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Each week our investment policy committee meets to discuss different market scenarios and what we are seeing and hearing.
The Fed and the Prisoner’s Dilemma
In the classic prisoner’s dilemma you have two prisoners being kept apart. If neither confesses then they both go free, if one confesses and the other doesn’t, the confessor gets a light sentence and the other gets a harsh sentence. If they both confess then they both get a medium sentence. The Fed is in a similar dilemma when it comes to QE. If they pull out now then they risk the stock market and economy declining and the end of the “wealth effect” they have been trying to create. If they don’t pull out then they risk a bubble, eventually leading to a stock market and economic decline. If the economy enters a full blown expansion on its own, then it probably doesn’t matter what the Fed does, they get off free.
It will continue to be interesting theater to see them try to navigate this dilemma going forward.
Bonds Still Aren’t Dead Yet
Bonds continue to defy expectations as yields continue to decline. We all know that bond yields will be higher in the future but we don’t know when that will be and if they will go lower before they go higher. We even see a scenario where global bond yields, Ukraine, Israel, and Chinese bond buying, drive Ten Year Yields to 2.25%. This all makes the case for being tactical with your bonds. Instead of shortening duration and buying floating rate bonds in anticipation of higher rates it is more prudent to stay in harmony with bond market trends.
Are You Too Diversified?
Frequent readers know that I am a big fan of using underwater correlation to effectively diversify portfolios. Underwater correlation measures the correlation of asset classes or methodologies when they are in a drawdown. So for example, stocks and Treasury Bonds aren’t really correlated on an underwater basis because when stocks go down Treasuries tend to go up. So adding Treasury Bonds to a stock portfolio can help protect against downside risk.
That is only part of the story, because while you can protect from the downside by adding Treasuries you can also significantly limit your upside. So the Holy Grail of diversification is finding asset classes or methodologies that are uncorrelated on an underwater basis but are correlated at other times. This is probably just about impossible to do with asset classes as I can’t think of two asset classes that would have this type of correlation pattern. So pretty much anything you try to put in your portfolio to protect against downside will also probably limit your upside. However, this can be done with different methodologies. For example, a short term counter trend methodology for the S&P 500 and an intermediate term momentum methodology for the S&P 500 might be uncorrelated from an underwater basis but they can both still do well in an up market.