Why I am not changing my portfolio even though the yield curve has inverted

On Friday it was reported that the yield curve in the US inverted for the first time since the last (great) recession. This is supposed to be a reliable harbinger for a future recession in 12-18 months.

What does it mean when the yield curve inverts?

It means the US short-term interest rate (as measured by the 3 month Treasury Bill rate) is now higher than the long-term interest rate (as measured by the 10 year Treasury Bill rate). An inversion like this is generally regard as a negative market/economic sentiment that can affect economic and market behaviour.

The yield curve inversion has sent some scurrying to make changes to their portfolios by raising cash, selling riskier stocks and becoming more defensive (buying utilities, telcos, REITS and consumer staples equities).

Why I am not scurrying to do anything on the news:

  1. I already have some cash (about 10% of my portfolio, including high-interest savings and short-duration bonds maturing later this year)
  2. I already have good exposure to defensive equities: ~18% utilities + ~11% consumer defensive + ~6.5% communications services + ~3.5% real estate = ~39.0% defensive
  3. I have less than 50% of our total portfolio in equities so a market downturn should be offset somewhat by non-correlated holdings in fixed income, cash and bullion (this was true in 2018, when my portfolio returned ~+1% in spite of equity drawdowns in Canada and the US)
  4. If I sell something to raise cash there could be tax consequences in our non-registered accounts, due to potential capital gains being taxed
  5. I don’t know which non-defensive equities to sell to raise cash – I like all my holdings for the long haul or I wouldn’t own them
  6. Recessions tend to be short and I believe my long-term portfolio is structured well for riding out short-term events
  7. An inverted yield curve has reportedly accurately predicted upcoming recessions eight times (by some sources) since 1968 but, if on January 1, 1968, I bought and held the S&P 500 (^SPX) I would have made a return of 2.81K% in spite of the eight recessions (including the Great Recession of 2008-09)
  8. According to Forbes, the chance of a recession in the next year is always about 27% (based on their data pointing to 16 recessions since 1960) and today the chance is 30%, hardly more than average
  9. If the chance of recession is 30% next year there is also a 70% chance there won’t be a recession next year which means, based on probabilities alone, I should be buying risk-on stocks
  10. If the US Fed surprises by lowering interest rates, that could change the situation immediately
  11. I don’t know how to time when to start re-buying the risk-on equities I am supposed to sell now – presumably when the yield curve corrects to non-inversion

I am not saying a recession won’t happen in 2019-20. It may well.

What I am saying, as a long-term investor who buys, holds and monitors a portfolio of retirement assets designed for all markets, who relies primarily on asset allocation rules when making security weighting decisions, and who makes limited and selective trades intended to improve overall portfolio quality, I don’t react to news like this.

Do you?

 

 

 

Author: Michael

staff@money4retirement.ca

9 thoughts on “Why I am not changing my portfolio even though the yield curve has inverted”

  1. Michael,

    I really happy with your analysis of the yield curve, using probabilities and multiple sources. I totally agree with the advice.

    A couple of notes :

    No one really understands the causal nature between the yield curve and an oncoming recession. History has nevertheless shown the yield curve to be a very good predictor of bear markets (not always). There are a few limitations to consider. An inverted yield curve in the usa is not enough to create confidence. The world is interconnected and the inversion needs to be prevelent in world rates as well (its not). Also in previous times, no one paid attention to the yield curve inversion, and now everyone and my mother is worried about it. This likely means that its effect is being priced into the market and potentially less valuable as an indicator. At this time, its probably more of a head fake than anything else, but predicting these things are notoriously difficult. Further, there are other leading economic indicators that are still not flashing caution. The recent lyft ipo also suggest that the market is not overpriced…no hype in the ipo market is great for stocks. All these things to me say bullish. My prediction of a strong year remains.

    Good call on the yield curve.

    Raven

    1. Thoughtful comments Raven. Thank you. I don’t disagree with any of them, but we could both be wrong!

      I agree about causality – don’t future rates change based on expectations and sentiment anyway? It seems like rates and market prices are based on the same things. I suppose of course that fundamentals inform expectations and sentiment. /sarcasm

      The real burning issue for me right now, switching channels a bit, is what very long term (20-30 years) average rate to use for estimating total portfolio returns and retirement spending inflation. These two things alone may affect retirement forecasting more than any.

      Predicting the next recession is maybe about as easy. LOL.

      1. Michael,

        That is a good question, and i must say that trying to estimate portfolio return is difficult when building custom portfolios. The problem is related to the diversion away from a benchmark. If you held the market by purchasing an etf you can get a pretty good ballpark idea of long term returns as there is a hundered+ years worth of data to back it up. Most equity markets in the long run return simillar results.

        Your problem and less so mine, is that we diverge away from the benchmarks, and we create volatility related to returns. The more your portfolio is unlike your benchmark the more your return will deviate away. We are both trying to deviate positively i.e. above market returns, but we will run the risk of under performing as well. The more you deviate away from a known benchmark the more it is almost impossible to predict longterm returns. The best you can do is say that your returns will be different. This is why i do not like to deviate too far away from my sp500 benchmark. I like to build some certainty of returns, as i kind of depend on them to live. If i recall, your equity side is devoid of traditional energy, has a large gold play, and relatively large utility positions. I think you are close to benchmarks for financials, and tech as i recall. Basically your portfolio not like a benchmark so your returns are much more difficult to project into the future. All that can be said is that they will be different, maybe good, maybe bad.

        As for inflation, equity portfolios suffer less than fixed income. Dividend growth tend to outpace inflation, and equity assets are subject to inflation as well, somewhat washing out its effect. Rates and inflation tend to be unpredictable, wrecking havoc for bond expectations. As you know i am not a fan of bonds as it increases a portfolios volatility in the longrun. I prefer the higher returns of equity at the expense of higher short term volatility. I dont know if its even possible to predict rates that far out.

        I like to keep things simple, my draw down of 2.5 % happens to be equal to my dividend rate. I can never out spend my portfolio. I would stay well under a 4% draw down, and you likely will not need to worry about forecasting. Underperform the market and this could get you into trouble, especially if you cannot say for certain what your returns will be. Lots to consider here. Not that easy to solve, lots of variables and unknows.

        Lots to ponder.

        Raven

        1. Hi Raven, that all makes sense.

          If I break things down a bit more what is your reaction?

          Does a 4% blended total portfolio return, long term, seem crazy? The breakdown would be as follows:

          Bonds 3.5% (I can get or beat this YTM now)
          Income Stocks 4.0% (3% dividends, 1% capital appreciation)
          Growth Stocks 6.0% (capital appreciation)
          Blended Stocks 5.0% (3% capital appreciation, 2% dividends)
          Real Estate 5.0% (Canadian residential real estate, Ottawa area – assuming a holding there)
          Bullion 2.8% (capital appreciation)
          Cash/Near Cash 1.5% (interest)

          Based on my weightings, this breakdown provides a 4% annual return.

          I would update this breakdown in my retirement forecasts every year to keep current with expectations.

          For retirement spending inflation, I am using the CPI for now (2.15%). In later years I am reducing retirement spending by first 1% per year and then 2% per year to reflect expectations that spending tends to drop off later in life. Again, this would be reviewed annually and spending plans adjusted accordingly.

          Both of these estimates are in current dollars – the forecasting tool can adjust to future dollars as well.

          Annually, as I update my forecasts, if things don’t look as good as expected, I can revise spending in the forecast to compensate. If things look better than expected, the excess funds are automatically reserved for future years assuming I don’t increase spending.

          Not sure I’ve explained the approach fully for you to follow. So you know, the forecasting tool I used is found on Brad’s page on the Ottawa Share Club members’ site: https://money4retirement.ca/brads-page/

          1. Michael,

            I believe in the long run 4% return is actually conservative and not crazy. My point really is that with a custom portfolio that is not like a known benchmark, you will have more volatility against the benchmark. Will you achieve your 4% in the long run? Likely as its quite a low threshold target. If your equity portion manages a market like return of 9% and your fixed income averages 4% that gives you a weighted average of 6.5% .

            The problem lies with the equity side of your custom portfolio. As i mentioned before, your longterm return is unknown, because it cannot be compared easily to a known benchmark. Known benchmarks like the sp500 have 100+ years of data available that can provide a statistically sound probability of returns. An extreme example would be to have a “one stock” portfolio, that is obviously very different than the benchmark. What would be the long term return, say 25 years from now? I have no clue, all i can say is that its likely different than the benchmark, maybe better, maybe worse, but still no clue. There is no certainty of return here. From a retirement perspective, i like to have a good understanding of what i can expect from my portfolio. Since i structure my portfolio to my benchmark, my returns are quite tight around the sp500, -1% to +4% over seven years. Which means i am achieving market like returns.

            I find your portfolio fascinating because it does not follow a benchmark, yet its built for safety and over performance at the same time. Its contradictory in nature, like an all season tire. It has the safety of an asset allocation model, but holds some speculative positions, its using a large gold position to reign in short term volatility similar to your bonds, has basically no energy sector exposure, a high utility exposure. This is why your return will be different. Luck will play a big role in your returns.

            My guess is that over the long run you will achieve somewhere between 4 and 6.5% total return with the assumption that your equity returns somewhere between what the average small investor gets 4% and a market return of 9% , added to a 4% bond return all things remaining equal. Maybe you are special and can achieve better than market, but few can do this in the longrun, i would not count on it. I am happy to achieve market like returns, and ecstatic to beat by 1-3%, but its not something i can expect all the time.

            In the end i think you will achieve your low threshold of 4%, but i really do think that you can optimize your portfolio for better returns and lower longterm volatility. Short term volatility is merely a distraction to the retail investor that causes a flight to fixed income and therefore provides lower returns in the longrun.

            I often ask other investors what they think of my portfolio, this provides perspective, lowers my over confidence and checks my biases. Emotion feeds cognitive errors and biases and is really hard to manage when building portfolios. I would suggest you do the same and ask some key share club members for their opinions, as most are likely much smarter than me. I know you openly publish here, but most people are shy or afraid to hurt your feelings. By keeping an open mind, you can reduce your risk and be a better investor. I believe that is why you publish your portfolio to begin with.

            Raven

            1. Hi Raven,

              So, 4% seems like a conservative rate of return. Good. Even if it is being generated by a custom portfolio. You are really making an argument for buying the market and not trying to pick individual holdings. Maybe that’s what I should do! It would be a lot simpler. What do you think?

              But, you are also making the assumption that past performance is a predictor of future performance. I realize a hundred years of history is something to consider, but you never know what the future will bring. I am not as accepting of future returns based on the past trend. Luck is very important in all portfolios. Luck, like what age cohort you belong to, may be more influential than any specific picks we humble individuals can make….

              My portfolio does have some contradictory features but that is largely by design. I want to offset risk with stability (e.g., tech with utilities). Unlike you, I do mind riding out large price swings even in the short term. It may not be rational but I know myself well enough that I prefer less volatility provided I make my required total return (4% is enough for me, more is just gravy for the vacation train).

              Regarding your remark about a “flight to fixed income.” I already have lots of fixed income. If the equity market falls, my flight will be to equities so I can keep my overall asset allocations balanced. I agree lots of investors sell stocks when they are down and buy fixed income. Not a good idea. In my case, my re-balancing rules would require me to allocate cash or maturing bond money to equities if equities fall too low.

              I may have some others look at my portfolio. Thanks for the suggestion. I am predicting almost everyone will say I need more equities, less bonds, cash and bullion. LOL.

              Would you consider sharing your portfolio here by the way?

              Thanks as usual for your thoughtful comments.

              Cheers. Michael

              1. Yes there is an argument for buying the market, but for those who like to do the investment thing like we do, i would say that as long as you are returning market like returns, its not really necessary to buy the market. But on the other hand if you underperform then you basically just have an expensive hobby. It might be more satisfying to buy ETFs and race Porsches with the extra money, it comes to the same thing really. I have managed to convert a few people to the market ETF club just prior to the beginning of this year. They are all slightly beating me with 15% returns via their simple ETFs. Anyone who underperforms in stocks needs to seriously consider market ETFs.

                As for choosing individual stocks, i think its still necessary to be a good analyst (picker), but realize that the individual stock choice represents less than 30% of your success while sector allocation is far more important at 70%+. For example, if you happened to pick the greatest healthcare stocks ever and loaded up on these, but the market went big on technology this year…it will not matter how great your picks were, you missed the boat and were left behind. That is why a diversified portfolio that has broad economic exposure is the way to go (like a market benchmark).

                Yes, past performance may not play out into the future. This is particularly true in the short run, but not over a 20 year or more period , if you look at all 20 year rolling averages, they are all positive, some higher, some lower but all positive. Lets face it, there are no guarantees in stocks, we all play the game and our returns are what the market calls the equity premium which varies over time. You eventually get paid for the risk, but if it were guaranteed, you would only be making 3% and need more than twice as much money to retire. Equities over long periods return about 9% or so including dividends. It reflects the return on growing economies, so there is a causal reason for these longterm numbers. Could the next 100 years be different, it could, but my guess is that capitalism will continue on its merry way, with ups and downs just like it always has. Its a probabilities game not a certainties game. You and i bet with the odds on our side, we win most years but lose some now and then, but in the long run i think we will do pretty well.

                Please find below my portfolio holdings:

                Biogen
                Ge
                Apple
                Cf industies
                Thor industries
                Amazon
                SAN banco Santander
                Gilead
                Novo Nordisk
                Ing Ing groep
                Cognizant
                Conoco philips
                BCH Banco de chile
                Mondelez
                Cgi
                SAP
                CNR
                TD
                CVS
                Tjx
                BCS Barclays
                Hon Honeywell
                Verizon
                Sp500 call option December expiry

                A few notes:

                I rebalance 2 times a year.
                The sector weightings are primarily based on the sp500, except where i deviate for specific strategies.
                Single holdings are not to exceed 5% during a rebalance.
                Sector Strategies should not cause a portfolio beat by more than 2-3%. The opposite is also true, a strategy that fails should not underperform by more than 2-3%. Basically limiting the size of the bet. The “I could be wrong” failsafe.
                The breakdown internationally is 40% usa, 40% international and 20% Canadian.
                I dont sell positions that are under water unless there is a fundamental problem with the company, i generally buy more during rebalances.
                I dont make sector strategy bets unless i can use data or something tangible to back it…no touchy feely bets permitted, no “i have a feeling” or this tv analyst said buy this…sell that…i feel anxious about the market…the lumps on my dogs head tell me to sell….etc…
                I partially pare down positions that have exceeded my 5% rule at rebalance.
                I do sell positions that have become expensive from a pe or ps or historical perspective. I often buy these back years later when they are out of favour again.
                Number of positions must be between 20-30.
                For complicated sectors like energy and some health care i use representative companies and avoid stock picking.
                GE is a small speculative play. These are not to exceed 1-3% at purchase.
                The call option is a deep in the money call with a 4-1 leverage. Its a presidential cycle strategy on the entire market. Its my primary strategy at this time.

                1. Thanks for sharing your views, portfolio and strategies. Your approach to equities makes sense to me.

                  I don’t know if equities will return their long-term historical averages going forward simply because growth seems to be trending down (e.g., the recovery from the financial crisis has been slower and shallower than previous ones).

                  I didn’t realize your portfolio is as diversified geographically as it is. I had the mid-impression it was mostly US-focussed.

                  I am curious about your call option and the mechanics of the leverage at 4:1. Can you elaborate a bit more?

                  1. Michael

                    The use of options in a portfolio is not something that I recommend to anyone who knows me. However if used properly they can be an effective tool to protect or enhance returns. There are a couple of realities that most people should understand, first is that the vast majority of options expire worthless, second is that the individuals selling or writing options make most of the money when compared to the buyers of options. This can all be verified statistically.

                    So why did i buy a call when the sellers make most of the money and most options expire worthless? Well there is an exception to this and its called a deep in the money options. Before i get into the strategy, i will try to explain how a call option works for your readers who may be less familiar with these. I will avoid the complicated math and try to stay conceptual. A call option is a contract between the buyer (me) and a seller who owns the asset. The seller feels that the market is going to go nowhere for at least six months, so he sells the option to buy his stock at a certain price over a certain time frame in the options market. Remember most options expire worthless. The market determines the value of the option and things like time, strike price and volatility play a big role in determining value. So what is in it for the buyer? Its mostly leverage! When the seller sells the call option he normally does so for a fraction of the value of the stock. The seller is smart, he creates income this way, he can continue selling more options every time as they expire worthless but eventually the stock will move up past the contractual strike price and now he is obligated to sell at the agreed upon price no matter how high the stock goes. So a call option which the seller may have sold for a 1$ per contract or 100$ may now be worth 8$ or 800$ because that is how much the stock moved past the stock price. Basically the buyer controls a stock for a moment in time at a fraction of the value of the stock in the hope that it makes a move up. If he is wrong or runs out of time he loses his investment, if he is correct he makes huge profits. The seller normally wins but eventually loses his position in a contractual sale to the buyer.

                    So a deep in the money call is when a stock goes up in value past the contractual strike where its almost impossible that it will expire worthless. Generally as in the last example, the seller was way off and the 20$ stock (from which he sold a call option) went to 40$ and the option went from 1$ to 20$. So the option after the big move acts very different than it did when it traded for 1$. These are the ones i buy. The option is likely not going to expire worthless, its deep in the money. Its leverage has been lowered simply because its value is so much greater. In this case the leverage is 2:1, the 40$ stock goes up a 1$, so your 20$ option on that stock goes up a dollar since you continue to control it. The stock went up 2.5% but your option went up 5% because you only paid 20$ for it. Its like owning the stock for half price.

                    The same holds true on options related to the broad based etfs. Its a bet on the market instead of a stock. In my case the leverage is 4:1 instead of the above example, so its less in the money than the above example. I paid a quarter of the index cost and i control it for six months. If the market goes up only 5% then my option value goes up 20%. However leverage works both ways, if i am wrong, i will see a 20% loss on that position. The bet is based on the 80%+ probability that 3rd year presidential cycle is positive. In a bull market year a 20% gain is normal, so a 80% option return is not out of the question.

                    I rarely make these types of bets unless i have a credible strategy to back it up…time will tell. For perspective the option only represents about 7% of the portfolio, since i could be wrong. I have also reigned in other sector strategies to compensate on total risk.

                    Note that this is not my first rodeo, i have used this strategy on individual stocks about 6 times over the years. Best returns were a couple at 2:1, a 3:1 and i had two sustaining losses of 10% and 30% . I did have one with a 7:1 gain but it was closer to an at the money option than a deep in the money option…..speculative bet.

                    Caveats: the explanations i have provided are conceptual only, there have been many books written on options and the significant amount of statistical math involved in describing the dynamics of option values and strategies. Also note that i did not consider “put” options which is the direct opposite of call options where your looking at sell contracts. Of interest, deep in the money put options could be used to soften a downward market as their value goes up as the market falls….direct opposite to my call position. Sort of like buying insurance for your portfolio.

                    Hope makes sense.

                    Raven

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