Bulletproof Your Portfolio Using the Four Economic Seasons

Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss how our portfolios must be built on diversification, we need to have a plan for all four economic seasons. Watch the Trader Tip Episode for more information!

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!


This economic seasons matrix was developed by my partner Mark and it's something similar to what Ray Dalio came up with, with his all weather fund. The concept here is there are four economic seasons. Inflation, deflation, economic contraction, or recession, and economic expansion, or growth. Our portfolios must be built on diversification, we need to have a plan for all four economic seasons. When we construct our portfolio, we want investments that will thrive in each of the seasons.

One interesting thing is if we look back over the last 40 years, the last 40 years have been dominated by just two of the seasons. That is deflation, and economic expansion. Interest rates peaked in 1982, and interest rates basically went lower and lower for 40 years from 1982, all the way down, really to 2020. During that time, we've had consistent economic expansion. One of the interesting things is that people have been conditioned to only look at investments in those two seasons. In addition, the financial industry pushes investments for these two seasons alone.

Now, there's a couple of reasons for this. One, if you're somebody like BlackRock, or Fidelity, or Vanguard or somebody like that, and you're going to sell a product, you need scale. To make money, you need scale. If you look at the credit market, where we have bonds, corporate bonds, and so forth, that's a market that's trillions of dollars. Then we look at the stock market and the stock market is trillions of dollars. But when we start to get into other asset classes, even big asset classes like crude oil, they are tiny, compared to stocks and bonds. Something like gold is tiny, compared to stocks and bonds. So for somebody like let's say BlackRock, there's no money in it for them to be pushing heavily into these other seasons.

One thing that's important for you to understand is that your financial advisor who's really just a salesman, for the firm he represents, your administrator for your 401k, the offerings for your IRA, these are all being pushed by financial services firms that have an interest in you paying them fees. They push products, in just two of the seasons, deflation and growth, just like we talked about. They don't have incentive to put you in these other seasons. This is why you need to control your own portfolio.

You need to control your own money, and understand that you need diversification. One of the things that's happened this year, if you go back like a year ago, Mark and I talked about that modern portfolio theory, which is the theory that the optimal portfolio for long term growth is 60% equities, 40% bonds. Go back a year ago, we said that modern portfolio theory was dead. In fact, I put out a series of Facebook Lives and webinars at the beginning of the year in which I said your net worth was in trouble. Now, why did I feel so passionately about this? I felt so strongly about this for two reasons. One, everybody was tired of not getting any return in bonds. Bonds were in a place that if you did have an investment in bonds, you really can only lose money. The risk reward was totally against you. If bonds at zero where they're going to go? All you do is lose money. You shouldn't be invested in bonds. But that seems pretty obvious. What did people do? They went, they took the money that was usually in bonds, and they put it into equities, increasing their risk, and that's what I saw. I saw people with either bonds that were could only go down, or an abnormal amount of risk in equities.

The average modern portfolio theory portfolio is down over 16% this year, because both stocks and bonds have lost money, and why is this? Well, one of them is because rates are so low. The second reason is because we got massive inflation, and massive inflation is really bad for bonds, and it's not great for stocks either. That's what we've been dealing with. If we look at that, if we just add commodities, now, commodities have broken quite a bit in the last week, but commodities were up 30-35%, just as of a week or two ago. If you build a portfolio that had commodities in it, they would have really helped offset the losses from equities and bonds, and this would be if we were even invested in bonds. Okay, so a number of the portfolios that we use, have been up money this year, while the average investor is getting clobbered in equities or clobbered in the equity bond mix. We want to add commodities and hard assets as an inflation hedge, things like commodities, real estate, precious metals.

Now, what they don't want to teach you is how do we know what the Fed should do? How do we know when interest rates are where they should be? Remember, the Fed Funds Rate, which is the rate that the Federal Reserve sets for banks to borrow and loan from each other, and from the Federal Reserve. This Fed Funds Rate is set by humans. There's politics involved, there's beliefs involved, all this sort of thing is going on. What we like to do is we like to look at, we like to think of the two year note, the United States two year treasury note yield, as what is the fair value of interest rates, and then we look at the differential between the Fed funds rate and the two year yield, and when they're out of alignment, we believe that the free market does a much, much better job of setting rates than a bureaucratic panel, or bureaucratic committee like the FOMC, the Federal Open Markets Committee.

In this chart, the zero line 0% represents when Fed Funds and the two year yield are the same. But what you'll see is that the Fed Funds Rate kind of oscillates around the two year yield, it gets too far away, it comes back, if it goes too far above it comes back down and gets too far below comes back. The one interesting thing is recently, the US two year treasury note yield has been record high versus the Fed Funds Rate. What this is telling us is the Federal Reserve is way behind in raising rates, and that rates actually need to go quite a bit higher. In fact, the Fed Funds Rate is roughly one and a half percent behind the two year yield. That would say to get this fair, reserve needs to raise the Fed Funds Rate one and a half percent. Now, there's all kinds of issues with this. You're especially seeing this in Japan, but this is going to be an issue the United States and Europe as well.

As the central bank's raise interest rates, the governments have borrowed so much money by their national debts, that their interest costs are about to explode, and so you get into a situation where if you raise rates too much, you're going to absolutely destroy the government and destroy the economy. What Japan is doing is Japan knows they can't raise rates. They're not, and so what happens is either the rates have to go up, or the currency has to go down. The Japanese are choosing to let the currency collapse, basically, we're gonna run into the same thing. The Fed Funds rate is one and a half percent behind that the way I think this will play out is as the Federal Reserve raise rates, I think the two year yield is going to come back to it because if they raise it too much it we are going to be in for a major recession. Remember, how I said that the Federal Reserve is political. There's going to be pressure on the Federal Reserve to not raise rates, particularly going into an election year. That's something you can keep an eye on.

In closing, what are you doing to get your portfolio to be able to respond to inflation, and to be able to benefit in recession? That's the questions you want to ask yourself. Are you heavily loaded up on deflation and growth? Or do you have investments that work in inflation and recession? Because that's an environment we're in. Have a great week. I'll see you next Tuesday for an additional webinar, where we'll share with you different ways to think about training that will take your performance to an elite level. God bless. Take care, bye.