Bonds are not a good hedge if inflation is high...
60/40 can be risky too + Play inflation stock breakouts if inflation is high!
Just wanted to shoot out some important correlations:
The above basically means that if inflation is above 2.5%-3.5% bonds do not work well as a hedge for your long book. But if you long book is long inflation, then the long book hedges basically the bond exposure.
That can be seen here: A small cap value momentum strategy (which is doing well in inflation) hedged with longer term bonds ($TLT). So that works pretty well, even if inflation >3.5% because then the longs hedge the bond exposure.
So, if inflation comes down from here, $TLT might be a good hedge for a long inflation book.
But that would be a directional call, the call that inflation from here gets down.
What is my macro framework today (today, it can change fast!):
I am in the camp that I think that inflation will persist much longer than most think.
But I also think it will not get higher from here, e.g., ROC will be down (enough for bonds to go up, that is the question!).
But I understand the risk if inflation is going to get down from here for my long book.
If that happens, deflation is the probable outcome, since I do not think that we get a monster uptick in growth here.
Therefore, I stay with the Russel 2000 Short because the Russel 2000 is doing poorly in an inflation regime and in a deflation regime.
Also, I can be (relative!) sure, that if my stocks are down hard, IWM will be down hard too and do not have to worry about days where my stocks are down and TLT is down too (which is extremely frustrating if your chosen hedge does not work!) because inflation is above 3.5%.
Furthermore, I have to think about the fact, that my portfolio is in Dollar, but I live in Europe. In a deflation regime, the dollar goes up, another great hedge.
At least I want to wait until $TLT is printing higher highs until I consider it.
But consider risks of a 60/40 portfolio (60% Stocks / 40% Bonds): If you are long growthy stocks and long bonds in a regime where inflation gets above 3.5% (and gdp ROC down = inflation (read stagflation) regime) you will lose big time on both ends!
To put it in another way:
The red line is a small cap value momentum system.
The green line is $ARKK (high beta growth names).
See what happens to growth names when inflation ticks up (that call was made by 42macro.com mid-November and has been discussed in a video with 42macro.com and me beginning of December)? They get killed!
Small cap value momentums beauty is that it works great in goldilocks, reflation and inflation, but gets destroyed in deflation.
So, to take on the less risk I start to hedge my long book (small cap value momentum) in a inflationary regime (which leads sooner or later to a deflation regime most of the times) to be protected right from the start.
BUT!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
If you are a CANSLIM breakout trader, do not miss out in an inflation regime with really high inflation (let us say >3.5%).
From what I have seen in the last months breakout on inflation stocks work great in a big time inflation regime.
$VTNR is a great example (got it yesterday!!!):
15 min. Chart on the left, weekly chart on the right, fundamentals in the middle:
The N in CANSLIM stands for New. Well that we have inflation is new too ;-). Be pragmatic, be flexible!
What I have learned:
Bonds are a great hedge in an inflation regime if inflation gets not too high. But when inflation is very high (see first picture!), beware, they will not work.
Small cap value momentum works especially good in a (high) inflation regime (ROC inflation up hard, ROC GDP down).
Inflation stock breakouts work in a high inflation regime (even when growth is tanking at the same time, that scared me out, so I did not play them, next time I know better!).
What is really, really important: Be only long high beta growth when you we are in a clear goldilocks or reflation regime.
Have a great week!
Disclaimer: For educational purpose only. Not investment advice. Seek professional advice from a financial advisor before making any investing decisions.