Dynamic Asset Allocation

Multi-factor Recession Portfolio

Close to 90% of investment returns are determined by portfolio asset allocation. The strategies amount to a regime-switching asset allocation model, moving from risk-free assets and defensive equities during periods of high variance to momentum stocks during low variance states.  Skillful selection and sensible timing is the overarching goal.

Bearish Scenario: Equity markets are fragile and an earnings recession is likely.

  • US leading economic indicators down 11 months in a row and at lowest since Nov ’09.  Probabilistic risk points to more downside risk than upside.
  • Debt-bloated companies are repairing their balance sheets rather than spending capital on growth.
  • Small caps (IWM), retail (XRT), financials (XLF), and transports (IYT) are down concomittantly. Shippers’ 6-12 month outlook for freight demand is at a new low, having declined sharply since December 2018.
  • Stocks are overvalued; investors are paying higher prices for lower growth.
  • The government deficit grows ever-larger.
  • The US housing market is richly valued with little alpha generating potential and significant risks associated with deteriorating corporate earnings.
  • Trade tariffs are disrupting complex supply chains that the world has developed for years. This results in economically unnecessary costs, creates investment uncertainties, and increases the risk of broad economic recessions.
  • Baa corporate bond yield vs yield on 10-Year Treasury has declined during SPX rallies in 2018 and 2019.
  • 10-year Treasury yield continues its decline after a series of rate hikes. When the economy is doing well, corporate earnings are good, stocks typically rise, and bond yields move higher. 
  • Financial crises result from excess credit growth. Credit booms go bust.  Systemic risk is approaching historically significant levels ($4 trillion). [1]

Strategy: Defensive.

  1. Rebalance allocations to those that outperform during a bear markets (e.g. gold, USD index, cash, long-term IG bonds, long-term Treasurys, dividend aristocrats, and volatility).
  2. Actively trade long-short strategies. (Buy-and-hold underperforms.)
  3. Listen to the bond markets, not the equity markets. (In 2019, we have the most overleveraged corporate balance sheets in history.)

Bullish Scenario: Equity markets will experience a decline but not a collapse.

  1. Unemployment is low.
  2. Inflation is modest.
  3. Risk associated with 25% tariffs on Chinese imports has been priced in.
  4. The Fed is strategically neutral.
  5. Self-interest will motivate trade negotiations to support investments.

Strategy: Defensive.

  1. Increase relative weight in dividend aristocrats and volatility.
  2. Volatility-scaled time-series momentum strategy.

Note: USD appreciation fueled by global slowdowns and US recession fears.



Portfolio analysis
Asset Correlations
Geopolitical Risk Index (GPR)
FRED Economic Data
Moody’s Baa Corporate Bond Yield vs 10-Year Treasury Yield
FINRA short sale trade data (off-exchange data explained)
Citigroup Economic Surprise Index (Economic Indicators)
Discounted cash flow valuation model
Selection process: Correlations and Dividend Analysis

  1. Engle, Robert F. and Ruan, Tianyue, How Much SRISK Is Too Much? (September 27, 2018).