Going into 2024 the CSPM™ asset allocation model looks like this:
- Equities overall, are rich.
- Long-Term Bonds face supply headwinds from large increases in debt and credit expansion.
- Shorter-Term Bonds and cash equivalents have attractive yields. Credit Spreads on Corporate Bonds are historically tight, agency mortgage spreads offer value.
- Allocation to Alternatives, represented by Gold, has a history of price increases in bull markets, and defensive trends in economic stress scenarios.
The Economy
Unfortunately, the component parts of an economic downturn are in place:
- Labor Participation is poor, and Labor Productivity has not picked up the slack.
- The demand damage caused by recent inflation portents a market correction both on main street and wall streets.
- Debt expansion is significant at Government, Corporate, and Consumer levels.
- The tone of either a decline in globalization or domestic exceptionalism is not helping.
Unemployment is low because labor participation has not recovered from COVID and longer-term it has declined significantly. A 6% loss in workers since 2000 is a large decline.
The productivity of a smaller workforce has been leveling off. Likely domestic concentration of service industry employment is a factor, yet the % efficiencies in production have been waning for years.
The demand damage from inflation was considerable, taming it now is a hollow victory. The Fed is high-fiving themselves for trying to fix the problem they created by allowing the cost of capital to go to zero.
The debt expansion has been significant. Even the world’s greatest debt restructuring may not be able to put the budget back together again.
Equities
- Risk-Free interest rates are higher so Price-Earnings Ratios should be lower.
- The consumer is running out of ammunition.
- Cash-rich technology stocks sell at extremely high multiples of earnings.
The current short-term interest rate and equity valuation looks eerily comparable to those in 1999-2001 and 2005-2007. It takes time for higher interest rates to impact markets, even more so where mortgage holders have fixed rate mortgages and investing in assets with dubious value is commonplace.
$1 Trillion in credit card debt and counting. The $8 Trillion in stimulus initially spent by consumers was not enough, replaced with money at 20% plus interest rates.
Consumer payment issues appear in mid to smaller sized banks as the larger banks cut better payment deals extending minimum payment plans for months. Eventually, delinquencies spread to all banks and will put credit pressure on consumers.
Low debt/cash rich technology stocks were a good play, but prices are at unsupportable levels even with aggressive earnings growth projections. Take away these tech giants and the S&P 500 is still expensive.
Fixed Income
- The yield curve is upside down (inverted) and the supply of treasury debt coming to market is ever growing.
- Credit spreads are at historical “tight” levels and the high issuances of public and private debt are growing and will need refinancing.
- Mortgage spreads are historically wide and callable agency debt also looks attractive when interest rates pop up.
The yield curve inversion is about 1 percent (4% long-term minus 5% short-term). The market is pressuring the Fed, its puppet, to lower interest rates. Longer-Term rates face lending supply at levels never contemplated at the national level.
Credit market yields are not attractive when you look at the “spread” to like duration treasury assets. AAA, BBB, and Municipal bond spreads are only in the 10th percentile of historical distributions.
As 10-year treasury interest rates increased we purchased agency mortgage-backed securities. The mortgage spread to treasuries wider (cheaper) as the supply of new securities is smaller consistent with poor housing affordability. We also see value in “callable” government agency bonds.
Gold
- Purchases by Governments have expanded in recent years.
- Gold performs well in stress scenarios and has continued to increase in value with “safe haven” demand buoyed by high debt levels and currency volatility.
When central banks are ramping up the purchase of gold assets, the largest buyer in the $4 trillion annual gold market, expects volatile economic times.
Gold returns have been comparable to equity returns this century. More importantly, in investment stress periods defined by large stock and bond declines, Gold has held its value.
Appendix A – CSPM™
The Common-Sense Pricing Model (CSPM™) is JMN Investment Management’s capital allocation model. Market participants utilize the Capital Asset Pricing Model (CAPM) to determine portfolio design amongst various market sectors including equity, bond, and alternative investments.
CSPM™ model is a modified version of the Capital Asset Pricing Model (CAPM). The CSPM™ seeks an improved process to capture how wealth managers make asset allocation decisions as they look at history, adjust for the current market, and “hedge” for stressed markets.
Like CAPM, the CSPM™ determines the portfolio mix of assets resulting in the highest return/risk profile within a range of risk. The major differences in the models are:
- in the calculation of returns and risk, CSPM™ limits or increases category investments based on comparison to all asset classes and not just the “risk-free” asset class.
- CSPM™ significant difference to CAPM is risk “buckets” and expected returns are not linear (risk down and returns up) as history reflects idiosyncratic valuation, risk, and economic volatility periods, so we need to adjust allocations accordingly.
CSPM™ – Calculation of Risk & Return
The CAPM skews allocation looking solely at a six-month treasury asset. Decisions skew to overallocation to “risk” assets as the “risk-free” asset approaches zero and under-allocation as interest rates rise significantly. The expected return formula for CSPM™ is:
Maximum Of:
Expected Return = Alternative Asset Yield + Beta * (Risk Premium to Alternative) or
Expected Return = Risk Free Rate + Beta * (Risk Premium to Risk-Free Rate)
The priority is wealth preservation with a secondary objective of growth (or income). Risk category 1 is essentially “risk off” in any market with wealth maintenance the goal. Risk category 6 is for investors that can stomach larger valuation swings and view overall risk differently. Setting risk limits is in the eye of the beholder. Surely there are Bond, Stock, and Metals “bulls” that consider their markets less risky (or defensive) due to comfort within their favored spaces.
Mr. Krsnich has 37 years’ experience in financial analysis, securities trading, and executive management. Mr. Krsnich was the Chief Investment Officer of Countrywide Financial Corporation in the early 2000’s. Mr. Krsnich determined that the secondary market for mortgage-backed securities was paying prices that did not compensate them for credit risk investors were taking. This view, not shared by other executives, led to his departure in 2005 described in the New Yorker 2009 article “Angelos Ashes”. In 2007, “the collapse of the mortgage market predicted by Krsnich finally occurred”. Mr. Krsnich started JMN Investment Management (JMN) in 2006 to provide financial industry consulting and started a hedge fund to purchase Non-Agency Mortgaged Backed securities. JMN has consulted top financial institutions and hedge fund managers; JMN’s hedge funds returned 50% and 27%, over consecutive 18-month periods in 2008-2013. (See Wall Street Journal – Investor Escapes Trouble) JMNARM managed accounts purchased non-agency RMBS bonds from 2013 to 2020 outperforming fixed income and competitive benchmarks. JMN Income Opportunities (JMNINCO) has easily outperformed equity income fund competitors over the last 26 months. JMN’s Common-Sense Pricing Model (CSPM™) provides the asset allocation to JMNINCO and is now available to JMNINCO investors and subscribing clients. CSPM™’s Wealth Allocation report is issued semi-annually with quarterly asset allocation updates.