Diversified Portfolios Mean Less Risk
Christopher Norwood • January 13, 2025

Executive Summary

  • The jobs report on Friday sparked stock and bond market selling
  • Economic data hasn't justified rate cuts
  • The Bond market has been signaling its disagreement with the Fed since the September cut
  • The 10-year Treasury Yield is rising. Bond investors see inflation risks
  • The Jobs market is strong
  • Disinflation is slowing
  • Investors should expect more volatility in 2025
  • Diversification means less portfolio volatility but also lower returns
  • True diversification means always owning something that is underperforming
  • Diversified portfolios will trail during a bull market

S&P 500 5-day chart

Last week, we wrote that " the jobs report has the power to move the market. A better or worse-than-expected number could lead to serious volatility on Friday. The volatility could carry over into the following week.” We got the volatility on Friday because of the jobs report. We’ll see if we get more volatility in the coming week.



The jobs report released Friday was much stronger than expected. The stock and bond markets sold off as a result. The S&P 500 fell 1.54% on the day. It lost 1.9% during the week, finishing at 5,827.04. The Nasdaq fell 2.5% on the week. Bonds didn’t do any better. The 2-year Treasury yield rose to 4.39% by Friday. The 10-year yield rose to 4.76% from 4.60% the prior Friday. The 10-year yield hasn’t been as high since late 2023. The 10-year yield was 3.63% when the Fed began cutting rates in September. Mortgage rates are back over 7%.

We’ve been writing for months about a data-dependent Fed that doesn’t really seem to be data-dependent. We’ve pointed out that the data doesn’t warrant interest rate cuts. Yet the Fed has cut the funds rate by 100 basis points since September. It did so based on the notion that an unobservable neutral rate was somewhere around 3%. The Fed seemed to believe the gap between the funds rate and the estimated neutral rate was too wide. So, there was a need to lower the funds rate to closer to 3%. This is despite a wide range of estimates of the neutral rate by Fed officials.


A wide range smacks of uncertainty. The December Summary of Economic Projections (SEP) showed estimates ranging from 2.8% to 3.6%. Sonal Desai thinks the neutral rate is 4%. Desai is Chief Investment Officer at Franklin Templeton Fixed Income. Her guess is as good as any Fed official's. Importantly, the bond market seems to agree with Desai. Or at least it has been signaling its disagreement with the Fed since the September cut.

The 10-Year Treasury Yield is going the wrong way. Bond investors see inflation risks



(See last week’s newsletter for more on rising interest rates and the strong labor market).

Payroll growth with the latest jobs report added


Norwood Economics has also cautioned for months that disinflation is slowing and could reverse. The core personal consumption expenditures (PCE) price index has been stuck at 2.7% - 2.8% since August.

The gradual but persistent rebound in core CPI suggests inflation has stabilized. Core CPI is running at a 3.3% annual rate. The Fed is far away from its 2% inflation target.

The red line above is Core CPI

Below Courtesy of James Picerno of CapitalSpectator.com:


“A more concerning trend is shown by 5-year inflation expectations via the Treasury market, based on two models. One is the 5-Year/5-Year Forward Inflation Expectation Rate; the second model is based on the implied market forecast using the yield spread on the 5-year nominal Treasury less its inflation-indexed counterpart.” 

“The upside bias for the average in recent weeks is starting to look worrisome.” According to Picerno. “If this average continues to run higher, the trend will soon signal a flat-out warning on inflation.”


The jobs report showed a surge in hiring with 256,000 new jobs added in December. It was some 100,000 more than economists forecast. The unemployment rate dipped by 0.1 percentage point, to 4.1%. The homerun jobs report resulted in selling in both the stock and bond markets. Rate cut expectations are changing. We could see more volatility in the coming week.



The CME FedWatch tool isn’t pricing in a rate cut until at least May. Forward contracts for the 3-month Treasury bill—specifically the 12-month and 18-month forward rates—are trading above the current 3-month Treasury bill spot rate. Forward contracts are indicating that rate cuts are history, and hikes may occur in the next 12 to 18 months.

“With the December jobs report, the only mystery is why the market is still forecasting cuts in the funds rate in 2025 and 2026,” Steven Blitz, chief U.S. economist at TS Lombard, wrote in a research note on Friday. Blitz sees 3% real gross-domestic-product growth and 3% inflation. He expects no cuts in 2025. He sees as much as 100 basis points of hikes in 2026. A 6% 10-year Treasury yield is “far from a stretch given the history and the volatility that the Trump administration is bound to usher in,” wrote Blitz.


Rising yields can lead to contracting P/E multiples. Robust earnings growth estimates need near-record profit margins. The coming earnings season and guidance from the C-suite will tell us a lot about the short-term direction of the stock market.



There are indications of a looming short-term top on a technical basis. We wrote last week that, “The S&P 500 may be putting in a short-term top. The 20-day is falling toward the 50-day. It hasn’t crossed yet but will in the next week or two if the index can’t regain some momentum.”

S&P 500 3-Month Chart


The S&P 500 held the 100-day moving average on Friday. There is support around 5,800. The 20-day is going to cross the 50-day moving average in the coming week. The algorithms will factor that in and more selling could ensue. A “dark” cross, as it’s known, indicates that the near-term direction of the market is down. A close below 5,800 and the 100-day would solidify the technical case for a short-term top.


We also wrote last week that, “sentiment is extremely bullish with investors expecting another double-digit gain in 2025. A correction early in the new year wouldn’t be a surprise. Barring a deterioration in the economy, any pullback should be a buying opportunity.”

The correction may already be here. A 10%-15% pullback in the market would be completely normal. The economy is strong, although earnings estimates are likely too high. Returns are likely to be muted this year but still positive.


More selling this week is likely. The VIX is only 19.54. It needs to rise into the mid-30s before sufficient fear allows a bottom to form. That’s assuming this is the start of a 10% to 15% pullback, which isn't a given. Investors should expect more volatility in 2025.


Stock/Bond/Commodities/Precious Metal Portfolios Equals Real Diversification

You can’t have your cake and eat it too. Diversification means less portfolio volatility. It also means lower returns, although possibly higher risk-adjusted returns. Risk-adjusted returns are what matter. Efficient portfolios mean higher risk-adjusted returns. True diversification means always owning something that is underperforming. One hundred positions that move in lockstep means zero diversification.


People love diversification when markets are falling. They get angry though when their portfolios trail during a bull market. It’s worth noting again. You cannot have your cake and eat it too. Higher returns mean accepting higher risk (more volatility).



Bonds are the go-to for investors who don’t want the 17.5 standard deviation of the S&P 500. Bonds are less volatile by half or more. The iShares Core U.S. Aggregate Bond ETF (AGG) has a 5-year standard deviation of 6.4. The Vanguard Short-Term Treasury Index fund ETF (VGSH) has a 5-year standard deviation of 2.0. Standard deviation is the square root of variance. Standard Deviation gives you an idea of how much volatility to expect with an investment.


More importantly, The AGG has a 5-year correlation to the S&P of 0.57. The VGSH has a 5-year correlation to the S&P of 0.18. A correlation of one means no diversification. A correlation of 0.18 means lots of diversification. Investors must own assets other than stocks for real diversification. Treasury bonds, commodities, and precious metals all fit the bill.

All-Weather Portfolio


The Ray Dalio-inspired all-weather portfolio is a truly diversified portfolio. It should perform well in all economic environments. But you won’t keep up with the S&P 500 when it is climbing.

Diversified Stock Portfolio


A diversified stock portfolio (chart above) isn’t all that diversified. Although, the emerging market/S&P 500 correlation is noteworthy. Investors need to decide how much risk they’re willing to take. A lower-risk approach requires owning assets other than just stocks. Returns will be lower but risk-adjusted returns can be higher. Food for thought…


Regards,


Christopher R Norwood, CFA


Chief Market Strategist

Slower Growth and Higher Inflation

By Christopher Norwood • April 21, 2025
Executive Summary The S&P 500 fell 1.5% last week to finish at 5,282.70 Counter-trend bounce started on April 7th Counter-trend rallies are short and sharp Thursday was an inside day Any trade war announcements will lead to more volatility Uncertainty is high, and consumer confidence is low The Federal Reserve is focusing on inflation The Philly Fed and Empire State indices continue to rise Small business owners are raising prices to offset input costs The Stock Market is still in a downtrend The Stock Market

Expect the unexpected

By Christopher Norwood • April 14, 2025
Executive Summary The S&P 500 had its best weekly gain since 2023 due to the suspension of most tariffs The Trade War and tariffs have dominated stock market action Daily announcements on the tariff front have led to high volatility The market is still in a downtrend Tariffs will negatively affect the U.S. economy Rising prices will reduce consumer demand U.S. earnings estimates are coming down; currently $267 and falling Pay attention to what bond investors are thinking The weakening dollar fell to its lowest level since 2022 The U.S. needs foreign capital

Uncertainty is high. Don't Panic.

By Christopher Norwood • April 7, 2025
Executive Summary The S&P 500 fell 9.1% and ended the week at 5,074.08 Bond yields are declining as investors flee stocks CME FedWatch tool now forecasts 3 to 4 Fed funds cuts in 2025 Inflation is higher than the Fed’s target and trending in the wrong direction The Volatility Index (VIX) spiked on Friday. Investors are showing fear The Stock Market is due a bear market bounce The longer-term downtrend likely won't end until Trump’s Trade War ends Market strategists are raising the odds of a recession and reducing price targets The Fed has a dilemma. It doesn't have the tools to deal with rising inflation and slowing economic growth simultaneously

The economy is vulnerable to a declining stock market

By Christopher Norwood • March 31, 2025
Executive Summary The S&P 500 fell 1.5% and ended the week at 5,580.94 The energy & healthcare sectors are the leading gainers year to date The S&P early highs and late lows are a sign of market weakness The fixed income market is signaling higher for longer Mortgage rates seem high to younger home buyers Mortgage rates were higher from 1972-2002 Earnings & GDP growth estimates are coming down The stock market reflects the economy Consumer confidence plunged to a 12-year low The economy is vulnerable to a declining stock market

The Fed is leaving two rate cuts on the table for 2025

By Christopher Norwood • March 24, 2025
Executive Summary The S&P 500 rose 0.5% last week to finish at 5,667.56 breaking its four-week losing streak The uncertainty surrounding the trade war will weigh on the economy and capital markets for the foreseeable future. Economists and the public aren’t sure whether to worry about inflation, weakening economic growth, or both. The Summary of Economic Projections (SEP) signals two rate cuts and a higher year-end inflation number Invoking the Alien Enemies Act of 1798 will lead to higher prices U.S. stocks are the only asset class losing money in 2025 The Stock Market The S&P 500 rose 0.5% last week to 5,667.56. The Nasdaq rose 0.2% and the Dow was up 1.2%. The S&P broke a four-week losing streak. It was due for an oversold bounce. We wrote last week, “The S&P is primed to bounce this week, likely at least back to the 200-day moving average residing at 5,740.” The S&P did bounce but only reached 5,715.33 on Wednesday around 3 p.m. Fed Chairman Powell was speaking soothing words at the time to investors during his press conference following the Federal Reserve FOMC meeting. The S&P couldn’t build on Wednesday’s late gains though, although it did try.

Tariff Talk Creating Uncertainty

By Christopher Norwood • March 17, 2025
Executive Summary • The S&P 500 fell 2.3% last week to finish at 5,638.94 • The S&P is down 4.13% year-to-date • The Nasdaq fell into correction territory and is down 11.6% since mid-February • Market strategists are saying recession risk is rising • Tariffs hurt the economy • Consumers and small business owners are feeling the pinch • The NFIB Uncertainty Index rose to its second-highest level ever in February • The Trump administration is targeting a lower 10-year Treasury Yield • Interesting Charts below The Stock Market

All Eyes on Trump for now

By Christopher Norwood • March 10, 2025
Executive Summary The S&P 500 fell 3.1% last week to finish at 5,770.20 The S&P closed 50 points above the 200-day moving average on Friday A bearish crossover or a “dark cross” indicates a loss of momentum A correction of 10% or more is increasingly likely Founder of AQR, Cliff Asness makes some important observations Interesting Charts below The Stock Market The S&P 500 fell 3.1% last week to finish at 5,770.20, its worst week since September. The S&P is down 1.9% for the year. Technology (XLK) is down 6.01% year-to-date. Consumer discretionary (XLY) is down 8.33%. The other nine S&P sectors are up on the year, led by Health Care (XLV), which is up 8.51%. Consumer Staples (XLP) is the next best-performing sector, up 5.41%. The 10-year Treasury Yield rose to 4.31% from 4.21% last week. The two-year yield was unchanged at 4.01%.

The Economy is Growing but Perhaps Slowing

By Christopher Norwood • March 4, 2025
Executive Summary The S&P finished the week at 5,954.50 High government spending has kept the economy growing The S&P has been trading sideways for four months now The Magnificent 7 and technology are out. Healthcare, Financials, Real Estate, and Consumer Staples are in Uncertainty is high Interesting Charts below  The Stock Market The S&P 500 lost 1.0% last week, closing at 5,954.50. The Nasdaq fell 3.4% during the week. Treasury yields continued to fall. The 10-year Treasury closed the week at 4.21%. The two-year Treasury yield dropped to 4.01%. The 3-month yield ended the week at 4.34%. The yield curve inverted once more. The 3M/10Yr curve inversion increases the chance of a recession in the next 12-18 months. Of course, the curve was already inverted until last December when it began to normalize. The 3M/10Yr curve last inverted in late October 2022. The period from October 2022 until December 2024 marked the longest continuous stretch of inversion since 1962. And yet no recession materialized, at least it hasn't yet. The lack of a recession in 2023/24 was most likely because of massive fiscal spending. The federal government has run large deficits since the pandemic. Government spending was $6.9 trillion in 2024, almost 25% of GDP. The government's deficit spending has kept the economy growing.

Expensive Money Means Slower Economic Growth

By Christopher Norwood • February 24, 2025
Executive Summary The S&P finished the week at 6,013.13 Volatility is still low despite last week's rise to 18.21 The tech sector is trailing the S&P More stocks are participating in the U.S. stock market gains International & Emerging markets are outperforming the U.S. markets Interesting Charts below  The Stock Market

Rising Interest Rates are a Problem

By Christopher Norwood • February 17, 2025
Executive Summary The S&P finished the week at 6,114.69 The 2-year yield hit 4.38% after the Consumer Price Index (CPI) was released on Wednesday, but ended the week at 4.27% Investors dumped stocks when the CPI report was released Producer Price Index (PPI) has accelerated for five straight months PPI is a leading indicator of consumer inflation Inflation expectations are rising among fixed-income investors The 5- &10-year breakevens are rising The Stock Market
More Posts