FIVE THINGS YOU SHOULD KNOW
INSIGHTS for INVESTORS
Investing is an emotional game … period. Success is far more determined by discipline and patience than genius; to that end both Vanguard and Russell have done research showing an advisor’s greatest value is in addressing the behavioral finance challenges associated with investing, which they believe adds 2%+ to returns over time (https://russellinvestments.com/-/media/files/emea/insights/emea_value-of-an-adviser_case-study.pdf?la=en-gb).
After a fantastic run in the stock market, investors are faced with the same old challenges of being excessively bullish and chasing returns, or too bearish and prematurely believing the next “crash” is upon us. To the former we’d caution them to look for the next bull market (see more below) and to the latter we’d say that volatility is a part of life, even if we suspect the next correction, not crash, isn’t too far away.
Market corrections and volatility are a part of life, but what gives us extra pause is that the typical buffers to volatility, traditional bonds, likely won’t provide much protection this go around. If investors are both prepared through repositioning and/or readying themselves for drawdowns throughout their portfolio, panicked decisions are likely to ensue.
To help you prepare emotionally we’ll take a quick look at the current market set up, to help prepare your portfolio we’ll look at some alternative asset classes and investing concepts to the traditional 60/40 and its outsized allocation to traditional fixed income – whose issues we discussed at length last week. For last weeks commentary click here.
The Current Market Set Up
Tom Essaye summarized the current landscape wonderfully in the following excerpt “after a year of constantly digesting positive events (Fed backstopping everything, CARES Act, electoral clarity, second stimulus, third stimulus, vaccination progress) the markets are transitioning to a new paradigm where 1) There isn’t a majorly positive event looming every three months, and 2) Some of the stimulus etc. will be dialed back, and that transition will be a process of starts and stops likely causing more volatility, which we saw that last week.
General inflation fears are a headwind on stocks, and they will be until it becomes clear that inflation is a temporary phenomenon. Similarly, the Fed will have to transition to tapering of QE, and how that transition is handled will go a long way to deciding whether the next 300 points in the S&P 500 are up, or down. Finally, after having that aforementioned constant stream of “good” news to push stocks higher, we’re seeing a market that is in search of a positive catalyst to send the S&P 500 to 4400-4500, and right now there’s not an easily identifiable candidate.
But while those are legitimate concerns, the fact remains there are powerfully supportive forces for stocks still very much in play (emphasis added). The economy is roaring, and corporate earnings are breaking records. Consumers’ personal balance sheets are very strong (which makes this very, very different from other recoveries and makes this almost like a “post war” recovery), meanwhile the Fed is keeping rates low for years into the future and likely won’t reduce QE until very late in 2021 or early 2022. That set up is very supportive of stocks, so while there are uncertainties and unknowns, support for stocks at these levels remains very strong.
As such, we continue to view the next several months as more volatile than we are used to, but volatility doesn’t mean corrections. And as long as these fundamentally positive supports for stocks are in place, and we do not have 1) Evidence that implies the Fed is getting behind the curve on inflation, 2) The Fed makes a policy mistake (tapering too soon, or not soon enough) and 3) A resurgence in COVID, then the risk of a major decline in stocks remains generally low.
Now, we are still lacking a positive catalyst, but given the generally reduced downside risks we continue to think it makes sense to essentially “wait” in stocks and weather any uptick in volatility, using dips in cyclicals and value to add exposure and create a balanced portfolio.”
Where are the Opportunities and Alternatives?
A. Diversify Globally
Goldman Sachs reminded people recently that there are more stocks than just the S&P 500 or FAANG, noting that “(g)lobal equities are trading at a substantial discount to the US, even after adjusting for differences in sector weights. This valuation headroom, combined with strong 24 month forward earnings forecasts (94% for MSCI EAFE and 53% for MSCI EM), a high beta to the global growth recovery, and attractive security selection potential, all make a strong case for investing with a global lens in our view.” See the chart below from Goldman Sachs highlighting the relative value of a few global markets.
We frequently remind clients there are three critical factors/mindsets investors need to remember in general, but certainly when investing abroad:
The other area of “value” are value stocks themselves. As you can see from the next chart (courtesy of First Trust) value stocks have underperformed growth since the Great Financial Crisis, due in large part to the unprecedented run/strength of mega-cap tech stocks (Apple, Google, Microsoft, etc.). However, as you can also see the long-awaited rotation back into value stocks appears to be underway. The rotation between growth and value has been very common, the length of the current growth run was not.
The previous “head fakes” regarding a rotation back into value has many asking if this time it’s real. As JP Morgan noted, “As we head into summer, one of the most frequently asked questions is whether the value vs. growth trade still has room to run. To answer this, one should start by looking at relative valuations (see chart below). As seen in this week’s chart, relative valuations continue to signal that value looks cheap relative to growth, with the ratio only just recently rising to one standard deviation below its long-run average. One might have expected that the outperformance of value since late last year would have done more to close this valuation gap, but the story has been heavily influenced by earnings. Breaking down the total returns of the Russell 3000 growth and value indices from March 2020 to present shows that growth’s outperformance was primarily driven by stronger profit growth, which accounted for 23.8% of returns compared to 14.4% for value. This comes as no surprise given that the industries most acutely affected by the pandemic (banks, airlines and oil) are some of the largest components in the value investment style and saw earnings crumble last year. However, value-oriented sector earnings tend to be more correlated to GDP growth than their growth-oriented counterparts, which suggests that a solid year of economic growth should support robust profit growth among the value-oriented sectors. This, combined with higher interest rates in the second half, suggests that value stocks can further extend their outperformance relative to growth into the end of 2021.”
It could be finding some “alternatives” to your equity exposure of late, as we discussed above, or it could be actual alternative asset classes.
Over the last year we were frequently asked about the dangers of investing in either real estate or “high-yield” bonds. The much touted (and doubted) work from home phenomenon had people worried about the former, while the shutdown of the economy brought predictions of catastrophic defaults in the credit parts of fixed income.
The reality? As is most often the case, the worries should have been faded and once again “buying low” or when there is “blood in the streets” as Buffet says would have made you a lot of money.
REITs are up over 20% year-to-date, and have also been one of the best performing asset classes on a risk adjusted basis as well. For more information: click here.
High yield and credit fixed income positions were also left for dead by many, despite their history of solid risk-adjusted returns – especially during periods (like today) of rising interest rates which are significant problem for traditional bonds.
As Lord Abbett noted, “At the onset of the pandemic early last year, investors believed that the last 12-month (LTM) default rate on U.S. high yield bonds would rise to 10-15% or beyond by the end of 2020, consistent with peak levels in prior recessions. But as we’ve noted before, the credit quality of the high yield market has consistently improved over the past decade. When combined with 2020’s swift and outsized monetary and fiscal stimulus, the LTM speculative default rate peaked at just over 6% at year-end 2020, per JP Morgan data, substantially short of the estimates noted above; as of April 30, 2021, it stood at just 3.2%. For more historical perspective, Figure 1 tracks the forward cumulative five-year default rate by ratings cohort. For example, the latest data point in the chart below represents the cumulative default count of the 2016 cohort in the subsequent five-year period. Notably, cumulative default losses are lower given recoveries greater than 0%. We should expect this measure to turn lower over the coming year, in line with the turn of the one-year default rate referenced above. What is clear is that the peak in the cumulative default tally has been moving lower with each successive recession-driven default wave.”
With high-yield bonds reaching new all-time highs, the run in that specific asset may be nearing its end, but there are many other areas within the credit universe of fixed income worth exploring. Finding quality opportunities within credit is a great way, but not an easy one mind you, to directly address two major concerns with traditional bonds in today’s environment in that:
C. Income as a “Life Raft”
As we covered last week, the broken math behind the traditional 60/40 portfolio is pretty simple.
The blended yield of the S&P 500 and investment grade bonds is +/- 1.5% on any given day – and that’s being generous. The typical distribution in retirement is between 4-5%. That means even before one consider taxes, inflation or fees an investor is being forced to liquidate 2-3% of their account value every year.
Of course, ultimately it really isn’t percentages for most people but actual dollar amounts, making that 2-3% shortfall based on an original account balance a much bigger percentage when an account drops in value during bad market. This is where investors can, and have (e.g. 2008) get into real trouble and bring the longevity of their account(s) into question (see https://www.investopedia.com/terms/s/sequence-risk.asp).
How do you solve for this?
Generate an income stream off the portfolio sufficient to cover and your living costs so you never have to be forced to sell off any of your positions.
Let me put it another way, you wouldn’t and likely didn’t, count on raises from year to year to justify spending more than you made while you worked, so why are you now doing that in retirement by relying on capital appreciation through stock market gains to make up for your income shortfall?!
By diversifying both globally and across more asset classes generating a sufficient income stream is absolutely possible and is something brings our clients incredible peace of mind.
If you are a client of the firm, keep in mind these strengths of your portfolio as volatility inevitably raises its head at some point and/or when you hear people sounding the alarm bell on inflation or rising rates – you are ready!
To those of you still using an outdated strategy, may we strongly suggest you consider some important changes before the past performance you are looking back on is with regret and not excitement.
Have a wonderful weekend,
Tim and the team at TEN Capital