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What Will 2022 Bring?
Nouriel Roubini, who in 2006 warned of the credit and housing bubble, lists some of the potential outcomes for this year in Clouds Over 2022:
As long as central banks were in unconventional policy mode, the party could keep going. But the asset and credit bubbles may deflate in 2022 when policy normalization starts. Moreover, inflation, slower growth, and geopolitical and systemic risks could create the conditions for a market correction in 2022. Come what may, investors are likely to remain on the edge of their seats for most of the year.
That article sets the stage for slowing growth. I will summarize Dr. Roubini's concerns as follows:
- COVID 19/Omicron pandemic
- Supply-chain bottlenecks
- Monetary policy and possible tantrum
- Potential stagflation/inflation
- Russia invading Ukraine
- Cold War with China
- Iranian nuclear threat
- Political dysfunction in both advanced economies and emerging markets.
In Investors Need to Pay Attention to the Capital Cycle, Merryn Somersett Webb (Financial Times) writes that high personal savings, low unemployment, and fiscal spending will encourage growth of the economy. She adds:
So what should the 2022 outlooks really say? That markets are fragile and set to be very volatile. That there might well be good times ahead, but that many prices already discount 20 years of partying. And perhaps that investors should bias their holdings towards cheaper sectors and, in particular, towards the capital-starved ones that it turns out we need as much as we ever did.
What is an investor to do? Adam Shell describes how to Make Your Portfolio More Defensive by tilting your portfolio toward utilities, real estate investment trusts (REITs), consumer staples, and healthcare companies. He suggests to trim winners and invest in low volatility and quality stocks and funds. Other suggestions are to buy dividend paying stocks and shorten the duration of bonds.
Still not a believer? According to the S&P 500 Return Calculator, the S&P 500 has returned 10.6% annualized with dividends reinvested for the past 30 years, but 24.3% for the past 3 years. During the same thirty year period, the price to earnings ratio increased from 15 to 30. The higher returns are due to increases in asset prices more than profits. We are more likely to see returns in the low single digits in 2022 than a repeat of the past three years.
These ideas form my baseline for 2022. The US economy is in the Middle Stage of the business cycle with slower growth, high asset prices, "less than transitionary" inflation, and normalization of accommodative monetary policy. This article positions two conservative portfolios for this "fragile" and "volatile" market in 2022.
Portfolio Strategy
More so, performance in the hedge fund space has been poor lately with many giving back multiple quarters of gains... This resulted in forced liquidations and deleveraging at a time of low liquidity, triggering extreme stock price action, especially across the High Beta stock complex.
- Market Positioning Is Too Bearish, J.P. Morgan Says, Kim Khan, SA
The above article points out that the top 50 stocks account for 56% of the S&P 500 market capitalization, the third highest level during the past 50 years. A balanced portfolio will contain all sectors. I tilt portfolios away from technology and toward defensive sectors.
I believe in the bucket approach with three years of living expenses in short term investments, buckets of conservative traditional IRAs where taxes have yet to be paid, being more aggressive in Roth IRAs, and diversifying with a tax efficient after-after tax portfolio. Each investors circumstances are different due to risk tolerance, savings needs, pensions, annuities, income requirements. The two Model Portfolios are intended for moderately conservative traditional IRAs at Fidelity and Vanguard.
The base allocation for all buckets is 50% stocks and 50% cash and bonds tilted to 65% stocks during the recovery stage of the business cycle and tilted down to 35% stocks in the late stage of the business cycle. I like to have approximately 75 to 80% allocated to core funds with the remainder selected based on where I believe the economy is headed, momentum, money flows, risk, and remaining potential of the fund to rise.
Universe of Funds
Building a strong watch list of exceptional businesses to buy or add to along with a written plan of execution would help during a decline when animal spirits are raging.
...The key driver of the stock market is likely to be Fed action and sector/style rotation as a result of anticipated higher interest rates.
I reduced the funds that I track down to nearly two hundred covering over ninety Lipper Categories using the Fidelity Fund Pick List and metrics available in Mutual Fund Observer including Fund Family Rating, MFO Risk Rating, MFO APR Rating, MFO Rating (based on risk adjusted returns), Lipper Preservation, Ferguson Mega Ratio, and Reamer Ratings.
The Reamer Rating is the quintile ranking of the percentage that a fund's 3-year rolling returns beat the rolling returns of its category peers over the past 10 years. It is named after Brian Reamer, a Wisconsin-based financial adviser, who uses it to help assess fund performance consistency. The Ferguson Mega Ratio is named after Brad Ferguson of Halter Ferguson Financial, a fee-only independent financial adviser based in Indianapolis, and measures consistency, risk, and expense-adjusted outperformance. Lipper Preservation rating reflects a fund's historical loss avoidance relative to other funds within the same asset class.
The Rating System
The rating system is based upon four metrics: 1) Business Cycle grouping of funds in quintile percentages for each of the stages of the business cycle plus the interest rate normalization period from January 2016 to December 2018, 2) Momentum (previous two month returns, three month exponential moving average, and trend of the ten month moving average), 3) Investor Sentiment (Money Flows), 4) Risk (Downside capture compared to 60% stock/40% bond portfolio, 5) room for the fund to rise further (Penalties for funds that have risen to extreme levels since the 2020 bear market). These metrics are weighted with Business Cycle having 30%, Momentum with 30%, Money Flows with 20% and both Risk and Valuations receiving 10% each. This will change over time to be more conservative.
Table #1 contains steady funds that are likely to perform relatively well during the completion of this business cycle. Performance by stage is in quintile groups relative to the other funds that I track. In other words, a fund may be in the bottom quintile in one stage and still have positive returns, and conversely may be in the middle quintile in a different stage with negative returns. To this list, I will add consumer goods (staples) and possibly real estate and health care.
Table #1: Steady Funds for 2022
Source: Created by the Author Using Mutual Fund Observer
Table #2 contains some of the top funds based on my rating system from December. The funds are divided into three sections with the top funds (DIVO, VPU, FMSDX, ETIMX, SPLV, and IAU) expected to do relatively well during the Middle Stage and Normalization. The second section are those that may do fair in the middle stage and better in the late stage. REMIX is less than three years of age so the rating is subjective. The third section are those funds that may not do well during normalization but should excel in a bear market. In addition, the components of the rating system are shown on a scale of 0 to 100 relative to the other funds tracked with 50 being the median fund rating. For example, DIVO rates highly on Business Cycle, Momentum, Money Flow, but it can be moderately volatile and has risen moderately well since the 2020 bear market.
Table #2: Top Funds During December
Source: Created by the Author Using Mutual Fund Observer
Fund Highlights
Most of those in the above forty [age] categories that I talk to, look at equity valuations and are convinced that given the increasing rate of inflation which is not transitory and an inconsistent but increasingly heavy hand of government interference, things will end badly. The signs are there...
I would urge caution then. One should be less concerned about the fear of missing out, which seems to drive so many investment decisions now. Rather, you should be more concerned about the danger of permanent loss of capital, which cannot be replaced once gone.
- Edward A. Studzinski, Behind the Curtain
This section looks at funds of interest for those who are looking for adjustments to their own portfolios.
End of Year Slow Down
While returns have been high for many sectors and styles for 2021, there was a slow down in the last several months as we moved from the recovery stage of the business cycle to the middle stage. For example, the S&P 500 returned 9.3 percent during the past six months, but only 1.3 percent during the past three months.
Table #3: Short Term End of Year Performance
Source: Created by the Author Using Mutual Fund Observer
Santa Claus Rally Ho-Ho-Ho!
What does the Santa Claus Rally (last week of December) tell us about investor Sentiment? Anything? Is it where investors are shifting allocations to start 2022 or will it be followed by a New Year's hangover? Of the funds that I track, the following funds had the highest one week total returns at the end of the year. I have divided them into three groups: 1) Those that will likely do relatively well over the completion of the business cycle, 2) Those that will likely do well during normalization of monetary policy, and 3) those that will likely do well during the Middle Stage of the business cycle and okay during normalization.
Investors are betting that real estate, utilities, equity income, value, materials, industrials, and small/mid caps will do well. Some investors are venturing out into consumer goods and international funds. INFL is a newer fund that I track for inflation protection. The worst performing funds that I track were Arbitrage, Bonds, Communications, Convertibles, Diversified Pacific/Asia, Health, Large Growth, Multi-strategy, and Technology.
Table #4: Highest Fund Performance During Santa Claus Rally - Nov Rank
Source: Created by the Author Using Mutual Fund Observer
Tactical Funds
As Ed Easterling of Crestmont Research says secular markets that start with high valuations and rising inflation are times for rowing. Table #5 contains my business cycle allocation strategy along with funds that typically do well by stage of the business cycle. I want a simpler approach where fund managers do the heavy lifting for me. Fidelity Multi-Asset Income (FMSDX) and Eventide Multi-Asset Income (ETIMX, ETNMX) are funds that are adept at changing markets, and may be suitable for a place in a portfolio. This section describes some of these funds. I use Table #5 and my ranking system for the tactical sleeve portion of portfolios.
Table #5: Business Cycle Performance
Source: Created by the Author Using MFO and Portfolio Visualizer
Columbia Thermostat (COTZX, CTFAX): Columbia Thermostat is a Fund of Funds that adjusts its allocations to stocks and bonds based on the cyclically adjusted price to earnings ratio. I own it as a way of automating adjusting portfolios according to the business cycle. Because of high valuations, it is currently about 90% bonds. It's effective maturity is twelve years so it will most likely suffer when rate rise, but benefit when rates fall. I have written about Thermostat in numerous articles such as Uncorrelated Funds for Building a Low Risk Portfolio. I like to invest about 10% of portfolios in it.
Fidelity Multi-Asset Income (FMSDX), Fidelity Advisor Strategic Income (FADMX), and Fidelity Strategic Real Return Fund (FSRRX): I wrote about this trio of funds in Comparing Fidelity Strategic and Multi-Asset Income Funds. They are managed by Adam Kramer, Ford O'Neil, and a strong team. FMSDX adjusts allocations according to market conditions. FADMX invests for income including investment grade debt, high yield debt and emerging market debt. FSRRX invests for return adjusted for inflation including inflation protected bonds, floating rate bonds, commodities and real estate. I view it as a lower risk hedge against inflation than a pure commodities fund.
Eventide Multi-Asset Income (ETIMX, ETNMX): I like Flexible Portfolios where the managers have the ability invest across asset classes. FMSDX is available at Vanguard, but investors may want to consider ETIMX as another fund with good risk adjusted performance.
Columbia Adaptive Risk Allocation (CRAZX, CRAAX): CRAZX is the institutional version available at Vanguard. It has returned over 5% for the past nine years with a maximum drawdown of 12%.
The investment seeks consistent total returns by seeking to allocate risks across multiple asset classes... It may invest in the securities and instruments described herein directly or indirectly through investments in other mutual funds, real estate investment trusts, closed-end funds and exchange-traded funds (OTC:ETFS) (including both leveraged and inverse ETFs) managed by third parties or the Investment Manager or its affiliates.
T Rowe Price Global Consumer (PGLOX): This five year old fund has a Lipper Category of Consumer Goods (Staples), but it has the discretion to allocate across consumer discretionary and consumer defensive. It is currently 62% allocated to Consumer Cyclical. Its performance has been higher than most consumer staples funds with similar or lower drawdowns.
Inflation Protection vs Rising Rates
High inflation usually causes price to earnings valuations to compress, which means lower returns for stocks in 2022. Interest rates often rise cooling demand and decreasing inflation. These are some of the issues facing markets in 2022/2023. Table #6 contains the funds that I track to offset inflation and to prepare for rising rates. They are sorted from highest rank to lowest. This is not your normal business cycle. Valuations and inflation are higher than typically encountered in the middle stage of the business cycle. Aside from inflation protected bonds, FDRR, PZRMX, and FSRRX are doing well. These funds often don't do well in recessions which are deflationary. For this reason, I have scaled back on commodities and FSRRX, locking in gains.
Table #6: Inflation and Rising Rates
Source: Created by the Author Using Mutual Fund Observer
Defensive But Not Bearish Funds
The defensive funds that I track are those that don't do well, relative to the funds that I track, during the recovery phase of the business cycle, but tend to excel during the late stage of the business cycle and during recessions. These are funds worth watching for entry points during 2022/2023.
Table #7: Defensive But Not Bearish Funds
Source: Created by the Author Using Mutual Fund Observer
A Smoother Ride
Are you looking for a smoother ride? During times of normalizing monetary policy, Invesco S&P 500 Low Volatility ETF (SPLV) and BlackRock iShares MSCI Global Min Vol Factor ETF (ACWV) may be decent options. SPLV currently invests mostly in Consumer Defensive, Utilities and Real Estate. It is a good late cycle fund for those who want to keep it simple. While I like PHDG, SWAN, and BAMBX, they may perform better in the late stage of the business cycle when rates are falling than during normalization. I will look for entry points as the business cycle matures.
- Invesco S&P 500 Low Volatility ETF (SPLV)
- BlackRock iShares MSCI Global Min Vol Factor ETF (ACWV)
- Amplify BlackSwan Growth & Treasury Core ETF (SWAN)
- Invesco S&P 500 Downside Hedged ETF (PHDG)
- BlackRock Systematic Multi-Strategy A (BAMBX)
- Vanguard Tax-Managed Balanced Admiral (VTMFX)
Table #8: Funds with Lower Volatility
Source: Created by the Author Using Mutual Fund Observer
Emerging\Developing Markets
What is clear is that if the Fed continues flooding the economy with a tidal wave of new money created from nothing more than a click on a computer, that is not going to be sustainable. Rampant inflation and economic stagnation are the most likely results. Even if the US Dollar continues to maintain its value on Forex markets, its days as the king of currencies are numbered.
Developing markets may offer growth potential but they can be volatile. Rising rates may negatively impact some emerging markets. My preference is for those that are not concentrated in China. Global funds are often an avenue to tap into emerging/developing markets with lower downside than emerging market funds. Table #9 contains funds with high risk adjusted returns (MFO Rating =5) relative to peers.
Table #9: Emerging\Developed Market Funds
Source: Created by the Author Using Mutual Fund Observer
Tax Efficient Funds
Table #10 contains tax-efficient funds as measured by Lipper "Tax Efficiency Overall" from MFO Multi-Search. I filtered the funds based on my ranking system to select fund that should do well over the completion of the business cycle.
Table #10: Tax Efficient Funds
Source: Created by the Author Using Mutual Fund Observer
Model Portfolios
Mutual Fund Observer rates both the following two portfolios as Moderately Risky (MFO Risk =3). Morningstar classifies the following two portfolios as follows:
Your portfolio is moderately risky. Financial planners typically recommend this type of portfolio for investors who have three- to 10-year investment horizons and who are concerned by volatility but not preoccupied by it. Such portfolios often generate a healthy stream of current income.
Vanguard Model Portfolio
The Vanguard Model Portfolio is intended to be simple, following Vanguard's principles. As we move through the business cycle, I will monitor to reduce or eliminate VCMDX and VGWAX and increase VWIAX or short term bond funds. At this point, I like the Global Wellington fund because its holdings are more concentrated in financials, health care, and industrials than the domestic Wellington which is more concentrated in technology. Changes in the direction of the dollar may affect this preference.
Table #11: Vanguard Model Portfolio
Source: Created by the Author Using Mutual Fund Observer
I use Morningstar to evaluate Model Portfolios such as this one. It is 47% in stocks and other with a tilt toward value. This portfolio will face headwinds if interest rates rise, because of the sensitivity to interest rates, but will do well during most bear markets.
Figure #1: Vanguard Portfolio Allocation
Source: Created by the Author Using Morningstar
I do like that the Model Portfolio is tilted to the defensive sectors.
Figure #2: Vanguard Portfolio Sectors
Source: Created by the Author Using Morningstar
And how have these funds performed at the end of the year? The fourth quarter was a good time to buy the dips in utilities and consumer staples. I reduced the commodities fund because of its high performance last year. I also exchanged part of VGYAX to purchase VWELX and VPU.
Table #12: Vanguard Portfolio Performance
Source: Created by the Author Using Mutual Fund Observer
Fidelity Model Portfolio
Table #13 contains the funds for the Fidelity Conservative Model Portfolio positioned for possible inflation and rising rates. In particular, I will monitor FSRRX for its performance with inflation and/or rising rates. EAPCX will be eliminated if inflation abates. NWFFX and FLPSX will be monitored for rising risk. The rest can probably be held through the next recession. REMIX is a newer fund with an unproven track record.
Table #13: Fidelity Model Portfolio
Source: Created by the Author Using Mutual Fund Observer
The Fidelity Model Portfolio is more tactical than the Vanguard Model Portfolio. It is 47% stocks and 11% other with some short positions.
Figure #3: Fidelity Portfolio Allocation
Source: Created by the Author Using Morningstar
I like the tilt away from technology toward healthcare and utilities.
Figure #4: Fidelity Portfolio Sectors
Source: Created by the Author Using Morningstar
And how have these funds performed at the end of the year? It was a good time to add utilities and consumer staples on the dip. Performance was hurt by FSMEX, TMSRX, and FLPSX. I will monitor these over the coming months to see if I want to make any changes.
Table #14: Fidelity Portfolio Performance
Source: Created by the Author Using Mutual Fund Observer
Closing
Now that we are through the end of the year and investors are settling into 2022, we will see if these trends continue. I will review these positions monthly using data from MFO and "rowing" accordingly. Next on my agenda is to build model portfolios for more aggressive Roth IRAs and after-tax portfolios.
I will be unavailable to respond to comments for most of this week.
