Franklin is the founder and chief investment officer of Directional Advisors. Since beginning his career in 2007, Franklin has been dedicated to helping investors of all kinds achieve their goals using financial markets.
A CFA charterholder and active researcher, Franklin is an international speaker and author of dozens of peer-reviewed articles and trade publications, including the 2023 book with Wiley, Goals-Based Portfolio Theory. In 2016, he was the winner of a Quora knowledge prize, and in 2017 Franklin was recognized by the National Association of Active Investment Managers for his work incorporating business cycle analysis to help individuals achieve their goals.
Franklin serves on the advisory board of the Journal of Wealth Management, and his written work has appeared in Enterprising Investor, Forbes, Financial Planning Magazine, RealClear Markets, CityWire, Foundation for Economic Education, HuffPost, Journal of Wealth Management, Journal of Impact & ESG Investing, Journal of Behavioral Finance, International Family Offices Journal and many others.
Franklin is an adjunct professor for the American College of Financial Services, and he is the incoming Season 4 host for the CFA Society of Dallas-Ft Worth Podcast. Franklin is also a member of the Sons of the American Revolution.
Franklin enjoys playing guitar and piano with his free time, and expressing his creativity in the kitchen. More than anything, he enjoys good food and good wine with good friends.
After some brief volatility, investors have largely shrugged off the Iran war. I am concerned about the consequences for oil & gas, though the US will be considerably less affected than the European Union, China, and India, who rely heavily on energy from the region.
Earnings are the big story for investors right now. Companies are growing earnings by about 15% over this time last year, and those strong earnings are supporting higher prices. As I have said before, so long as companies continue to grow earnings, we should see markets move higher.
I am concerned about the breakdown of private credit, however. It has largely moved from the headlines, but there is trouble brewing in these off-market funds, and that trouble has the hallmarks of contagion. In addition, corporate layoffs have begun to reach alarming levels. There have been over 100,000 announced layoffs in technology alone!
Overall, I see storm clouds forming, but there is probably still some time before the rain drops start to fall. That said, we need to keep a close eye on the risks hiding beneath the market’s all-time highs, especially in private credit.
Chart of the Week
This week’s “chart” comes to us courtesy of Reuters, and it demonstrates the strategic challenge of the conflict around Iran. Given their long coastline, Iran can exert considerable control over the the Strait of Hormuz, through which some 20% of the world’s oil flows.
There are pipelines to move oil to a seperate port, but that capacity is very limited and it will take many years to build new pipelines. Until then, energy flows will be largely determined by the whim of the Iranian regime.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
We finally got labor data for January last week and it was considerably better than expected. It appears the US economy added 172,000 jobs, which was about 100,000 more than economists expected, and the unemployment rate dropped to 4.3%. Earnings season also continues, with companies growing earnings by about 13% over this time last year. Price increases continue to slow down, with inflation coming in at 2.5%. Not far from the Fed’s 2% target.
From an investment perspective, these are all very good signs. It may be that the US economy accomplished the first “soft landing” in history (a slowdown of inflation without a recession).
The confusion comes from other data that paints a very different picture. We are also seeing the most amount of announced layoffs since the Great Financial Crisis (2009). Retail sales stalled in December, and companies have begun to announce price increases for 2026. Markets are also quite volatile, with the S&P 500 seemingly unable to cross above the 7000 mark.
What does this all mean for investors? We have two takeaways. First, the era of a buy-the-index strategy outperforming may be at an end. We are finding that picking quality names out of the index is working better than a simple “buy everything” approach.
Second, investors with goals to achieve should be cognizant of the losses that could derail their goals. Understanding that number, and developing a strategy to mitigate the risks of it happening, makes a lot of sense in an ambiguous market like this.
Chart of the Week
This week, I want to share the one chart that gives me some confidence in this volatile market. Ultimately, stock prices follow earnings growth. In fact, stock prices anticipate changes in earnings by about 3 to 6 months, as this week’s chart shows. The blue line is the 1-year change in stock price, and the brown bars are the 1-year change in expected earnings. As you can clearly see, the blue line tends to move in advance of the brown bars by about three to six months.
The comfort this chart gives is that, at least for now, the earnings growth is expected to be quite strong. Therefore, I expect there to be a floor to these selloffs. At least for now.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
Stocks dropped last week around 4%, with gold, silver, and bitcoin all falling dramatically. Bitcoin is now down almost 50% from its October high. While it was a wild week, we’ve all struggled to point to a cause. A new feature launch from Anthropic, the makers of Claude AI, was pointed to as the culprit in stocks, but that still doesn’t explain the sudden risk-off mood across all asset classes.
For stocks, earnings are coming in better than expected, and it appears companies will increase earnings by about 13% over this time last year. Again, this is very good earnings growth. So long as companies continue growing earnings, I expect there is a floor to any selloff.
For precious metals, however, I am growing cautious. As I mentioned in last week’s note, they have significantly outgrown any reasonable valuations, and I think this is a good point for investors to take profits, where they can.
I have, for over a year now, been cautioning investors against the weakness brewing in the underlying economy. We got a fresh round of news on that front, unfortunately. Announced layoffs have grown to the highest number since 2009, standing at 108,000 announced in January. Job openings also fell much more than expected last month. While this may be AI-related, there are numerous forces at work on the labor market making it difficult to tease apart.
Overall, I am still cautious. I am tired of saying this, but it would appear that, so long as companies continue to make money, markets will go up. However, layoffs and unemployment are tell-tale signs of a recession, and it does appear that risk in markets has only built over the last year.
Chart of the Week
This week’s chart comes courtesy of Reuters and it illustrates the growing concern with AI investment, generally. Nvidia makes chips for Open AI and Oracle. However, OpenAI also received a $100 billion investment from Nvidia — effectively, Nvidia is buying their own chips. Similarly, Oracle is receiving a $300 billion of orders for infrastructure from OpenAI, but to fill that order requires chips from Nvidia.
It is a very circular loop and the question keeps coming up: are there enough paying customers to keep this cycle going?
Source: Reuters.com
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
Earnings are top-of-mind for investors, and AI is the talk of the town. Companies that have relied on AI narratives to push their stock price over the past year are now seeing investors asking “when do we get paid”? For companies that have delivered good results from their AI spend, we are seeing rewards in stock price. For companies still failing to deliver, however, the punishments have been heavy.
Overall, analysts expect earnings to grow about 11% over this time last year, which are strong.
A concerning development over the past weeks has been the increasing number of announced layoffs. Amazon plans to lay off 16,000 workers, UPS plans to lay off some 30,000 workers(!), and Dow plans to lay off around 4500 workers, to name just a few. It is important to put these figures into perspective, however. The post-Covid years have regularly seen announcements as high as 100,000 per month. And, yet, no recession behind those announcements. A development to watch, but not one to worry about just yet.
Besides, the employment has been deteriorating for some time now, yet that has not been affecting consumer spending much, if at all. Until those unemployed workers stop spending, I expect corporate earnings will continue higher.
Overall, I maintain my view that the economic backdrop is very weak. That said, earnings continue to improve. Risks are to the downside, but if the S&P 500 breaks above 7000 there are probably higher prices after that. In short: investors should be cautious, but we cannot afford to sit on the sidelines forever.
Chart of the Week
Gold and silver have been in the news with a huge upward surge in price, followed by Friday’s swift downward crash. The big question — is this the end of the run, or just the beginning?
I am a collector of arcane financial theories, and there is an one that I somewhat subscribe to known as the log-periodic power law. I’ll spare you all the gory details, but it says, in short, that “normal” price growth should be approximately exponential. However, when growth becomes more than exponential, it is dangerous. This is the fancy version of “pigs get fed, hogs get slaughtered.”
We don’t even need a fancy model to see this. On a chart, exponential growth looks like a smooth upward curve. Or, if we look at the logarithm of prices, that curve becomes a tilted upward line. Hyper-exponential growth, however, still looks like a sharp curve even when we take the logarithm of the price. We can clearly see this behavior in silver over the past year.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
Investors are expecting a rate cut at this meeting, followed by a series of cuts into next year — with an expectation for rates to end up around 3.25% by end of summer 2026. Some data last week may make this a harder decision than investors would like, and markets will be watching Powell’s press conference very closely. If Powell expresses any doubt about the future path of cuts, that will likely push markets around.
Other than the Federal Reserve meeting, there is not much data on tap. Investors are wrapping up their years and getting their portfolios in position for taxes and quarter-end window dressing. As I have repeatedly discussed, my view is that a recession is brewing out there, though markets seem not to care. I am urging investors to evaluate their portfolio holdings in light of that likelihood.
Chart of the Week
There has been lots of talk about the “white collar recession” brewing as companies introduce AI and have need of fewer human workers. October’s spike in job cut announcements was taken as a sign that this has finally come to pass. However, in context (with COVID layoffs, for example), October’s jump was negligible. It was however, part of a larger trend in 2025 — companies have increased layoffs, and this may be an indication of normal economic slowing ahead of a recession.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
Ambiguity is still the main theme for markets today.
Earnings season is over, with companies growing earnings by about 13% over this time last year. Those are very solid earnings, yet we’ve seen markets trade mostly sideways. This is largely due to the underlying economic data, which has been getting progressively worse. Consumer confidence, business indexes, inflation, and unemployment have all sapped investor confidence.
This week we see important data on personal expenditures, consumer debt, and data on the health of the services sector. Early indications of black Friday retail sales were positive, but whether that momentum is maintained into the end of the year remains to be seen.
The Federal Reserve meeting is approaching with the FOMC somewhat divided over whether to continue the path of interest rate cuts into the end of the year. Chair Powell has indicated that the data they see is murky with the risks of inflation still lingering, yet several committee members have indicated they want to continue cutting. Markets see a 90%+ chance that the Fed cuts at their December meeting — a change to that expectation could push markets around quite strongly.
Overall, I am still cautious. The underlying economic data has worsened despite strong corporate earnings. That said, a rally into the end of the year would be a normal seasonal occurance, so we do have that tailwind for markets. 2026, however, may get interesting very quickly.
Chart of the Week
One challenge over the past month and a half has been the delay in data releases (or their outright cancellation). Corporate earnings, therefore, have taken on a more important role than normal. Looking more closely at corporate earnings we see that, despite strong earnings growth, the US stock market is more expensive than about 90% of its history. That should give investors pause about future returns as high valuations tend to foretell lower future returns over 3-, 5-, and 10-year periods.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
With earnings season mostly done and the government shutdown putting a lid on new data releases, there isn’t too much to talk about.
Earnings have been mostly good for US companies, and more evenly distributed than in past quarters. That said, the AI bubble appears to be deflating a bit. The sky-high valuations given to AI companies have come down, with Nvidia and Amazon’s valuations coming back to earth and Tesla’s valuation replacing them in space (see Chart of the Week).
The big problem right now is that investors are mostly flying blind. We are seeing job cuts on the rise, with over 153,000 job cuts announced in October alone — bringing the year-to-date total to over 1 million (last year at this time we had 653,000 job cuts). Without figures for job creation, we are struggling to understand if these job-seekers are now joining the ranks of unemployed or if they are finding new jobs. Recall, job creation has been very slow this year, as well, so my estimate is that these folks are now unemployed. But, again, without official employment reports it is hard to know.
On that front, the US Senate has cleared a procedural hurdle to re-open and fund the government. There is still some wrangling to come, but investors are celebrating the milestone.
Overall, there are positives and negatives weighing on the economy. I see the balance of risks to the downside, but it is difficult to know which trigger might break investor confidence and push markets over a cliff. The deteriorating labor market is a serious concern and if it has gotten considerably worse while investors sat in the dark, I suspect markets will react negatively. I am still recommending caution to our investors, but your goals will determine which risks are appropriate for you.
Chart of the Week
Today’s chart shows the valuation of the “magnificent seven” stocks (NVDA, AAPL, META, GOOGL, MSFT, TSLA, and AMZN) as measured by each company’s price-to-earnings ratio. The more extreme valuations have come back to earth, but Nvidia and Amazon’s 2023 valuations have been replaced by Tesla’s of almost $300 for every $1 of profit!
The challenge with valuations, however, is that they are not a very good timing indicator. Sometimes extreme valuations can still lead to above-average returns. NVDA is a good example. Despite watching their valuation fall from 250x to 54x (an 80% contraction!), the price of their stock still moved higher, tripling over the same period! Valuations are a tricky business.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
Traditional investment wisdom says “buy and hold forever.” Don’t worry when markets sell off because they will come back. I remember early in my career repeating these lines often — it was 2008 and market losses were all anyone wanted to call and talk to me about.
However, what I learned the hard way was that for investors with a goal to achieve (like retirement), losses do matter. And they can matter quite a lot. It isn’t because I worry that markets won’t recover. Historically, US markets have recovered and gone on to new highs. Rather, it is a worry about whether they will recover in time for you to hit your goal.
This is something I have written about extensively, including in my book Goals-Based Portfolio Theory. In this post, I want to use python to help us build an intuition around when investment losses become too great to recover from.
A quick background
In traditional investment theory, we look to maximize the following function
$$ u = m – \frac{1}{2}gs $$
where m is the expected return of your portfolio, s is the expected standard deviation of those returns, and g is how averse you are to volatility.
What should be clear is that this equation assumes that the only thing you are averse to is volatility — that is why your financial advisor gives you a risk-tolerance questionnaire. But that isn’t really true, is it?
You are probably investing because you want to do something with that money at some point in the future. You are, most likely, a goals-based investor because you have, well, goals to achieve. That means you aren’t averse to volatility per se, but rather averse to “not having the money you need when you need it,” to quote my friend, Martin Tarlie.
I’ll spare the entire background, but it should be clear that this changes the nature of the investment problem entirely. You now want to maximize the probability of achieving your goal:
$$ u = P( R | m, s ) $$
where P is the probability that your portfolio meets your required return, R, given your portfolio’s expected return and volatility, m and s. In this equation, volatility is an input to the equation, of course, but it isn’t what you are ultimately caring about. You ultimately care about the probability that you get the return you need to accomplish your goal in time.
A simple way to think about losses
Since what you really care about is achieving your return requirement, let’s dig into that a bit further. We can use the time-value of money to set up this equation for thinking about the role of losses in your portfolio:
$$L = \frac{ W }{w(r+1)^{t-1} } – 1 $$
where L is your maximum allowable loss, W is the total wealth you need to achieve your goal, w is the wealth you have dedicated to this goal today, r is the return markets provide during a recovery (after a signficant loss), and t is the time horizon within which you’d like to achieve your goal.
Here’s the logic: we’ve assumed that we had a one-year loss in your portfolio meaning we have a new and higher return requirement. If we have some assumption about the recovery rate of markets, r, then we can rearrange the whole thing into the equation above, solving for the maximum loss we can sustain in a year so that our new required return is met by the recovery return of the market.
Using python, let’s visualise our portfolio’s maximum loss tolerance with various inputs (I’ll generate it based on time as L decreases with time horizon). We’ll start by loading our libraries:
import numpy as npimport pandas as pdimport matplotlib.pyplot as pltimport mathfrom scipy.optimize import minimizeplt
From here we can build our L function and then input some variables to build some intuition about portfolio losses over time, and at various levels of funding.
# Build a simple max loss functiondefmaximum_loss(w, W, t, r):return W / (w * (r+1)**(t-1) ) -1# Make time a variable and return max allowable losst = np.arange(5, 20, 0.5)# Assumes I have $650,000 (or $500,000) with a need for $1,000,000 in t years.# Portfolio recovery return is 12%MAL_1= maximum_loss( 650000, 1000000, t, 0.12)MAL_2= maximum_loss( 500000, 1000000, t, 0.12)# Arrange into a dataframedf = pd.DataFrame({'Time Until Goal': t, 'Maximum Allowable Loss, 65%': MAL_1,'Maximum Allowable Loss, 50%': MAL_2})# Generate visualizationplt.plot(df['Time Until Goal'], df['Maximum Allowable Loss, 65%'], label='Max Loss, 65% Funded', color='blue')plt.plot(df['Time Until Goal'], df['Maximum Allowable Loss, 50%'], label='Max Loss, 50% Funded', color='black')plt.xlabel('Years Until Goal')plt.ylabel('')plt.title('Maxmium Allowable Loss Over Time')plt.legend()
And this yields a plot showing how time erodes our portfolio loss tolerance in an exponential way. Also of interest is how your funding level also erodes your portfolio’s loss tolerance.
Upside risk versus downside risk
The method above, however, only looks at downside risk. This is, of course, the most common type of risk investors think about. However, goals-based investors must also balance upside risk against downside risk. That is because you are unlikely to achieve your goal unless you gain the return that financial markets provide. Upside risk is, in summary, the risk that you are in cash when markets run higher.
A simple framework for thinking about this balance might be
$$I = \frac{S-B}{P-B}$$
where I is the percent of our portoflio we need to invest, S is the price at which we sold and moved to cash, B is our desired breakeven price, and P is our buy-back-in price.
Here’s what is going on: our breakeven price is the price at which we must buy back in lest we fall behind because markets moved higher without us. By default, that price is the price at which we exit. When we buy back in at a lower price (or higher price), that breakeven level moves higher (or lower). We can set an arbitrary value here, but something like 10% to 20% higher than our exit price would give us some comfortable room to breathe. If we sold as markets went down, then bought back in at a lower price with some of our portfolio, then our breakeven price is higher than the level we sold at — we gained some advantage in the sale.
Assuming, then, that we have some market outlook (if we don’t, then this whole exercise is moot), we can balance our downside risk with the same variables:
$$I = \frac{L}{G}$$
where L is the expected portfolio loss, I is the percent we reinvest at this new price, and G is the expected portfolio loss still to go. Using these two equations we can begin thinking about the balance between upside and downside risk. Let’s set up the problem in python:
# Build our % invested for downside riskdefinvested_downside(L,G):return L/G# Build our function for % invested upside riskdefinvested_upside(S,B,P):return (S-B)/(P-B)# Build our visualization using some assumptionsP = np.arange(0.65, 1.00, 0.01) # Price is our variable# Percent to invest to mitigate downside riskdownside = invested_downside( maximum_loss(0.65, 1, 6, 0.12), 0.50- P)# Percent to invest to make our breakeven 20% higher (we exit at 1.00)upside = invested_upside( 1.00, 1.20, P )# Generate visualization
What this plot is showing us is when upside risk outweighs downside risk, and vice versa. As this demonstrates, we could invest a little under 50% of our portfolio when price drops to about $0.77, and thereby neutralize both upside and downside risk at the same time (that is the point where the two lines cross). Then, so long as we reinvest the remainder of our portfolio at $1.20 or less (we exited at $1.00), then we are ahead on the trade.
Of course, our market outlook could be wrong! Such is the travesty of investing: generally, all you can do is move risks around — you can never eliminate them. That said, the goals-based approach at least helps us quantify which risks you can afford to take, and which risk you can’t afford to take. Ideally, we move risks from the places you cannot afford it to the places where you can.
Again, this is a simplistic way to think about the problem, but it does at least offer us some framework for thinking. And, notice, none of this has anything whatsoever to do with your psychological risk tolerance (whatever that is). It is quantitatively derived from your goals.
Paying for hedges
When we talk about protecting against downside risk, hedging is an obvious solution. The next obvious step is to ask, “what are you willing to pay for those hedges?” And therein lies the rub.
So, what are we willing to pay for hedges, as goals-based investors? It turns out that is a quantitative question that we can answer.
The full derivation of this solution is a bit too long to post here, but you can read about it in chapter 5 of the book. But let’s sketch the basic idea.
We have two axes of things we care about. First, what is the probability of having a loss year verses a typical year (call this p)? And second, for each of those scenarios, what is the return of the hedged versus non-hedged porfolio? To visualize:
Hedged Portfolio
Non-Hedged Portfolio
Typical year, 1 – p
R_H
R
Bad year, p
R_H&L
R_L
Where each return scenario has a different definition. The hedged portfolio’s return in a typical year, for example, is the return of the portfolio in a typical year minus the cost of the hedge. Drawing from our probability equation in the top section, we can then set up our problem in python.
# Build our probability function - use left-tail logistic cdfdefphi(x, location, scale):return1-1/(1+ math.exp( -(x - location)/scale) )# build our optimizer functiondefoptimization_objective( cost ):# In this function, R_L is the recovery needed in a non-hedged portfoliio that experienced a loss# R is the recovery return needed in a non-hedged portfolio that experiences a typical year# R_HL is the return needed after a loss with a hedge.# R_H is the return needed after a typical year where you paid for a hedge.R_L= (required_wealth / (1+ loss_return * initial_wealth) )**(1/ (time_until_goal -1)) -1 R = (required_wealth / ( (1+ typical_return) * initial_wealth ) )**(1/ (time_until_goal -1)) -1R_HL= (required_wealth / ( (1+ amount_of_max_loss) * (initial_wealth + cost) ) )**(1/ (time_until_goal -1)) -1R_H= (required_wealth / ( (1+ typical_return) * (initial_wealth + cost)) )**(1/ (time_until_goal -1)) -1# Probability of attaining the long-term return requirement in each scenario. phi_L = phi(R_L, recovery_return, recovery_vol) phi_R = phi(R, typical_return, typical_vol) phi_HL = phi(R_HL, recovery_return, recovery_vol) phi_H = phi(R_H, typical_return, typical_vol) output =abs(p * phi_HL + (1-p) * phi_H - p * phi_L - (1-p) * phi_R)return output# Probability of a bad year as our input variableprob = np.arange(0.01, 0.65, 0.01)# Look at how different variable values change FV cost to hedge# Scenario Aloss_return =-0.40# loss in a bad yearamount_of_max_loss =-0.25# what is our maximum loss toleranceinitial_wealth =1.00required_wealth =1.35time_until_goal =10typical_return =0.08typical_vol =0.11recovery_return =0.10recovery_vol =0.09p =0.45c = []for i inrange(0, len(prob)): p = prob[i] c.append( minimize(optimization_objective, -0.01).x )# Scenario Bloss_return =-0.30# Change loss return to -30%amount_of_max_loss =-0.15# change hedge protection to -15%c2 = []for i inrange(0, len(prob)): p = prob[i] c2.append( minimize(optimization_objective, -0.01).x )# Scenario Ctime_until_goal =5# Change time horizon to 5 yearsloss_return =-0.40# change loss return back to -40%c3 = []for i inrange(0, len(prob)): p = prob[i] c3.append( minimize(optimization_objective, -0.01).x )# Generate visualization
Giving us the plot below. As the plot demonstrates (and the numbers bear out in our modeling), how much you are willing to pay for a hedge is dependent on numerous factors. But, all of those factors are quantitative, bringing together your goals, your market outlook, and what the hedge does for us.
Closing thoughts
Despite the relatively simple framework, this analysis at least gives us some idea of how to think about hedging in light of our goals. Once we input your goal variables we get a simple number — 2.5% of your portfolio, let’s say — and we can then look at the market price of a hedge. If the market price is lower than our fair-value, we should hedge the portfolio. If it is higher than our fair-value, we do not hedge (or we hedge in another way!).
In any event, it is worth thinking through for investors with goals to achieve. Those goals are valuable. We should protect them.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
Trade tensions, earnings, and economic data (or lack thereof) are on investors minds this week.
The US-China trade spat broke out again on Friday with Chinese officials declaring a dramatic increase in controls around rare-earth mineral exports. The Trump administration threatened a 100% tariff on Chinese imports unless that was walked back. All eyes are on a potential Trump-Xi meeting in Korea later this month.
Earnings season begins this week with major banks reporting such as JPMorgan and Bank of America. Cash set aside to offset bad loans will be an important figure to watch, as that tends to be a bellwether for the economy. Overall, however, investors expect a good earnings season with earnings coming in about 13% higher than this time last year.
Finally, investors are waiting on important data, such as the unemployment rate, retail sales, and inflation — all of which have been delayed due to the government shutdown. Investors tend to get jittery when flying in the dark, so the longer important data is delayed, the more risk that tends to build up in markets.
Overall, I still see ample weakness in the underlying economic data: all of the classic recession signals are flashing red. However, earnings continue to be strong and, despite high valuations in US stocks, I expect a good earnings season could create a tailwind through the end of the year. There are lots of risks to that view, of course, including the sudden failure of some large companies in recent months, trade tensions, and a drawn-out US government shutdown. In the end, the risks you take in your portfolio are entirely dependent on your goals. If you are unsure what that should look like, let’s talk about it.
Chart of the Week
This week’s chart is courtesy of LSEG and Reuters, showing expected earnings growth by sector. Technology is yet again expected to outperform (largely driven by darlings like Nvidia, Oracle, and other AI names), with the market expecting to average about 8.8% higher earnings than this time last year. Factset suggests that this figure could be closer to 13%. In any case, earnings have been the one bright spot. As investors listen to earnings calls, they will be listening carefully for any sign of future weakness. Valuations are very high, and that can create quite a bit of fragility.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
Last week the Federal Reserve lowered interest rates by 0.25%, which was widely expected, and indicated that two more rate cuts are likely before year-end. In his press conference, chairman Powell pointed to the very bad jobs figures that came in through the summer as reasons for their cut. This week we see some data on durable goods orders, consumer sentiment, and personal consumption expenditures, but it is overall a light data week.
Cryptocurrencies sold off hard over the weekend — bitcoin fell 2.5% and ether fell 6.9% — in what looks like the unwinding of a significant number of positions (Bloomberg reports that over 400,000 traders liquidated in a 24-hour period). While crypto markets are subject to their own dynamics, this could well be simple profit-taking after a strong run upward. In related news, we have seen gold rally substantially, moving higher by 10% in the last month.
Overall, the underlying economic data is still weak. Employment is deteriorating, and the restatement of employment figures over the past year has indicated that employment is far worse than previously thought. That said, corporate earnings have been the little engine that could — powering forward no matter the underlying data. As this quarter comes to a close, investors are watching earnings reports very, very closely for any sign of weakness.
Chart of the Week
I came across another indicator that I am adding to my lineup — a thank you to LSEG’s Worskspace team for this one! This indicator is, essentially, an indicator of how fragile the current market is. Of course, fragility is a difficult indicator; just because something is fragile does not mean that it will break. That makes this indicator a poor market timing tool — but it does tell you to be cautious and keep your eyes open for something that may rattle markets too much. As the indicator shows, this market has entered a fragile state.
In other words, be careful out there.
source: LSEG Workspace
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
