap Gr AlphaDEX® ETF (FYC)
  • iShares Morningstar Small-Cap Growth RTF (JKK)
  • Vanguard S&P Small-Cap 600 Growth ETF (VIOG)
  • Vanguard S&P Small-Cap 600 ETF (VIOO)
  • Hartford MidCap HLS (HIMCX)

BALANCED AND DEFENSIVE

  • Vanguard Balanced Index (VBIAX)
  • Invesco Defensive Equity ETF (DEF)
  • AMG Yacktman Focused (YAFFX)
  • Janus Henderson Balanced (JABAX)
  • Invesco DWA Consumer Staples Mom ETF (PSL)

HEALTH CARE

  • iShares US Medical Devices ETF (IHI)
  • Vanguard Health Care (VHT) or (VGHCX)
  • Invesco S&P SmallCap Health Care ETF (PSCH)
  • Fidelity® Select Medical Tech and Devcs (FSMEX)

REAL ESTATE

  • Vanguard Real Estate Index (VGSLX)
  • Fidelity® Real Estate Income (FRIFX)

FACTOR FUNDS

  • iShares Edge MSCI USA Momentum (MTUM)
  • iShares Edge MSCI Multifactor USA ETF (LRGF)

UTILITIES

  • First Trust Utilities AlphaDEX ETF (FXU)

OTHERS

  • iShares Global Timber & Forestry ETF (WOOD)

FUNDS IN THE SEPTEMBER MODEL PORTFOLIO NOT LISTED ABOVE

  • iShares Gold Trust (IAU)
  • Vanguard Short-Term Federal (VSGBX)
  • Loomis Sayles Securitized Asset (LSSAX)
  • FPA New Income (FPNIX)
  • Berwyn Income (BERIX)
  • Fidelity® Low-Priced Stock (FLPSX)
  • Gabelli ABC AAA (GABCX)
  • PGIM High Yield Z (PHYZX)
  • American Funds Income Fund of Amer (RIDFX)
  • Vanguard Wellesley® Income (VWINX)

Mutual Fund Spotlight

AMG Yacktman Focused (YAFFX) was formed in 1997, and has $4B in assets. Morningstar rates YAFFX four stars and an Analyst Silver Rating. It has a standard deviation of 9.7 and a sharp ratio of 1.12. For the past 1 and 3 years, the fund has captured about 70% of the S&P500 upside and about 50% of the downside. In 2008, YAFFX lost 23% compared to 37% for the S&P500, but returned 62% in 2009 compared to 26% for the S&P500. Year to date, it has returned 4.7%. According to Morningstar, YAFFX has a

preference for companies with strong free cash flows, reasonable debt, high returns on capital, and modest cyclicality makes high-quality companies the default.

YAFFX has an expense ratio of 0.7%, and a Bear Market Percentile Rank of 36.

Conclusion

The current environment for equities is one of decreasing reward for increasing risk. The S&P 500 may rise another 10% or more over the next year or two, but probably with bumps along the way. I will most likely be retiring during the next recession. The often quoted rule of thumb is that one's allocation in equities should be 100 minus their age. I will continue to reduce equity exposure to this level as it is good preparation for the next bear market. Each month, I look for the riskiest fund that I own that does not fit into the Model Portfolio categories and trade at least a portion of it for one that fits better into the Portfolio, is doing well, and is less risky. Slow and steady.

Disclosure: I am/we are long IBUY, PSL, VWINX, IAU, YAFFX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not an investment professional nor an economist. I am employed in the precious metals industry. I enjoy reading about and researching investing. Investors should do their own research or use an investment professional. I own many of the funds in the model portfolios or similar funds from the same Morningstar Category.