Diversified portfolios perform well during a hiking cycle – a simple and undeniable observation in a recent Fortune article by Joshua Brown @reformedbroker.
The points made in this post elicit my response, as they touch upon the core of my own strategy. I offer not a rebuttal, but rather a discussion of nuance on some of those points.
Point 1. Success of diversified portfolios during tightening cycles over the last forty years. I believe this is mostly a function of the overall secular bull market in stocks AND bonds. Given the short-term negative correlation between equities and fixed income, the diversified portfolio of stock and bonds has been performing extremely well in the idiosyncratic environment of the last few decades.
Point 2. Bonds don’t do too badly during a hiking cycle. Very true. I have observed this historical pattern and it has been at the heart of my bond bullish strategy over the last two years. The fact is, bond investors are usually well compensated for the anticipation of tightening and major surprises tend to arrive on the side of lower rates.
Point 3. Stocks do well during a hiking cycle. Can we agree with that? Here is how S&P500 performed relative to the Fed Funds target during the last two tightening cycles.
As you can see, in both cases the stock market rally continued throughout the cycle and, in one case, even beyond the end of tightening. Both of those rallies, incidentally, were followed by major bear market.
I don’t argue agianst the statement “stocks tend to go up, as the Fed hikes”, but I wouldn’t translate it into the statement “the Fed is about to hike, thus it is good to own stocks”. This would be confusing concurrency with causality. Indeed, the correct causality statement would be “absent a major inflation threat, the Fed continues hiking only for as long as stocks go up”.
Hence, if we have a GIVEN knowledge that the hiking cycle will go on and on, it is reasonable to assume that stocks will be performing. But with this knowledge we can do many other trades, such as short eurodollar futures or five-year notes, or long the dollar.
As we don’t know when the hiking cycle will end, we also don’t know when the bull market in stocks will turn.
Interestingly, this observation doesn’t undermine the credentials of a diversified portfolio. Indeed, this is exactly how it works: the end of hiking and the bond rally cushion us against a possible stock setback, when the economy turns.
Image by Skarphéðinn Þráinsson
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