Don't put all eggs in one basket

S2N spotlight

Many of us are focused exclusively on the stock market, ignoring other asset classes and the benefit of diversification. Growing wealth requires compounding returns over many years. The best way to achieve this is through adopting an approach that produces good risk-adjusted returns. We all love the big returns, but when the big drawdowns inevitably come, we tend to be unprepared and change our game plan through fear or the necessity to sell because of overexposure. This defeats the strategy of compounding returns consistently over time.

I will share 2 basic portfolios, and in future letters we will add to these 2 and look at ways to enhance them.

The first is a simple 60% stock and 40% bond portfolio. I have used the bonds’ total return as yield is the primary component and not included in a normal price time series. I have said it so many times, it is worth repeating: you really need to try and see returns through a risk-adjusted return lens. I like the Sharpe Ratio; it is the gold standard.

This portfolio outperforms with a Sharpe Ratio of 0.65 over the last 20 years.

Two asset classes is perhaps a little too restrictive. So in this portfolio I am going to include gold. I am not going to add a big %; it is tempting because we know gold has been a huge performer, but gold should be seen as a hedge against inflation (more on this below) and a store of wealth against a devaluing currency. In this portfolio we take 5% away from stocks and 5% away from bonds and give 10% towards gold.

This portfolio does even better with a Sharpe Ratio of 0.75.

S2N observations

I mentioned earlier that gold is often perceived as a hedge against inflation. Not so fast.

This chart is somewhat counterintuitive; it suggests that the rolling 10-year inflation does not drive the 10-year real or nominal return on gold over the last 50 years. There is a lot in this that needs further examination but is something interesting to chew on. I am referencing Professor Campbell Harvey’s latest paper for Research Affiliates.

What is interesting is that the German DAX is about to make an all-time high. I nearly jumped out of my skin when I saw how high this index had jumped. I still think that the high is in for the S&P 500, and we will soon be making new 52-week lows. This would be a fitting diverging non-confirmation if the DAX makes a new high not to be followed by the main US markets. Read potentially bearish.

The Nasdaq 100 has met with some resistance at the 200-day moving average. Only 23% of the Nasdaq 100 index stocks are above their 200-day.

Corn and Oil are also looking particularly weak. In terms of their technical look, these 2 charts are weaker than my knees on a big surf day at Bondi Beach.

S2N screener alert

I promise you that you won’t see a currency producing a 17.99 Z score every decade. This is a super rare event. I am showing the less popular combo of TWDUSD vs. USDTWD, as this shows clearly that the Taiwan dollar is strengthening.

The Taiwan dollar surged 5% due to uncertainty over future U.S. dollar inflows, as Taiwan, traditionally relying on exports and a weak currency, now faces a more unpredictable trade environment due to the ongoing trade wars. Taiwan's pension funds, which had long been unhedged in anticipation of steady dollar flows, are now recalibrating in response to these shifts. I am sure this is not the end of sudden explosive moves as the trade wars’ effects send shockwaves through the system.

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