As an alternative policy he [an investor] might choose to reduce his common-stock component to 25% 'if he felt the market was dangerously high,'... The Intelligent Investor (1973), page 5, Benjamin Graham
I have read great books about business cycles like Nowcasting the Business Cycle, Leading Economic Indicators, Conquering the Divide, Investing with the Trend, and Forecasting Financial and Economic Cycles, among many others. I started building Investment Models in 2012 when I discovered the St. Louis Federal Reserve FRED database. Statistics books like Data Smart: Using Data Science to Transform Information into Insight and Business Statistics for Competitive Advantage with Excel 2010 were essential.
The Investment Model is built upon having a different portfolio for each stage of the business cycle which was derived from the performance of the fund categories shown below over the past 24 years. We are currently in a Business Cycle Late Stage of decelerating growth and the possibility of entering into a recession in late 2019 or 2020 is increasing. In general, value funds do better in a late stage and recession. Gold performs well as a safe haven as does real estate.
The performance of Corporate Bonds is shown below by quality and duration. During a recession, high quality bonds of longer duration tend to perform better while high yield bonds tend to underperform.
My goal in building the Investment Model was to determine the allocation that will maximize return six months from now. Below are six-month forward returns for the past 24 years of the S&P 500 by Stage of the Investment Model. During the Expansion Stage, returns are initially high but then are often flat in the Late Stage of Decelerating Growth. The Business or Investment Cycle normally, but not always, then goes into a recession and a Bear Market.
Source: Created by the Author
Indicators: Foundation of the Investment Model
The Investment Model consists of about 30 Main Indicators which are made up of nearly a 100 sub-indicators. Many of these indicators are shown in the chart below. To the front and left are the weakest indicators. The purple indicators are moderately weak. The indicators to the right are stronger. For example, the Recession Indicator is strong because the risk of recession is low in the short term. At the other extreme, tightening Monetary Policy is a drag on the Investment Environment. In general, it can be seen that many indicators are weakening.
Source: Created By the Author. Data from St. Louis Federal Reserve (FRED)
Below are the Stages of the Business Cycle (black line), 1) Recovery, 2) Expansion, 3) Deceleration, and 4) Recessionary. It is no surprise that we are in the Late Stage of Decelerating Growth. The Investment Environment Index (blue line) is moderately low and falling rapidly, providing warning that conservatism is warranted. The number of negative indicators (red line) is increasing which shows a moderate risk of a recession starting later this year or next year.
Source: Created By the Author. Data from St. Louis Federal Reserve (FRED)
Portfolio Performance During the Business Cycle
Four Portfolios consisting of Vanguard Short-Term Treasury (VFISX), Vanguard Interm-Term Tx-Ex (VWITX), Vanguard Wellesley Income (VWINX), Vanguard Dividend Growth (VDIGX), and the S&P 500 were created with allocations of 25%, 50%, 70%, and 100% to stocks. The average annualized performance of these portfolios for Stages of the Investment Model is shown below. The performance during recessions defined by the National Bureau of Economic Research (NBER) is also shown.
When the economy is strong and growing, allocations to stocks should be higher. In the Late Stage like we are in now, allocations should be between 25% and 50% stock. Notice in the Late Stage (Decelerating Growth) that a portfolio with 25% stock has historically done as well as one with 50% stock. However, in a recession, a 25% stock portfolio outperforms.
|Annualized Returns By Investment Model Stage||NBER|
Source: Created by the Author using data from Portfolio Visualizer and FRED
Decelerating Growth and Recession
GDPNow estimates Real GDP growth for the fourth quarter of 2018 to be 1.5%. If this occurs, it will be the slowest quarterly growth since the first quarter of 2016.
Estimates of a negative quarter of GDP growth in "Fourth Quarter 2018 Survey of Professional Forecasters" by the Federal Reserve Bank of Philadelphia reach about 20% later this year. "The Silencing Of The Bears" by Gary Gordon and "Here's What A 10-Year/2-Year Term Spread Inversion Tells Us About Economic Growth And Recessions" by David Rice show excellent research on the rising risk of recession. According to CNBC, "Probability of a recession rises to the highest in 7 years: WSJ Survey," over half of the economists surveyed by the Wall Street Journal believe there will be a downturn in 2020.
Adjusting Allocations According to the Business Cycle
The chart below shows how hypothetical million-dollar portfolios invested in 1995 would have performed over the past 24 years. The "Business Cycle" Portfolio was invested in a 25% stock allocation in the Recessionary Stage of the Business Cycle, 50% stock in the Late Stage (Decelerating Growth) and 70% stock at all other times.
A disciplined rotational strategy following the business cycle allows an investor to have lower draw-downs in a bear market and higher returns in a bull market than a traditional 60:40 stock to bond portfolio, even if it is not executed perfectly.
|Business Cycle||$ 10,509,927||9.8%|
Source: Created by the Author using data from Portfolio Visualizer
What Funds Do Well in a Bear Market?
Below is how Lipper Categories performed on average during the last two recession-related bear markets. The categories are sorted with the highest returns at the top and the lowest at the bottom. High quality bonds did best. Core, Growth and International did worst.
|Best Performance||Intermediate||Worst Performance|
|Return 14.7% to 3.8%||Return 1.0% to -20.1%||Return -20.7% to -33.1%|
|Alt Equity Market Neutral||Multi-Sector Income||Small-Cap Growth|
|U.S. Treasury Gen||Alt Event Driven||Mid-Cap Core|
|U.S. Gov Intmd||Emg Mrkts Hard Crncy Debt||Global Multi-Cap Core|
|U.S. Gov Short-Intmd||General Bond||Large-Cap Value|
|GNMA||Municipal High Yield Debt||European Region|
|U.S. Gov Gen||Flexible Income||Industrials|
|U.S. Treasury Short||Mxd Ast Trgt Today||Consumer Services|
|U.S. Mortgage||Mxd Ast Target Consv||Utility|
|Short-Intmd Invst Grd Debt||High Yield||Multi-Cap Value|
|Core Bond||Consumer Goods||Intern Large-Cap Value|
|Alt Credit Focus||Small-Cap Value||Mid-Cap Growth|
|U.S. Gov Short||Health/BioTech||Global Equity Income|
|Municipal Short-Intmd Debt||Flexible Portfolio||Multi-Cap Core|
|Inflation Protected Bond||Global Health/BioTech||Large-Cap Core|
|Municipal Intmd Debt||Mxd Ast Target Mod||Intern Multi-Cap Value|
|Core Plus Bond||Global Multi-Cap Value||Multi-Cap Growth|
|Municipal Short Debt||Convertible Securities||Intern Large-Cap Growth|
|Corporate Debt BBB-Rated||Mid-Cap Value||Intern Large-Cap Core|
|Short Invst Grade Debt||Mxd Ast Target Growth||Large-Cap Growth|
|Global Income||Small-Cap Core||Global Multi-Cap Growth|
|International Income||Global Large-Cap Value||Intern Multi-Cap Core|
|Municipal Gen & Insured Debt||Equity Income||Intern Multi-Cap Growth|
|Ultra-Short Obligations||S&P 500 Index|
Source: Created by the Author based on Mutual Fund Observer data
Bear Market Portfolio
I searched through funds that did well in both the 2002 and 2007 Bear Markets. Below, I used Portfolio Visualizer to maximize return at 6% volatility starting in October 2007 when the market started to decline until February 2013 (six years) when the S&P 500 returned to its starting level. I used a minimum allocation of 5% and a maximum of 20%. The portfolio is approximately 25% allocated to stocks. Over 50% of the bonds are rated "AAA" with only 7% non-investment grade.
|Ticker||Name||Alloc||Avg Rtn||Stdev||Max. Draw-Down||Sharpe Ratio||Sortino Ratio|
|SDGIX||Dreyfus/Standish Global Fixed Inc||20%||8.2%||3.8%||-2.5%||2.0||5.2|
|JAFIX||Janus Henderson Flexible Bond||20%||8.0%||3.7%||-4.6%||2.0||4.4|
|CPTNX||American Century Gov Bond||5%||5.7%||3.5%||-1.9%||1.5||3.6|
|VSGBX||Vanguard Short-Term Fed||5%||3.7%||1.9%||-1.1%||1.7||4.1|
|FMSFX||Fidelity Mort Securities||5%||5.2%||2.4%||-2.5%||1.8||3.7|
|SNDPX||AB Diver Muni||5%||4.5%||3.4%||-2.8%||1.2||2.0|
|FPNIX||FPA New Income||5%||3.1%||1.0%||-0.5%||2.8||6.9|
|VWINX||Vanguard Wellesley Inc.||5%||6.9%||7.7%||-18.8%||0.8||1.3|
|YAFFX||AMG Yacktman Focused||20%||11.3%||19.6%||-38.4%||0.6||1.0|
|RYSEX||Royce Spec Equity||5%||7.7%||17.5%||-32.5%||0.5||0.7|
|Bear Market Model Portfolio||7.9%||5.7%||-7.7%||1.3||2.3|
|Vanguard Wellesley Income||6.9%||7.7%||-18.8%||0.8||1.3|
Source: Created by the Author based on Portfolio Visualizer
The Bear Market Model Portfolio outperformed the Vanguard Wellesley and S&P 500 funds over the six-year period, because it had less draw-down.
Source: Created by the Author using data from Mutual Fund Observer and Portfolio Visualizer
Below is the performance of the February Model (Bear Market) Portfolio since January 2018. The allocation to stocks is approximately 25%, and the maximum draw-down is -1.9% with a standard deviation of 3.6%. It returned 2.5% with a dividend yield of 2.6%. The average expense ratio is 0.76%.
Below is Morningstar data on the funds.
|Ticker||Morningstar Rating||Analyst Rating||Morningstar Risk||%Return 3 Month||%Return 12 Month||%Return 3 Year||%Div Yield|
Below are some of the metrics from Mutual Fund Observer for the past 12 months. Standard Deviation, Downside Deviation and Ulcer Index are used to classify funds as least risky (1) to most (5) relative to the S&P 500. The Martin Ratio is used to classify funds on a risk-adjusted basis relative to others in the same Lipper Category with 5 being best and 1 being worst. Maximum draw-down and return compared to peers for the past year are shown. Ferguson metrics measure the outperformance (FOM) and consistency (FIC where 1 is best) compared to peers on an annual basis for the past 10 years.
|MFO||Dividends||Ferguson 10 Year|
|Symbol||Lipper Category||Risk||Rating||Yield %/yr||Freq||MAX DD%||APRvs Peer||FOM||FIC|
|CPTNX||U.S. Gov Interm||1||2||2.5||Daily||-1.3||-0.2||-0.1||0.0|
|FPNIX||Alt Credit Focus||1||5||3.4||Qrtly||0.0||2.5||-3.8||-0.4|
|JAFIX||Core Plus Bond||1||2||3.0||Daily||-1.6||-0.6||-1.1||-0.5|
|SNDPX||Muni Interm Debt||1||3||2.3||Daily||-0.9||-0.1||-1.7||-0.6|
|VSGBX||U.S. Gov Short||1||4||2.0||Daily||-0.2||0.5||0.3||0.5|
|MERFX||Alt Event Driven||2||5||1.1||Yrly||-1.3||5.9||-1.7||-0.6|
Visualizing the trends helps identify funds with positive and negative short-term trends.
Source: Chart by the Author Based on Portfolio Visualizer
The Small Cap Value fund, Royce Spec Equity (RYSEX), is the most risky with regard to a major correction, and has the highest volatility and draw-down. I may consider it after a substantial correction has occurred, but not immediately prior to a recession. I own the Moderately Risky fund, YAFFX, the conservative fund, VWINX, and the very conservative bond funds, VSGBX and FPNIX, following my bucket strategy to spread investments over Risk Categories according to when the money might be needed. I own MERFX because it does well in the Business Cycle Late Stage and Recessions when mergers and acquisitions tend to be more frequent. I also like government intermediate bonds, mortgage funds, and world bonds for diversification.
Fund Spotlight FPA New Income
FPA New Income (FPNIX) is a Mutual Fund Observer Great Owl Fund meaning that it is in the top quintile in the "Alternative Credit Focus" Lipper Category. Morningstar gives it a 3 Star rating with a Bronze Analyst Rating, and classifies it as a short-term bond fund.
According to Morningstar, over 80% of its bonds are rated "AAA":
FPA New Income boasts a strong management, process, and risk/reward profile and has been a safe haven from losses and bond-market excess... The fund has scored 30 consecutive years of positive returns in part by deftly navigating volatile markets.
According to the Prospectus (paraphrased).
The Fund's portfolio managers ("portfolio managers") primarily invest in a diversified portfolio of debt securities, cash and cash equivalents. The portfolio managers will, under normal circumstances, invest in the following instruments, among others:
- Corporate bonds, municipal bonds, bank loans, bonds issued by governments and their agencies and instrumentalities, mortgage-backed pools, sovereign debt, and supra-national agency obligations; and
- Structured investments, commercial mortgage-backed securities, residential mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, collateralized loan obligations, collateralized debt obligations and structured notes.
- Common stock if received as a result of a conversion, corporate restructuring or recapitalization;
- Privately placed securities;
- Currency forwards, swaps and other certain currency derivatives, in each case for hedging purposes only.
The Simple Bear Market Portfolio
If I wanted a Simple Portfolio to buy and hold through the next bear market, what would it be? Something close to this depending upon tax an investor's considerations and risk tolerance, but with some cash equivalents. It has a 25% allocation to stocks, over 60% of the bonds are rated "AAA". It's maximum draw-down in the past 13 months is -1.5% with a Standard Deviation of 3.2%, return of 3.2%, and dividends yield of 2.3%. The Yacktman Focused Fund (YAFFX) does very well over time, but may have large gains and losses in any year.
Source: Portfolio Visualizer
I subscribe to Morningstar Premium Service for about $199 per year. One of the services that I like is X-Ray Interpreter which classifies this Simple Bear Market Portfolio as a Large Value Portfolio and describes it as:
Your portfolio is conservative. An asset mix such as yours normally generates low returns but experiences very little volatility. Financial planners typically recommend these types of mixes for investors who have investment horizons less than three years, are risk averse, or have already saved enough to meet their goals. Portfolios of this nature normally generate a high level of current income. If this portfolio is designed for the long term, however, you run the risk of failing to keep up with inflation.
My risk tolerance changes with the business cycle, and these Bear Market Portfolios describe where I want my portfolio to be before the next major bear market arrives. I like and own several low volatility funds, but did not include them because most do not have the history through a recession.
Disclosure: I am/we are long FPNIX, VWIAX, YAFFX, MERFX, VSGBX. 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 an engineer with an MBA nearing retirement and not an economist nor an investment professional. The information provided is for educational purposes and should not be considered as advice. Investors should do their due diligence research and/or use an investment professional.