Friday, February 3, 2017

Three Parts, Part I Dynamically balanced equity portfolio during politically corrupt Fed

Return Objectives:

150 % of NGDP with 60% risk of SP500.
6% current

The “Origin Process”

Axioms of the Origin Process:

  1. Return is sourced from the “origin”" of all return: NGDP;
  2. NGDP return is increased by assets that use leverage - The Origin Process uses SP500 companies. SP500 companies all use leverage which makes for a higher and riskier return than NGDP;
  3.Origin Process does not seek a greater long term return than the SP500, but does seek a lower risk than the SP500;
  4.Along with providing a lower ongoing risk than the SP500, the Origin Process also seeks to mitigate the recession or business cycle impact;
  5.The Origin Process focus is on knowing NGDP and the business cycle. The Origin Process seeks to reduce risk that does not result in return, strives for simplicity and clarity, uses a small number of assets used, and provide offset to the business cycle downturn;   6. The Origin Process uses the SP500 major sectors with the SPDR suite of sector ETFS, the SP500 ETF SPY; and the long duration US Treasury ETF the TLT.
  7. The Origin Process first seeks to mitigate the business cycle risk and then via active portfolio management weight those sectors which in combination provide the optimal use of pairwise correlation with volatility. While return is very difficult to predict, or anticipate, volatility is prescient that results in a useful forward looking view of risk.


  The “Origin Process” is unlevered and long only management process that that is keyed upon the business cycle of NGDP. There are 11 allowed assets which are amongst the most liquid assets available - the SP500 sector ETFs (XLF,XLU,XLP,XLK,XLY,XLB,XLE,XLK,XLI), the long duration US Treasury ETF (TLT), and from time to time the SP500 ETF (SPY).
Origin Process feels a portfolio can be constructed with lower risk yet stay in approximate of the benchmark used, the SP500. The business cycle for NGDP, the US economy, is the most important variable, especially understanding where the economy is currently in the business cycle.
If GDP turns down, no “long only” portfolio will have return, but a correctly structured pragmatic portfolio using the Origin Process will greatly reduce risk and adverse results of a business cycle downturn, reduce ongoing risk, and seek to realize good returns over time. Since Origin Process seeks to capture the innate return of the US economy via the SP500 sectors, and provide a business cycle offset with US Treasurys, there is no need for international assets or to increases with corporates and non-investment grade.      

Table of Contents

1. The source of return for US investors.
2. Analysis applied to the main drivers of return.
3. Mapping the risk management and “insurance” of long maturity US Treasurys.
4. Backtesting to understand the potential return, likely risk and the number of US Treasurys, the weights, that were effective in the past.
5. The extraordinary nature of the current US Treasury rates and the risks it presents
6.Current portfolio construction.

1. The source of return for US investors.

  The basis of all return is the ubiquitous steady growth of the USA economy, measured by NGDP (Nominal Gross Domestic Product - the US economy including inflation). This ubiquitous engine of return is always present, yet few portfolio managers realize 100% of their return is in the end sourced from NGDP and that their management of the portfolio is effective in that context. The most direct reflection of this NGDP growth is the SP500. The SP500 does not have a credit risk, being in general the risk of the USA, and is approximate in credit quality to US Treasurys. SP500 are more volatile the NGDP and US Treasurys given the leverage used in the corporate structure.
There are two attributes that are offsetting for adverse economic moves of the SP500. The SP500 has pricing power in that it can accommodate inflation while being a fixed rate contract, US Treasurys low money in an inflationary environment. The US Treasurys fixed rate contract will do very well during a business downturn and with dropping to even deflationary environment. Since the NGDP over time has inflation and has business cycle setbacks, SP500 will have higher volatility and with leverage outperform NGDP. SP500, but for periodic business cycle downturns experiences approximately double the return of long maturity US Treasurys. Since SP500 and US Treasurys have the same credit, it is the weighting and reweighting of the US Treasury to SP500, with the foundation the growth of the US NGDP, that will allow “Origin Process” to reach the objective return and the objective risk.
Cumulative return of the SP500 - throughout this report since 1980 - plotted against the GDP cumulative growth shows the obvious basic relationship between the US economy and the SP500. If one could stomach the periodic business downturns, for the last 5 years there has been 6 business cycles or systemic downturns, the best strategy is to be always long SP500 with no active management.

2. Analysis applied to the main drivers of return.

The impact of the business cycle is mapped with Cumulative SP500 return netted against the cumulative growth of the US economy.
Since the SP500 is based upon the growth of the US economy, setbacks and excesses of the SP500 are temporary as long as the long term growth of the US economy maintains. (This is why the question of “secular stagnation” is critical to the investor, for if secular stagnation does take place then the backbone of the SP500 return in removed resulting in an adverse investment environment and the only return available being US Treasurys. But we feel that the pursuit of corporate profit is endemic to the US so that secular stagnation will not occur.)
The return of long US Treasurys is approximate of the US NGDP, yet more volatile as the risk of inflation increases and decreases. It should be noted that long US Treasurys show no signs of demand or supply changes - such as increasing or decreasing deficit or quantitative easing by the Federal Reserve.
SP500 cumulative return are mapped against cumulative return for long US Treasurys, and while similar to that previously shown of SP500 to the NGDP, it is “messier” and the six SP500 sell-offs are not apparent. This means a correct mix of long US Treasurys and SP500 that is dynamically and actively managed can reduce the adverse effect of the business cycle downturns.
The correct mix of long US Treasurys to SP500 is keyed to the business cycle, with increased long US Treasury before the cycle downturn and increased SP500 weights at the low point of the business cycle. The current stage of the business cycle can be readily determined by monitoring key macroeconomic indices. It is not necessary to be correctly forecasting NGDP, just approximately which phase of the business cycle.
Given that long US Treasurys are approximate to NGDP, the current yield of long US Treasurys are the most useful macro-economic indicator. Long US Treasurys are in step with unemployment the most used macro indicator and the main tool to set the Fed Funds rate by the Federal Reserve. However, this utility in long US Treasury rates is not applicable when rates are under 2%. So, a more careful read of economic indicators is required. It is not to forecast NGDP that macro-economic analysis is done, but to identify the current phase.

The current phase for NGDP is late stage recovery.

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