The Value Inflection Point?

Sure enough, as soon as the media (and I) make a point of a market anomaly, the market turns!  No sooner did I make a blog post titled, “Growth versus Value Redux” on August 4, highlighting the tremendous underperformance of the value versus growth style of equity investing we have seen recently and over the past 10 + years, the value style picked up some lost ground!

As seen from the chart below, the value style ETF (IVE, the purple line on top) made a big pop on August 5 and surpassed the growth style (IVW, the blue line) through month-to-date on August 10 with a return of 3.5% compared to the growth and S&P 500 (IVV, the bold black line) returns of 2.2% and 2.8%.  We haven’t been able to say that for a while!

There is no telling if this is the beginning of a trend, but since the growth style has been bid up so much during the stock market recovery, the value style does seem ripe for a catch-up trade.  As always, best to be broadly diversified.

Growth vs. Value Redux

Everyone is talking about it!  Month after month and year after year, value investing in the equity space has been a losing bet against growth investing. 

Value investing means buying stocks that appear to be “cheap” based on underlying fundamental metrics like price to earning/book ratios.  Growth investing, on the other hand, means buying stocks that appear to be cheap based on their growth and earnings potential.  News today from Vanguard that they are “giving up” on their active value mutual fund, Vanguard US Value Fund (VUVLX) since its returns have mirrored its passive counterpart, throws more angst into the mix.

How bad has it been?  From the chart below, the long-term trend over the last 10 years has been humbling.  The iShares Growth ETF (IVW, the purple line on top) has generated a cumulative price return of 330% over the last 10 years compared to 220% for the S&P 500 (IVV, the black line in the middle) and only 125% for the iShares Value ETF (IVE, the blue line holding up the bottom). 

Total returns over the last 10 years ended June 30 are 16.40% for growth (IVW), 13.91% for S&P 500 (IVV), and 10.59% for value (IVE).  Notably, a shorter horizon of YTD returns through June 30 puts it really into focus:  IVW is up 7.81% easily besting IVV of -3.09% and absolutely crushing IVE of -15.55%!

While academics are still battling over the significance, it is unclear when or if the value style of investing will ever overtake growth as a preferred investment style.  Either growth will collapse or value will rally, or something in the middle.   For now, all it will take is one good earnings miss of a few large growth names (e.g., Apple?, Amazon?, etc.) to start a bubble pop.  Until then, be cautious and balanced with a well-diversified portfolio.

More Good News on Credit Spreads

Readers of this blog site will know that I am an advocate of long term strategic investing, global multi-asset diversification, and tracking of diverging relationships between and within asset classes.  One asset class that I have previously commented, the high yield bond (“junk bond”) market, bears notice again.

The coronavirus pandemic initially shocked the high yield bond market causing a spike in their credit spreads to over 1,000 basis points (10%) back in March.  A jump in credit spreads is usually attributable to an increased potential for bond defaults and investor losses causing bond prices to fall.

This year’s ensuing dramatic weakness in the economy and the resultant recession prompted extraordinary actions by the Fed and Congress with fiscal policy.  As of today, high yield bond spreads are at the post-crisis low of about 528 basis points.  Though not at the early-2020 lows of 338 basis points, the recovery has been notable.

The chart below is instructive on the paths we can follow.  The last recession back in 2007-2009 (the grayed-out area) was preceded by a jump in spreads for about a year from December 2007 to November 2008.  The peak spread then of almost 2,000 basis points was much higher than levels reached this year, so at least in theory, more poor performance is possible during a protracted recession.

However, from March through today, you can see the decline in credit spreads and most economic and capital market action has been driven by news on the progress in the fight against the coronavirus pandemic.  With strong Fed and fiscal policy used as a backstop, the some parts of the capital markets have partly recovered from a near meltdown; though some still have not!  The economy is still very weak and coronavirus surges grab the headlines.  News on a vaccine and treatment are a good offset to the bad news.

High yield bond market spreads are one indicator to follow to help us gauge the strength of the recovery.  This is one positive nugget of news to help lead us out of the current situation.

Do or Die

The New York Times published a book review on July 12, 2020 that bears noting.  It has an ominous title, “Die With Zero”, but it does highlight an interesting perspective on retirement planning.  As the review states, the book covers important concepts on “why you save and how you live.”

Most financial and investment planners will tout the benefits of tax-deferred saving.  The benefits of compounding of returns within tax-deferred accounts are well-documented and, everything else being equal, tax-deferred accounts always beats taxable accounts on an after-tax total return basis over any time horizon.  So, if that is the case, keep the money invested in tax-deferred accounts as long as you can.  But, for what purpose??

Certainly, as I have indicated in previous blog posts (“Is there a Number for You?”, https://www.dattilioash.com/our-blog/2020/4/30/is-there-a-number-for-you), cash flow testing of expenses and income overlaid with your investment portfolio is important to help you determine your probability of retirement success.  If you have a high probability of success and a good amount of excess “cushion”, then you owe it to yourself to think about how you want to deploy the excess – whether save it for your heirs, gift it currently, or spend it currently on something that you value.

These are very personal decisions and only you can decide on the best answer for you.  My role, as an investment planner, is to bring this point to your attention and identify the pros and cons.

The Income Strategy Problem

I have reported the wide dispersion of performance across different asset classes so far this year in previous blog posts.  There are clear winners and losers so far this year and nothing is more telling than the wide dispersion of returns amongst the S&P asset class sectors.   Perhaps unsurprisingly, this wide dispersion has been a major detriment to income strategies this year.

The S&P 500 index is classified into 11 broad industry categories including information technology, health care, financial, consumer discretionary, consumer staples, communication services, industrials, energy, utilities, materials and real estate.  Each of the sectors includes companies that have business characteristics unique to that sector.  In the current COVID-19 environment, the sector performance has diverged in a meaningful way.

As seen from the chart below, the information technology sector (the bright pink line at the top) has led the performance of all other sectors and the S&P 500 (the bold black line) by a wide margin.  Huge laggards include energy (the purple line at the bottom), financials (light blue line), industrials, and utilities.  The consequences of this are significant and have an impact on targeted strategic approaches, especially strategies targeting income.

Strategies targeting income usually look for investments that have a few common characteristics including consistency of payments, lower price volatility, and higher portion of return coming from income versus price appreciation.  These traits all tend to cluster in stocks in the four S&P sectors that have generated the weakest YTD performance being energy, financials, industrials and utilities.  For example, the iShares Select Dividend ETF (DVY), a popular $12 billion high dividend-paying ETF, has its largest sector allocations totaling 56.8% in financials, utilities, and energy causing its staggering 2020 YTD return of -25.01% compared to the S&P 500 that is down only -1.4%.

So, unlike the tremendous recovery we have seen in other sectors from the lows in mid-March, these weak sectors have not shown a similar bounce-back.  It appears that the market is assessing a prolonged period of weakened earnings and ability to pay dividends from these sectors.

The question, of course, is how long this situation will persist.  No one knows the answer to that, but this is certainly not a situation like the Dot-Com Bubble in 2000 where many of the companies were wiped out and went out of business.  Like always, patience is needed during times like this.  A long term investor will be rewarded by holding a diversified portfolio of quality investments.

Q2 Turn for the Better, but More to Go

The performance of capital assets in 2020 Q2 is a result of the actions taken in the aftermath of the Covid-19 outbreak that started in Q1.  In early April the Fed announced unprecedented monetary policy and lending activities to complement the $2.2 trillion fiscal Cares Act to help protect the economy from the consequences of the coronavirus.  From that point, the capital markets applauded the actions to guard against increased economic fallout and plodded to a semblance of a recovery; albeit, narrowly focused.  The markets are now showing somewhat normal volatility driven by news on the path of Covid-19; both good and bad.

Despite some pockets of relative outperformance, the benefits of diversification failed to materialize again in Q2 just like in Q1.  The largest capitalization U.S. equities, comprised of Microsoft, Apple, Alphabet, Facebook, and Amazon, have generated very strong positive returns during this period while the broader markets continue to show negative year-to-date returns.  Just like in Q1, exposures in some asset classes held to cushion large drawdowns failed to perform; they either followed the market down or, worse, underperformed the markets.

The large returns for Q2 are partly due to the recovery from the dire state of Q1.  Consequently, it is best to look at how performance moved from Q1 to Q2 and where performance stands today on a year-to-date basis for a better understanding; we still have a long way to go! The following table shows performance for Q1, Q2, and Year-to-Date (YTD).

On a year-to-date basis, the S&P 500 (IVV) fell -3.2%, but other broad equity markets fell more including small cap (SCHA) -13.06%, international developed markets (SCHF) -10.82%, and emerging markets (SCHE) -10.64%.  High dividend equities (DVY, SCHD, SPHD) suffered, as well, with much worse performance due to concerns about dividend cuts.  Likewise, REITs (SCHH) faltered due to the potential for cash flow and lease deficiencies with a decline of -22.56%.  Some diversifying exposures bucked the trend, including momentum (MTUM) +5.08%, but those were the rare exceptions.

The bond markets continued to show strength, consistent with Fed support of investment grade and non-investment grade corporate bonds.  Broad core bonds (SCHZ) were up +6.41% year-to-date, led by U.S. treasury exposures, and credit exposures recovered as investment grade corporate bonds (LQD) generated a +6.46% return.  High yield bonds (HYG) recovered from a very weak Q1 return of -11.61% to show a YTD return -5.10%.

Like I said on April 9 (https://www.dattilioash.com/our-blog/2020/4/9/new-ball-game), the economy and capital markets may have been given a temporary reprieve, but we are still hostage to the emerging path of Covid-19 should it’s negative consequences exceed expectations:

No one can predict the length and depth of the coronavirus crisis, but these new huge Fed actions certainly have the potential to fill a critical role to keep businesses and municipal governments functioning and support the pricing of risky investment assets.  Due to this, and pending any additional unforeseen events, it is difficult to see a larger drawdown of financial assets than we have seen thus far.  With the lows of the markets potentially taken out, certain classes of U.S. risky assets are likely to exhibit normal volatility and can be now be held.  Consequently, tactical positioning that sold U.S. risky assets can now be reversed over the near term.

The Short and Long of Factor Anomalies

Over the last several years, the magic of “factor analysis” was promoted by the academic and investment community as an innovative way to add value to an investment portfolio.  As it goes, certain factors, such as low volatility, momentum, quality, and size, represented by certain investments were proven to outperform broad benchmarks.  For example, stocks that had shown low volatility (i.e., low standard deviation of return) tended to outperform stocks that had more volatility.  Some factors were more robust and better predictors of better returns including low volatility, momentum, quality, and size.  All of these studies, of course, were based upon long term studies that inevitably showed some short term periods of underperformance; a period where we seem to be in now (for some of the factors).

On a year-to-date basis through yesterday, the S&P 500 (IVV) has returned -4.58% whereas the only popular factor to produce outperformance has been the momentum factor (MTUM) with a total return of +3.04%.  All the other factors have lagged significantly over this short term horizon, except the quality factor (QUAL) that just barely underperformed at -5.42%.  Low volatility (USMV and SPLV) and small cap (SCHA and IJR) showed negative returns of -8.18%, -15.52%, -15.35%, and -21.11%, respectively.  The chart below shows the dramatic variation of price return of each of these factors against the S&P 500 (the bold black line).

This short snippet of time demonstrates the importance of being a long term investor.  Though we all wish that our investments would always outperform the broad benchmarks over every time horizon, we know this will not be the case.  This situation reaffirms the need to match an investment strategy with your objectives and then sticking to it.

What a Difference a Week Makes!

My blog post from last week suggested that diversification was failing the goals of risk mitigation and return enhancement since the broad indices were leading all sub sectors on a year-to-date basis.  Well, that changed quickly with some astounding employment economic news and some positive signs on the coronavirus front, and despite some troubling social unrest. 

Per the chart below, you can see that the broad S&P 500 (the bold black line) certainly had a good week being up 5%, but ALL other sub asset classes including small cap, mid cap, high dividend, and especially, real estate investment trusts (REITs) were up by more; with REITs up a dramatic 12.4%.  Likewise, international developed markets and emerging market equities were both up about 7%.  In the fixed income space, broad bonds and investment grade corporates were mostly flat, but high yield bonds were up 2%.

One week does not a trend make, but a rotation like this is telling that the lagging sectors are drawing attention from investors.  As I said last week, situations like this often occur in the short term and realign to historical norms over time; the previously out-of-favor sub-sectors are simply reverting to their mean with the potential to add diversification benefits.  We can expect this to be the story again, but the duration to recovery remains clouded due to the uncertainty surrounding the corona virus outbreak.

Hurtful, not Helpful

The past two months of April and May have been confounding in many ways.  In the face of dramatically weak economic and corporate reports due to the corona virus, we would expect to see very weak capital markets, but the broad indices are showing only a modest year-to-date setback.  Looking deeper into the story, however, we see much weaker underlying performance across many sub sectors of the capital markets.

The S&P 500 showed a recovery from its dire February and March performance of -8.1% and -12.9%, with respectable returns of +12.8% in April and +4.7% in May, respectively.  Year-to-date (YTD) through May 29, the S&P 500 is down only -5%; a relatively modest decline given the economic disruption we have seen due to the COVID-19 outbreak.  However, the S&P 500 is not the whole of the capital markets; some sectors are still well off their recent highs and still struggling to recover to former levels.

The following chart (of price performance) shows a sea of negative returns charted from the beginning of the year through the end of May.  Major sectors like small cap (SCHA) and mid cap equities (SCHM) are much weaker with YTD total returns of -15% and -13%, respectively.  Likewise, real estate investment trusts (REITs) have struggled with a total return of -23% (SCHH) due to the potential for disruptions in the earnings for income-generating real estate.  Other income-generating asset groups like high dividend stocks follow that path with returns of -20% (DVY) and -8% (SCHD) due to prospects for dividend cuts.  Alternatively, some equity asset groups did better like tech (VGT) with +7.0% and factor exposures like momentum (MTUM) +0.7%.

International markets were mostly weaker than U.S. markets.  International developed markets (SCHF) were down -14% YTD and emerging market equities (SCHE) were down -16%.

Fixed income, on the other hand, performed much better with the classical “flight to quality” trade.  Broad fixed income (SCHZ) produced a YTD total return of +4%, investment grade corporate bonds generated +4%, whereas high yield bonds were weaker at -4% due to the increased prospect of bond defaults.

So, once again, broad diversification proved to be hurtful, instead of helpful, to portfolio performance.  As we know, situations like this often occur in the short term and realign to historical norms over time.  We can expect this to be the story again, but the duration to recovery remains clouded due to the uncertainty surrounding the corona virus outbreak.

The Credit Spread Story

As we have seen, the COVID-19 pandemic has caused a tremendous global toll of death and suffering while also driving financial markets to steep losses.  Aside from the well-covered losses in global equity markets, another key impact has been felt on the credit markets.  The key determinant of credit market loss has come from the tremendous widening in credit spreads that began in late February and peaked to a recent high on March 23.  When credit spread widen, all else being equal, bond values go down and unrealized losses emerge.  Credit spreads widen in a crisis as a mechanism to compensate buyers of debt for the increased risk of default.

On March 23 the high yield bond index hit its recent wide credit spread of 1,037 basis points (bp) and the corporate investment grade bond index hit 401 bps from their recent stable levels earlier in the year of about 400 basis points and 100 basis points, respectively (see chart below).  The chart clearly shows that a widening of spreads correlates highly with recessions. Due to some dramatic actions from the Fed and huge fiscal stimulus taken (see my previous post here for more info:  https://www.dattilioash.com/our-blog/2020/4/9/new-ball-game), credit spreads for high yield and investment grade corporate bonds have narrowed from those levels to 777 bps and 221 bps, respectively, on May 14 - so far, before spreads widen to the dramatic level seen in the Great Recession of 2008/2009.

These widened credit spreads translate directly into total return losses.  On a year-to-date basis, high yield bonds (HYG) have returned -8.83% while investment grade corporate bonds (LQD) have recovered a bit to show a small gain of +1.50%.  It is worth noting that both high yield bonds and investment grade corporate bonds came off a great year in 2019 with returns of +14.09% and +17.37%, respectively, so the retracement so far in 2020 simply serves to move these markets closer to a long term return profile.

Most thought leaders seem to agree that the capital markets will follow the path led by the coronavirus; good results will lead capital markets higher and vice versa.  However, there is no way to know how the future will emerge.  It is reasonable to expect credit spreads to come back in to historical norms when the economy starts to see some signs leading to normalcy.  This will lead the bond market to positive returns from here, all else being equal.  In the meantime, it is prudent to be a long term investor and stay well-diversified to capture the recovery in capital markets without realizing losses.

Is there a "Number" for you?

Back in 2010, the ING financial services firm ran a marketing campaign asking what is “Your Number?”  The purpose was to encourage people to identify and calculate the total amount of money they need to have saved by the time they retire.  This campaign, though memorable, was criticized roundly as being too trivial and naïve and it oversimplified retirement planning to be of any real use.  But, was that too harsh a criticism?  What can we learn from “your number”?

Today’s investment modeling software has taken a good stab at answering this question.  MoneyGuidePro, one of the leading “fintech” planning softwares, does a good job at statistically calculating the “probability of success” of a retirement plan when all the relevant factors such as projected income, expenses, and investment portfolio are modeled.  Your “Number” is only part of the answer, but an important part.  Let’s see how it works.

Assume that you are 66 years old and your wife is 62 and you want to retire today.  Both you and your wife are eligible for social security at the maximum benefit at full retirement age and age 62 of $3,011 and $2,265 per month, respectively; $63,312 per year combined (pre-tax) with an annual inflation adjustment.  Let also assume that there is no pension, annuity, or other source of income.  Based on actuarial models, assuming good health, we can plan out 33 years; age 92 for the husband and age 94 for the wife.

With the income side taken care of, what about expenses?  Most people have a standard of living that they have become accustomed to and want to maintain it into retirement, including inflation.  How much that costs is specific to each family, but we can take some short cuts to model it out.  For example, for our sample family, let’s assume that they spend a level $6,000 per month (after-tax) to support their lifestyle (though we know spending is not “level”) and it inflates by 2.25% per year.

Now, let’s get to the investment portfolio; the part of the equation we are trying to solve for.  Once all the factors are populated into the model we can work backwards to determine statistically how large your investment portfolio should be to provide a safe “probability of success”, i.e., the level where you have enough income and assets to cover your expense through the “end of plan”.   For this example, we will assume a 50% equity weighting with 70% of the investments in tax-deferred vehicles (IRAs, 401-ks, etc.) and 30% in taxable accounts.

So, run the model and the answer pops out:  for this fictional family, their “number” is $490,000.  This means that there is an 80% probability of success (see chart below) that this family’s social security income of $63,312 per year (pre-tax), expenses of $72,000 per year (after-tax) and investment portfolio of $490,000 is enough to last the next 33 years without a deficit.  Higher living expenses would require more investments, and vice versa.

Sounds good, right?  Wrong!  There are many things that could go wrong.  The list is quite long and includes things like higher inflation, medical expenses and unplanned expenses, long term care costs, increased taxes, early or late death, value of a home, desired bequeaths, etc.  Also, there are many things that can impact the investment portfolio and the ultimate probability of success including the underlying risk profile, volatility and sequence of returns, investment expenses, and the asset class allocations.

Calculation of “Your Number” makes most sense when you are close to retirement and want some assurance that you have the financial wherewithal to proceed with a degree of success; especially since there are no “do-overs” in this league!  Since the inputs into the model are likely to change over time, it is important to update the plan on a somewhat regular basis, or when there is a material change in something.  For more on this topic, check out my prior post on our blog, here:  https://www.dattilioash.com/our-blog/2019/7/29/do-you-need-a-retirement-plan

All's Well That Ends Well...

…If it’s not Well, then it’s not the End!  I’ve seen this quote, or something like it, on greeting cards and miscellaneous memes. I did a Google search and it seems that John Lennon, of all people, is attributed a version of this quote!  I have thought this way about the capital markets since the recent lows on March 23 and a decent rally since then.  The question of the day:  when will we know we are Well AND at the End?

I wrote a blog post last year back on December 16 titled, 20/20 Foresight? (https://www.dattilioash.com/our-blog/2019/12/16/2020-foresight).  In it, I recounted the difficulty thought leaders have with forecasting capital markets.  Though I’m not going to hold them to it, Wells Fargo forecast a decent 7% return for the S&P 500 in 2020; we shall see!  It goes without saying that no one saw this coronavirus pandemic coming and could have predicted the market turmoil, never mind the winners and losers.

It is clear to me that we are currently subject to significant “headline” risk, i.e., the risk that either good or bad news will be released and impact the markets accordingly.  Market returns, thus, are “scenario dependent” and there is no way to hedge this risk – the best we can do is stay broadly diversified, including a cash allocation in your diversified portfolio. 

Though the market has recovered quite a bit from its recent lows, the S&P 500 is still down -12% year-to-date.  So, we are certainly not Well; we could re-test the lows or go higher from here (i.e., the “W”-shaped recovery versus the “V”-shaped recovery, the latter).

It doesn’t seem like the End, either.  Many areas of the capital markets still suffer from significant dislocations; high yield bonds come to mind (see chart below).

High yield bonds (“junk bonds”) are now trading off their recent high spread of 1,000 basis points, down to “only” 785 basis points; we started the year at about 350 basis points (wide spreads are bad, narrow spreads are good!)  So, one measure of the End for me is to see high yield bonds start performing better; we should be hopeful that there is enough already-enacted and available fiscal and monetary policy to help us get there.

Also, it goes without saying that as long as Covid-19 is with us and uncontrolled, we will be in some state of turmoil some distance from the End.

When asked what the market will do, though it is interesting to go through all the story lines, I still repeat the famous words uttered from my favorite CIO: “Beats Me!”

New Ball Game

Wow!  Today, the Fed has pulled out all the stops to protect the U.S. economy.  The new stimulus measures announced today, in addition to the $2 trillion fiscal CARES program and prior Fed rate cuts and buying programs, includes some new lending facilities to municipalities and small- and mid-sized business.  Also, and perhaps most importantly, the Fed is now putting some market price support on below-investment grade bonds and other risky asset classes (and perhaps equities, if needed!)

No one can predict the length and depth of the coronavirus crisis, but these new huge Fed actions certainly have the potential to fill a critical role to keep businesses and municipal governments functioning and support the pricing of risky investment assets.  Due to this, and pending any additional unforeseen events, it is difficult to see a larger drawdown of financial assets than we have seen thus far.  With the lows of the markets potentially taken out, certain classes of U.S. risky assets are likely to exhibit normal volatility and can be now be held.  Consequently, tactical positioning that sold U.S. risky assets can now be reversed over the near term.

The Q1 Crisis

The coronavirus took center stage at the end of February and blossomed into a full-blown health and financial crisis.  It is a foregone conclusion that there will be a worldwide contraction in economic activity of huge proportions that will negatively impact capital markets.  No one knows the depth and length of this crisis, but we are all hoping for a quick resolution.

During Q1 the benefits of diversification failed to materialize.  Exposures in asset classes held to cushion large drawdowns failed to perform; they either followed the market down, or worse, underperformed the markets.

The S&P 500 (IVV) fell -19.6%, but other broad equity markets fell more including small cap (SCHA) -31.6%, international developed markets (SCHF) -23.2%, and emerging markets (SCHE) -24.4%.  High dividend equities (DVY, SCHD, SPHD) suffered, as well, with worse performance due to concerns about dividend cuts.  Some diversifying exposures bucked the trend, including low volatility (USMV) -17.2% and momentum (MTUM) -14.8%, but those were the rare exceptions.

The bond markets were dominated by an extreme flight to quality with broad core bonds (SCHZ) up +2.0%, led by U.S. treasury exposures, but credit exposures were severely impacted with even investment grade corporate bonds (LQD) suffering with a -3.0% return and high yield bonds (HYG) returning -11.6%.

I took extreme action to raise cash (and other safe assets) in most client accounts, as I reported in my March 18, 2020 blog post, The 20% Solution, (https://www.dattilioash.com/our-blog/2020/3/18/the-20-solution):

It is a foregone conclusion that the economy will show significant weakness in the wake of this crisis.  Most of the factors that “tactical asset allocators” use to signal a “risk-off” environment are certainly signaling risk-off; either now or when the statistics are calculated and reported.

For this reason, I have taken most all of our client accounts to a 20% cash and U.S. Treasury position to help smooth the volatility.  For now, I have sold the riskiest asset classes including real estate investment trusts, international developed equities and emerging market equities with the expectation that they would suffer the most in a protracted situation.  I may do more selling depending upon how the situation evolves. I expect to reinvest the proceeds once the negative factors begin to turn positive.

No one can predict the future, but taking a position like this telegraphs my outlook that more downside risk is present.

The 20% Solution

In uncharted territory, like now, you need to think creatively and solve problems within a rationale framework.  Performance against a benchmark is interesting, but the ability for an investor to meet their financial and life goals is most important.  Though my investment philosophy is firmly grounded in the realm of long term strategic investing, these are special times. For this reason, I have implemented some important risk management processes into my investment strategies.

Regardless of your risk profile, the current coronavirus crisis is causing significant financial pain to all investors.  Uncertainty of the depth and length of this crisis has caused financial markets around the world to large losses.  Year-to-date through yesterday, the S&P 500 was down -22%, international developed markets were down -29%, and emerging markets were down -25%.  U.S. Treasury bonds have been a safe haven, but investment grade corporate bonds have sold off being down -9% due to the potential for increased bond defaults.

It is a foregone conclusion that the economy will show significant weakness in the wake of this crisis.  Most of the factors that “tactical asset allocators” use to signal a “risk-off” environment are certainly signaling risk-off; either now or when the statistics are calculated and reported.

For this reason, I have taken most all of our client accounts to a 20% cash and U.S. Treasury position to help smooth the volatility.  For now, I have sold the riskiest asset classes including real estate investment trusts, international developed equities and emerging market equities with the expectation that they would suffer the most in a protracted situation.  I may do more selling depending upon how the situation evolves. I expect to reinvest the proceeds once the negative factors begin to turn positive.

Be safe!

The Optimist View

Barry Sternlicht, billionaire and Chairman and CEO of Starwood Property Trust, was on CNBC on yesterday morning and presented a hugely positive and optimistic view of the current situation.

Yes, this is a serious situation, and Yes, economic growth and corporate earnings will be severely impacted in the short term.  But, he cited that China appears to be close to normalization.  He mentioned that Apple is opening their 44 stores in China and Disney is re-opening their park there.  He fully expects this to be a “V” recovery where GDP growth in Q2 will approach 2.5-3.0% and the markets will follow that trend up.

See the full video clip and story here: https://www.cnbc.com/2020/03/13/barry-sternlicht-stock-market-is-going-to-come-ripping-back-quickly.html

The Ignominious Power of 1.0

For those who followed the Financial Crisis of 2008/2009, we all remember how there was no place to hide (except U.S. Treasuries).  All asset classes struggled with steep losses and their correlations with each other all approached 1.0; a situation where diversification did not help portfolio performance.  A well-built portfolio will have some asset classes with low correlation and some with negative correlation to help weather volatility of returns.  The environment today has shown similar characteristics with most all asset classes “selling off”. 

Per the table below, you can see the year-to-date negative drawdowns of the S&P 500 and investment grade bonds that are usually negatively correlated; the S&P 500 (IVV) is down -14.78% and investment grade bonds (LQD) are down -2.71%.  The only safe havens with YTD positive returns are short treasury bonds and aggregate core bonds (that is made up mostly with U.S. Treasuries).  Other diversifying positions like in U.S. factor exposures (i.e., minimum vol, momentum), international markets, real estate, and bank loans have all suffered steep losses.

Just like the Financial Crisis, I expect this situation to rectify itself over time.  Like I said in my previous post, I have done some selective tax loss selling and de-risking in some portfolios that cannot tolerate steep losses due to a shorter time horizon than 5 years.  For accounts with a time horizon greater than 5 years, I expect to “sit tight”, but I will continue to look for selective opportunities to potentially rebalance into other opportunities to improve performance going forward.  

New Phase of Crisis

The capital markets were performing badly enough when the coronavirus threatened to quell global growth and potentially lead to a global recession.  However, the markets turned down in a new phase over the past few days when the oil markets collapsed with crude oil sinking 20% to about $30 per barrel due to a combination of decreased demand and a price war between Russia and Saudi Arabia.  The consequential crushing of oil patch debt due to potential cash flow gaps for debt coverage has spilled over into the high yield bond market and some investment grade bond markets.

High yields spreads have widened significantly with month-to-date total returns for high yield bonds (HYG) at -5.8% and even investment grade corporates (LQD) have weakened with a -4.9% MTD total return.  The energy equity ETF, XLE, has been crushed with MTD and YTD total returns of -25.5% and -43.9%, respectively.

Additionally, causing more pain to the market, today the WHO officially declared this situation a pandemic.  The Dow today has now fallen 20% from its recent high on Feb 19 and we are now technically in a “bear” market.  A bear market is just a name, but it certainly reflects some steep losses across most sectors in the equity (and bond!) space.

I have done some selective tax loss selling and de-risking in some portfolios that can not tolerate steep losses due to a shorter time horizon than 5 years.  For accounts with a time horizon greater than 5 years, I expect to “sit tight”, but I will continue to look for selective opportunities to potentially rebalance into other opportunities to improve performance going forward.

The Best Performing Asset Class Since 2017: Stocks or Bonds?

I updated one of my favorite charts with the periods from the beginning of 2018 through yesterday.  In it I show the cumulative value of $10,000 invested in the S&P 500, Core Aggregate bonds, and risk-managed Dow Jones Index portfolios from conservative to aggressive.

You can see from the chart that the S&P 500 (black line, mostly on top) looked like a big winner until the end of February!  The winner?  Core bonds (green line intersecting at the end)!  The balanced portfolio DJ indices lagged severely due to the extraordinary equity market drawdown during this time horizon.

I do not expect this situation to persist and there is no telling how long this situation will last, but it is worth noting to display the current market dynamics.    

What Now, Part 2?

The word “historic” is way overused, but today was a historic day.  Equities around the world sold off in all-time record numbers due to fears about the coronavirus and the consequential impacts on global growth (slower), oil prices (very much lower), high yield bonds (prices lower and spreads much wider) and safe treasury bonds (prices very much higher, yields very much lower).

Everyone has read the headlines, so no need to recount everything here.  Certainly, oil prices (including some geo-political intrigue), oil companies, and travel-related industries are leading the markets lower, but all sectors and markets are suffering.  The question everyone wants answered is, “What now?”; a question I already posed last Thursday, March 6, here:  https://www.dattilioash.com/our-blog/2020/3/5/what-now.

The last time the markets come close to this much volatility was the Financial Crisis in 2008.  That period of time saw a “drawdown” of -55% in the S&P 500 and lasted 1.4 years from “peak-to-trough” before heading back up.  So, it was painful then and it feels painful now; but we recovered from that crisis and I expect we will recover from this crisis. 

Unlike the Financial Crisis, however, this is a unique economic shock where actions taken by policy makers will dictate the depth and duration of the shock.  Aside from activities needed to quell the coronavirus, I expect there to be fiscal actions to support economic activity and capital markets in the U.S. and around the globe.

No one could have forecast the developments of the past week and no one can forecast when the markets will recover.  In situations like this it is best to “sit tight” and let the market psychology work itself out; certainly, that is what happened during the Financial Crisis and this is what I expect will happen during this crisis. 

As always, it is critical to have your investment portfolios managed to the appropriate risk profile for your specific personal situation.  If you have a long term time horizon with a well-diversified risk-managed portfolio that is consistent with your risk tolerance, I expect that this situation will just be an unfortunate blip in your financial life.  Aside from some small amounts of tax-loss selling that could benefit taxable accounts, I am not selling equities right now; best to let the dust settle before participating in this current market.