Investing the Down-Cycle

Since the beginning of 2009, we have been in a global business up-cycle. That's nearly ten years of growth this business cycle—driven in large part by massive central bank monetary policy. It has been a great time for investors so far, but we know every up-cycle is followed by a down-cycle.

You can almost think of the business cycle (and corresponding investment cycle in many cases) like a wave. The cycle tends to build slowly, driving the economy higher and higher. But eventually there is too much weight at the top and it crashes back down—often much harder than we would like.

Edited Photo. Source: Flickr - Warrick Wynne

If we read the pundits, there are varying opinions on the length of this particular business cycle. Normally, a "bull market" is considered to be over if the market-weighted equity index drops 20 percent or more from a peak.

That technically happened in 2011 and some argue it also happened in 2015-2016. I don't really buy that argument since the underlying business cycle was still in recovery by many metrics, especially in 2011. In 2015-2016 we saw a pause in the cycle, but there was not a real business cycle downturn.

We were in rock-bottom interest rates in both of these quick downturns. Unemployment was still extremely high in 2011 and loan growth was still quite low. Residential real estate was still in decline in 2011, usually an indicator of consumer confidence and financial capacity.

The 2015-2016 downturn was a little different. I think it was a situation where a business cycle downturn was very possible, but it was arrested by the world's major central banks. As a result, most of the common indicators did not fall 20 percent and the recovery was quick and very calm.

Regardless of the technical arguments, every day we are coming closer to the next real business down-cycle. That is a downturn marked by debt crisis, unemployment spikes, manufacturing and trade shrinkage, and a multi-period economic recession.

This unquestionable reality makes me think about how to invest during the next business and equity market down-cycle without losing a significant amount of the wealth I've gained in the past few years.

The Current Investor Paradigm

One of the biggest shifts and characteristics of this investor half-cycle (the upwards portion of the full cycle) has been the movement to low-cost index investing in a static portfolio allocation style.

These portfolios don't have a significant amount of thought process in their management. Assets are simply re-balanced on a regular interval, or sometimes on a somewhat strategic basis such as deviation from the target.

This movement goes by many names: Couch Potato investing, Bogle investing, Vanguard investing, passive investing, permanent investing, robo-investing, indexing, and so on. They all typical represent the same broad style and depend on the same elements for success.

The style is so pervasive that many retail money managers and financial advisors have moved their entire practice over to this investing style. The effortless portfolio has effectively become the fiduciary industry standard for professional money managers.

This passive investing approach has certainly performed well during this past business cycle. Backtests are pretty decent too when examined over extremely long time periods. However, I believe the sharp historical downturns are being largely ignored by investors who have adopted this approach.

It is reasonable to believe that many passive investors are going to get whacked hard in the next downturn. Almost no investor I know of is investing with caution, such as allocating heavily to Treasury bonds and gold. Instead, investors boast of 75 percent or higher equity allocations!

Some of the best models on future returns are suggesting a portfolio of market-cap weighted stocks and bonds will drop substantially. U.S. stocks may see a 60 percent decline to get back to historical valuations!

An investor with a 75 percent allocation to U.S.-centric equities may see their portfolio fall 45 percent. It's easy to brag about the high past returns seen with high equity allocations, but what about the future?

Many models are telling investors to count on your portfolio not being worth a dime more ten years from now. At the same time, advisors and passive investors are banking on returns of 7 percent or more compounded annually.

It is important to note that not all is bad with this move to passive investing. Investor costs are much lower and advisors have become slightly more ethical in many ways. Charging fees based on assets is much better for most clients than earning commissions from selling products.

Thinking About Protecting My Portfolio

I don't want to give the impression that I'm completely against index products, or even passive-style investing. I use index ETFs for much of my own investing—they're truly great products.

I just want to avoid the high levels of ignorance that I commonly see. Banking future success on well timed re-balancing, quick recoveries, and bond allocation counter-movements is not a strategy in my book—it is a wish.

Another issue is being realistic about my timeline. While 30 year returns can look impressive, it can be extremely difficult to think about the next three decades when my portfolio is half of the value it used to be.

Going all-in on stocks at the low point takes extreme confidence. If you can remember back to 2009, the world was very pessimistic. Upwards moves in stocks were dismissed as "dead-cat bounces" and the 2011 stock slide was widely believe to be the next leg down. 2008 all over again.

My objective is to try avoid a massive slide at the minimum and try squeeze out some profits if good opportunities are there for the taking.

I believe my goals are achievable with a combination of the two strategies I employ: Dual Momentum and trend investing. While Dual Momentum is a long-only strategy in global stocks or bonds, trend investing allows me to go long or short in anything. That said, I am much more cautious going short.

Dual Momentum

Roughly half of our money is invested in the Dual Momentum model. I'm quite confident of the downside protection that Dual Momentum provides.

Historically, Dual Momentum has not fallen more than 25 percent. Recoveries are fast and effort is low. The model makes a lot of sense to me in many ways.

I always count on a maximum potential loss being 25 percent higher than the backtested maximum loss in any model. For this reason, I am counting on a drawdown of 32 percent in my Dual Momentum accounts.

Since my Dual Momentum accounts form a little under half of my net worth, that translates to a theoretical loss up to 15 percent of my total portfolio.

Macro-style Trend Investing

In my non-registered accounts I invest much more dynamically and am open to exploring a broad range of choices to protect my portfolio. This includes use of long-dated call options and put options to bet on both sides of the move while limiting losses.

So far, I am almost entirely out of equities. My Brazilian stocks trade is still in play, but is very close to my stop loss mark as I write.

On the protection side, I have invested in 1,700 GLD call options and 10,000 ounces via silver futures to get exposure to precious metals. Given the depressed price of precious metals, along with the forming up-trend, I am not too worried about this position in a business cycle downturn.

I have also initiated put options trades betting on a decline in U.S. Real Estate (IYR) and Natural Gas (UNG).

U.S. Real Estate has held very well relative to stocks in the past months. Apparently many see it as a safe haven. I think it looks more like a ticking time bomb given the enormous amounts of debt sloshing in the system. It failed to make a new high this past month and dropped below the October low.

Natural gas had a crazy spike this fall which wiped out an options seller who didn't see "rogue waves" coming towards his ship. Prices are starting to drop quite substantially.

Given the long downwards trend in natural gas, I would not be surprised if we see new lows in UNG. However, I am watching my stops carefully on this one and used options to limit my maximum loss if an uptrend is solidified.

I am also exploring a more substantial focus on currencies and commodities, likely via futures contracts and futures options for better risk control, liquidity and access to leverage.


Currencies are extremely liquid markets that can move quite substantially during business cycle downturns. We are already seeing this in emerging currencies like the Turkish lira, Argentine peso, Mexican peso, and many others.

We can also see big moves in the larger currencies such as the Euro, Swiss franc, British pound, and Japanese yen against each other and the U.S. dollar.

Since options are not available on standard currency trades, I have to move to currency futures contracts to access the same kind of leverage and efficiency of cash deployment. My account is large enough at this point to trade currency futures and meet my risk parameters.


As mentioned, I already have exposure to gold via LEAPS options in GLD—a highly liquid gold ETF with significant options volume and tight price spreads.

Unfortunately, there are no good choices for trading any other commodities in ETF form, especially on the up-side moves. This means I must look to other instruments to get exposure to things like corn, wheat, lumber, oil, silver, and copper.

Again, I believe the answer lies in futures contracts. The futures markets were made for commodities, so they are extremely liquid. Again, the leverage opportunities are fantastic, so I can get exposure to commodities with very efficient capital deployment.

With agriculture commodities at very low prices and copper, lumber, and oil falling substantially, there are some opportunities building in this sector. I want to make sure I've developed my trading abilities to take advantage of the price moves these commodities can make down the road.


In the meantime, I am not ignoring the value of cash in my portfolio. Most of my portfolio is in cash (U.S. dollars at the moment), earning a small amount of interest each month.

The gains from cash are certainly not great. But I would rather have money in the account doing nothing than trying to be busy in a market with lousy opportunities.

If we are entering the down-cycle stage of the full business cycle, I would be very happy to come into the next up-cycle with my current account net worth.


Right now I'm putting a lot of my focus on protecting what I have in the portfolio. Although it is not yet confirmed, we would need a major shift in investor sentiment to avoid slipping into a business cycle downturn in the coming months.

A large portion of my portfolio is currently in U.S. stocks, as per the Dual Momentum signal for December, along with cash and gold exposure. If U.S. markets continue their pattern for the rest of the month, it looks almost inevitable that Dual Momentum will be signaling "Bonds" for January.

Given the lack of good opportunities in this market environment, I am being very patient with my investing activity. I've got a lot of U.S. dollars in my account and am quite happy with cash in my account generating a small amount of interest income.

In preparation for moves in commodities and currencies that I anticipate may materialize in the coming years, I am exploring the futures markets. Futures can give me access to commodities and foreign currencies with reasonable cost efficiency, unparalleled liquidity, and access to ample leverage.

In future years, I can see my trend portfolio moving to LEAPS options on highly liquid ETFs like SPY, EFA, and EEM. In addition, I will use futures contracts to trade commodities like corn, oil, lumber, silver, and copper.

I will also use futures contracts to trade emerging market currencies like the Mexican peso, South African rand, Indian rupee, and Brazilian real.

This will be my last post of 2018. I'll be back in early 2019 with my usual Net Worth Update and Portfolio update.

Have a good Christmas and holiday season everyone!

Comments & Questions

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7 Replies to “Investing the Down-Cycle”

  1. I was an index investor until earlier this year when I was not happy with the thought of losing ~50% of my portfolio during a recession. I have since switched to a Dual Momentum strategy (1+3+6mth) for US/Int’l; and Cdn Dividends for Cdn. Luckily, my overall portfolio is only down about 1.5% overall, as my Dual Momentum is in Long Term Bonds (30yr – VGLT) and my dividends have done ok. Overall, my dividend stocks are down an average of 5%.

    I guess the only thing I need to figure out is when to buy in again. I may just let my dividends build up until 2020 and buy cheap stuff then.

    1. Daren (Editor) says:

      Use a tested strategy to enter the market. If you’re adding to individual stocks, buying when the price crosses back over a long-term moving average can be a good signal. In the meantime there’s nothing wrong with cash.

    2. Hi JamesB,

      A couple of questions if you please about your DM implementation:

      What do you mean by (1+3+6months)? Are you averaging the total returns with those look-back periods?

      Why do you use long term bonds if we are in a normalization period (FED is not quite done hiking)? I personally prefer short term bonds in such an environment or even a bond aggregated index.

      Thanks, Marry Christmas and Happy New Year!

  2. Daren, wishing you a very Merry Christmas and looking forward to 2019 and your great posts.

    Warm regards,


    1. Daren (Editor) says:

      Thanks Victor! Enjoy this time with your family and friends.

  3. Well timed post Daren!

    When DM signalled to be in US stocks at the beginning of December I was hopeful there would be a Santa Rally. It seems we got Krampus instead 🙂

    I’ve been evaluating DM during November/December (but not reacting to it; I just react on the start of the month) and in hindsight DM almost “avoids” December’s decline. First, the evaluation at the end of November was pretty close between US stocks and short term treasuries. Second, just a week or so into December the latter was winning. I got this feeling that DM was “almost perfect”; but because perfection was not achieved I feel a little disappointed. The funny thing about this feeling is that I am not sweating the decline. I am simply lamenting the near miss of my strategy.

    Gary’s evaluation (as in the book) is not exactly what I do. I simply compare BIL, VOO, etc in perfcharts for simplicity. I wonder what Gary’s evaluation said at the start of Dec. Do you know? I tried to find that info in his website but I only found monthly returns.

    I know this does not matter in the long term; but I was curious nontheless.

    Happy holidays Daren!

    Happy holidays everybody!

    1. Daren (Editor) says:

      Based on my metrics, the DM signal was indeed close. Within 1 percent. I’m not exactly sure how Gary calculates the risk-free rate, but I believe he uses monthly compounded or monthly average of the 90 day T-bill over the prior 12 months. If I’m correct on this, he would still be in U.S. stocks for December.
      Also, the month is not over yet. 🙂 A lot of sectors in U.S. stocks are oversold at the end of this past week. That means we stand a decent chance of seeing a bounce this next week. Time will tell I guess.

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