The 60:40 is dead and buried. Trading Portfolio;Momentum update.

Trading Portfolio; Momentum 1st of October 2022 update.

Over two years ago the real money portfolio Trading Portfolio; Momentum was started in order to beat the S&P 500 index using a proprietary equal weight momentum method.

In this blog it is time for a relative return evaluation.

Also a new objective rule for the proprietary equal weight momentum method will be introduced that will be used going forward.

Last but not least some observations on the so called “safe” bonds and the performance of the 60:40 portfolios in 2022 so far.

Above new rule for the Trading Portfolio; Momentum picture

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The online safety bill is not an “open for business” policy.

So after that rant and disclaimer first things first; on the 1st of July 2020 Q3 the Trading Portfolio; Momentum strategy started with $50000 in investments in S&P 500 index companies. Now on the 1st of October 2022 the portfolio is worth about $ 60023. The cash dividends of Q3 have already been taken out of the portfolio.

The absolute return has been fantastic since July 2020. The starting point was $50000 in July 2020. Of course inflation adjusted the absolute return looks a lot less interesting. The absolute return in 2022 has been very bad. The portfolio lost a cool $16639 so far in 2022. That equates a return of about -21.7% in 2022.

Still that falls in line with expectations for the US stock market to go up around 70% of the time on average and down around 30% of the time. In other words 2 good years and 1 bad year is the “normal” which of course tells us absolutely nothing of the sequence of returns and when the bad years will happen. Global central banks hiking interest rates all at the same time in 2022 is doing a good job of letting the air out of all the assets bubbles.

The absolute return is not what is being measured here though.

How has the relative return versus the S&P 500 index fared?

Because if the relative return underperforms, it would have been better to just put the $50000 in an S&P 500 ETF and sit back and relax.

An S&P 500 ETF can be expected to modestly underperform the real S&P 500 index returns, because of the drag of the management costs of the ETF (the expense ratio etc.). The VOO Vanguard 500 index fund ETF was put in a paper portfolio with two portfolio tracking websites. On the SigFig website the paper VOO holding would now be worth $58109. In the Stockrover website the paper VOO ETF holding would now be worth $57915.

In Q3 2022 the S&P 500 first had a big bear market rally before giving up all those gains again and testing and making new 52 week lows at the end of the quarter. During the bear market rally the Trading Portfolio; Momentum massively underperformed. The momentum stocks that are currently ranking good are all really defensive (pharma stocks etc.). Also the number of stocks with good momentum is decreasing for every month that goes by. Soon all the active investors will be hiding in the same 20 stocks in the US stock market. When this bear market finished there will be a huge toxic waste rally as previously discussed. Stocks can only go down 100%. Stocks can go up more than 100%. Some of the losers of this bear market will go up multiple times 100% when the next bull market one day starts. This is something to keep in mind during this time of doom and gloom.

So the Trading Portfolio; Momentum outperformed the VOO Vanguard S&P 500 ETF by about $1914 or 3.2% after 2 years and about 1 quarters ((60023-58109)/58109). So the relative performance in Q3 2022 did not change a lot versus what is was at the end of Q2 2022. Still of note was that in the bear market rally from June-August 2022 first almost all of the outperformance was lost. The Trading Portfolio; Momentum was in Q3 invested in an ever shrinking number of “defensive stocks” that still maintained some momentum versus the broader S&P 500 index. The outperformance was only clawed back after the FED chair did his gorilla dance on having Volcker credentials at Jackson Hole Economic Symposium and since. Sorry Jerome Powell but you are no Paul Volcker.

Close to two years is still way too short to be able to draw any conclusions with some amount of conviction; time horizons of between five to seven years or longer are needed for that. Still the early conclusion can be that so far the Trading Portfolio; Momentum was a waste of time and effort. For Holland Park Capital London for the Trading Portfolio; Momentum experiment to be worth it in the long term the outperformance versus the S&P 500 ETF needs to be closer to 2% a year.

A new rule for this experiment will have to be introduced now to protect the Trading Portfolio; Momentum against a future toxic waste rally.

The recession definition on Google states that a recession is a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters. Now the US has some wishy washy subjective definition of a US recession when the National Bureau of National Research (NBER) announces a US recession. This is usually way too late and therefore less useful. Let’s use a fall of US GDP in two successive quarters instead for our new rule.

Real Gross Domestic Product (GDPC1) | FRED | St. Louis Fed (stlouisfed.org) The above website of the St. Louis Fed had the real Gross Domestic Product (GDP) for Q4 2021 as 19806, for Q1 2022 as 19727 and for Q2 2022 as 19699. So GDP in the US for Q1 and Q2 2022 showed a fall in GDP for two successive quarters. The Q2 2022 GDP first estimate of 19699 was released on the 28th of July 2022. That Q2 first estimate GDP release was after the rebalance for the holdings of Q3 2022 had already taken place.

So this new rule would not have changed anything in the real money experiment, but will now change the experiment going forward. So the experiment’s structure is still credible and repeatable.

The new objective rule will be that whenever the above two negative quarters happen in the US the Trading Portfolio; Momentum will solely go equal weight the S&P 500 index until the St. Louis Fed website shows two successive positive quarters.

This rule would have saved the portfolio in 2009 from the toxic waste rally. The new rule would not have worked in the toxic waste rally of 2003 as US GDP never went negative for two quarters in that period (as far as the St. Louis FED website shows now).

Hopefully some of the damage of toxic waste rallies at the start of new bull markets can be avoided with the new rule.

When all quant’s and factor followers, mutual fund managers and hedge funds are hiding in the same small number of defensive stocks and sentiment changes the price action can be violent to the upside.

A rebalance once a quarter is going to be way too slow when the new bull market starts one day. Some of the most beaten up names can literally move from pennies into pounds in the space of a couple of weeks then.

So by the Google definition the US is now in a recession and therefore the new rule gets activated.

For Q4 2022 the Trading Portfolio; Momentum was rebalanced yesterday as much equal weighted as was possible with a portfolio of only about $60000. The expectation is for the now equally weighted portfolio to small underperform the VOO Etf in down markets but to outperform in up markets. That is because equally weighted portfolios tend to outperform on the way up and underperform on the way down. That creates an expectation of first some small underperformance in the next 6 months or so for the Trading Portfolio; Momentum. Hopefully that small underperformance will turn into big outperformance as and when the toxic waste rally happens and introduces the next bull market for US stocks.

Of course it would have been easier to simply buy the Invesco S&P 500 Equal Weight Etf (RSP) (expense ratio 0.2%) than most of the underlying names of the S&P 500 index. Sadly the insanely stupid Mifid II regulation does not allow European investors to buy US listed Etf's as these US Etf's do not have some EU box ticking documents that nobody reads.

Finally inflation in 2022 has rocketed higher globally as everyone knows. Cash is worth now 10% less or more than 1 year ago in most countries thanks to inflation. The end of quantitative easing (just a fancy way of saying money printing) also has seen all asset classes trading at lower valuations and multiples in 2022.

Just about the only two good assets in 2022 were the US dollar $ and maybe the oil price/gas price assets.

Even gold is down in US dollar terms, but of course gold has held up well in weaker currencies like the Turkish Lire.

Inflation has now peaked and is slowly on the way down. By this time next year we might wish we had some inflation.

The 60:40 portfolio in the US in H1 2022 was down 16%. The 60:40 portfolio in the US had the worst H1 performance in more than 2 centuries (source Man Group).

Correlation is not causation. Just because stocks and bonds may have had an inverse correlation in the past doesn’t mean that that inverse correlation will protect investors in 2022 and in the future.

Holland Park Capital London Ltd has long warned against the folly of owning bonds when central banks have manipulated bond prices to historically unsustainable low levels.

Jim Rogers called it the biggest bond market ever historically and made it clear the bond market right now is still in a bubble.

If a stranger asks you for a loan at what interest rate would you let the stranger borrow money? The minimum interest rate to borrow money to a stranger would surely be closer to 5% than 1%.

Only central banks can explain the logic of negative interest rates as Holland Park Capital Ltd is too stupid to understand that.

Would you loan money to a stranger for a minus -0.5% interest rate?

Even without taking inflation rates into account that simply does not make any sense.

Sadly pension regulators have insisted that “bonds are safe” so a lot of people have their pension invested in a mix of bonds and stocks for their pension. Typically a lifestyle fund for a 60 year old would invest 60% in bonds and 40% in stocks. The logic that those pension investments follow is that the higher your age the more one should invest in bonds and the less one should invest in stocks.

Pension regulators also mistake volatility as being the same as risk. Volatility may be the same as risk when you are trading on margin, use leverage, have shorts, own derivatives or invest short term. For long term buy and hold investor’s volatility clearly has nothing to do with risk. If anything for long term buy and hold investors volatility can present an opportunity to pick up some bargains. Because equities in the short run are volatile pension regulators hate equities.

All assets are risky and all assets can go to zero.

That is why it is called investing in the future. Buy and hope. Even an investor in cash has made a risky investment decision (remember inflation?). You will by definition have to take risk somewhere in order to make money with investing. Safe assets do not exist. If someone claims an asset is risk free then that is the asset that is most likely to blow up in the next crises as everybody is likely to own that asset and that asset is likely a crowded long. Warren Buffett told CNBC on 26 February 2018 that he believed long term investors should buy stocks over bonds.

"If you had to choose between buying long term bonds or equities, I would choose equites in a minute".

Stocks have not had a great ride either in 2022, but Holland Park Capital is convinced that in the long run a diversified basket of stocks will recover to new all time highs. For bonds though Holland Park Capital thinks it can get a lot worse from here.

Central banks have manipulated interest rates since about 2009. The bond markets will have to find out the natural levels of interest rates without central banks constantly expanding their balance sheets. The central banks manipulation lasted over 12 years.

How long is the unwind going to take? Another 12 years?

We are still in an age of financial repression in the west.

When in Brazil the inflation goes to 10% the Brazilian central bank raises the interest rate to above 10% in order to have a positive interest rate versus inflation. In Brazil in the previous month the inflation was 10.07%. Brazil’s interest rate is now 13.75%. Brazil’s equity market is one of the few stock markets that is trading up year to date (5.56%) globally. That might have something to do with a normal interest rate policy of the Brazil central bank.

In the west the inflation rates are still deeply negative versus inflation. In the UK the interest rate is 2.25% as of September 2022. The inflation rate is about 10%. The financial repression rate is bigger than 7% in the UK. Even if inflation in the UK does go down to 5% in 2023 the interest rate in the UK needs to rise to above 5% to end the financial repression. That still leaves a lot of downside for Western bonds if central banks ever decide to normalize interest rate policy.

On the bullish case for stocks let me quote from Eoin Treacy of Fuller Treacy Money who has summarised it much more eloquently than Holland Park Capital can;

“Inflation probably has peaked but that is not a commentary on how quickly it comes back down. The bullish narrative for inflation is that the pandemic was an anomaly. The surge in inflation was created by supply shocks and liquidity-fuelled asset price appreciation. With the end of the pandemic and less money supply, inflation will fall back as quickly as it rose, so buy the dip”.

Holland Park Capital’s view is that the pandemic lasted about 2 years. Lockdowns did a huge amount of damage to the supply side of the world economy. Western central bankers went crazy printing money and expanding the money supply in those 2 years. Both problems got exacerbated by the Ukraine disaster that started in February 2022 and that one is ongoing and still hurting especially the European economy.

So fixing the above mess is likely going to take about 2 years as well. That will take us into the beginning of 2024 before the world economy has found some balance again. Until 2024 every time Western central bankers try to lower interest rates, inflation is likely to roar back just like Covid did after the end of every lockdown. So there might be another one and a half year left to buy the dip in the stock market before the start of a new and proper bull market.

Here is a genius quote from Druckenmiller on our beloved central bankers;

“They are like reformed smokers. They’ve gone from printing a bunch of money, like driving a Porsche at 200 miles an hour, to not only taking the foot of the gas, but just slamming the brakes on. “

Nice driving skills from the central bankers indeed Mr. Druckenmiller!

Going from zero interest rates to interest rates of 3 to 3.25% in the US in 2022 in 9 months is too much and too fast. When the FED lifts the US interest rates above 4% too soon this year some things in the global financial system are likely going to break.

Any other Western central bank that thinks they can hike interest rates to lower levels and slower than the US FED basically risks a run on their currency and importing even more inflation thanks to a weak currency.

Things will break. There is way too much debt out there. The question is only what will break and when.

Who has been swimming naked now that the tide is going out?

Western central banks have been blowing the biggest debt bubble in history ever. Everyone is a debt junkie now. Western debt levels are at least four times higher than in 1980. So the higher interest rates will do much more pain to Western economies than in 1980. Recessions tend to end when the central banks are getting scared and take countermeasures like TARP in 2009 or QE4 in 2020.

Just last week we saw the first blow up. According to a source in the FT 90% of the UK defined benefit pension schemes was about to blow up because of margin calls last week. The defined UK benefit pension schemes are worth about 2 trillion pounds (£). If 1.8 trillion pounds worth of UK defined benefit pension funds does blow up that 1.8 trillion £ number is simply to big to be rescued.

The Bank of England did a quick pirouette and “paused” quantitative tightening (QT) and opened the QE floodgates again on “whatever scale that is necessary”. The Bank of England’s plan from only the week before to sell 40 billion £ worth of UK bonds in the UK bond market in one year was never going to end well.

What were the good people at the Bank of England thinking?

The most boring topic in financial markets is the market structure. You can compare it to the plumbing of the global financial world.

Giving regulators more powers as a reward for failure in the financial crisis has changed the market structure or plumbing a lot in the last 10 years.

Very few people understand the plumbing properly but one of the few such people in the City of London told Holland Park Capital London a couple of years ago he was really worried about the plumbing of the global bond market and especially the European bond market. He said that all the liquidity in the bond market was gone and the liquidity was already not great during the financial crisis in 2008 and 2009....

Investment banks are not allowed to provide liquidity there anymore. Market makers have been bankrupted by onerous regulation and ever lower interest rate manipulation of Western central banks. Stupid EU Mifid II regulation was the final nail in the coffin for bond market liquidity.

Well he was right.

Some genius pension regulator in the UK scared all the defined benefit pensions out of equities and into bond leverage combined with derivatives. Apparently defined benefit pension schemes in the UK were allowed to leverage their bond holdings. They lend out the bonds they owned to investment banks and used the income to buy even more bonds and levering up and entering in interest rate Swaps and buying other assets with the money received from the leverage. Of course the investment bank reserved the right for a margin call if the underlying value one day went down. Down the underlying value went this year. The pension funds called this Liability Driven Investment (LDI). The UK pension funds did not just hedge interest rate risk. No they used leverage to leverage up to their eye balls.

As Jim Rogers said; anything is dangerous if you don't know what you are doing. If you want to be a successful investor, be extremely boring.

Basically in risk reward terms the UK pension funds were reaching for yield with very limited upside and unlimited downside. Traders call that collecting pennies in front of a steamroller.

If you get regulation wrong (and they did; again!!) than everyone will blow up at the same time.

The same happened with banks thanks to the Basel regulations. Triple A was safe according to Basel and banks did not need to hold any capital against it so all the banks blew up nicely at the same time in the same Triple A subprime boat in the financial crisis and were about to blow in the Greece Triple A rated bonds boat.

It is always the same. Central Bankers first allow bubbles to form and central bankers blow extra air in the bubble. Excess leverage and/ or derivatives will then collapse the bubble.

It is like regulators and politicians decide they know best how to get your boat over the oceans safely. So instead of a lot of different boats with different captains the new regulation states they will all need to go aboard one big huge ship. It will be unsinkable is the promise. Once everyone is onboard and the ship is going in mid sea the big huge ship is hit by an iceberg. It turns out the regulated big huge ship is not unsinkable at all. Bye bye Titanic.

Sometimes it is better to have no regulation at all than stupid regulation.

It is better to have some small boating accidents and not a big huge accident.

The few and small accidents don’t all happen at the same time so the coast guard is not overwhelmed and can offer help.

When an accident occurs that is huge and big everyone is blowing up at the same time and the coast guard will be overrun and overwhelmed.

Regulators are overconfident they know what is best.

Usually they don't as box ticking regulators simply miss the expertise to design fail proof regulation.

No doubt the UK pension regulator will ask now for a reward for failure of a lot more money and resources creating even more bad regulation.

Instead the UK should forbid new defined benefit pension schemes and move into defined contribution pension schemes and close down the UK pension regulator.

In your defined contribution pension self invested pension plan (SIPP) you are rightly not allowed to play around with leverage, Swaps and derivatives.

So SIPP's will be a lot safer than collective pension schemes and the blow ups will not be all at the same time and a lot smaller. If everybody invests differently it makes the system’s plumbing stronger and less fragile.

Holland Park Capital London was not planning to rant about the UK in this blog and has failed miserably at that again.

The forward looking P/E ratio of the S&P 500 index is about 15.1 (according to Yardeni) now. That is a normal valuation with good long term returns prospects for the S&P 500 index and our collection of lazy longs now in the Trading Portfolio; Momentum. Of course we first need to get past an S&P 500 index recession induced earnings hick up in 2023.

We are in a recession, but 2022 stock dividends are forecast to deliver a new record of $1.52 trillion (source Janushenderson). That is up 3.1% from 2021.

Stock investors that hold on to their diversified basket of stocks for the long term are getting paid to wait for better times. Dividends can also be re-invested to buy more stocks for the long term. Lots of loose hands in the stock market have already panicked and sold out and are in cash now or are in short term US treasuries. Of course cash will just as surely lose some of its value this year thanks to inflation.

Let’s sit front row and wait for something to break in the US. Only then will the US FED panic and that will signal the end of this bear market. As Mr. Connally said in 1971; "The dollar is our currency, but it's your problem".

Quantitative tightening with letting bonds mature is reasonable. Quantitative tightening by selling bonds in the bond markets that are already wading deeply in blood this year is irresponsible and unforgivable and will never end well. Pervasively QT that sells bonds in the open bond market has a huge chance of expanding the central bank’s balance sheet, because if things break the central bank will probably announce more quantitative easing (QE) just to calm financial markets down. The proof of that happened in the UK last week.

Anyway thanks for reading and good luck!

The blog is not advice on what you should do with your money and was written for information and entertainment purposes only. When you invest in the stock markets it is possible to lose money. Please do your own research. If in any doubt what is best in your individual situation, please hire a licensed financial advisor. Good luck on your investment journey.

Holland Park Capital London hopes you enjoyed the information in the blog. Holland Park Capital London Ltd is not receiving any compensation from anyone to write this blog. Holland Park Capital London is long most of the stocks in the S&P 500 index and is also long the S&P 500 index ETF. Holland Park Capital London has no business relationship with any company whose stock is mentioned in this blog. Holland Park Capital London expressed its own opinions. This is not advice. Make your own decisions please. Please go and see an authorized financial advisor before making any investment decisions. What works for Holland Park Capital London may well not work for you and your personal situation is unknown to Holland Park Capital London. Stocks go up as well as down and you may get back less than you invest. Any information in this blog should be considered general information and not relied on as a formal investment recommendation. This blog is for information purposes only and helps Holland Park Capital London expand on the book “Beat the Stock Market Casino” and brings extra discipline in the investment process. Holland Park Capital London is not liable for any mistakes in this blog. This blog cannot be a substitute for comprehensive investment analysis. Any analysis presented in this blog is illustrative in nature, limited in scope, based on an incomplete set of information and has limitations to its accuracy. The information upon which this blog is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore the accuracy cannot be guaranteed. Any opinions are as of the date of publication and are subject to change without notice.