Now What? (redux)

Back in March, at the dawn of the COVID crisis, I wrote two blog posts titled What Now? and What Now, Part 2?  My comments focused on the need to remain calm and to try your best to “sit tight”.  A fully invested long term strategic approach would pay off, but it would take time; the steep selloff in March notwithstanding.

Here we sit, today, with markets reaching new all-time highs based on the release of new information about vaccines from Pfizer and Moderna that have tested to be 90+% effective.  Medical experts still indicate that the next few months, prior to release of the vaccine, will be quite severe from an infection, hospitalization, and death perspective due to the highly contagious nature and large number of existing infections.  Capital markets are moving past this period, however, and projecting a robust rebound in 2021.

Many related industries, like travel, leisure, and airlines, have been hurt badly, while targeted strategies like strategies focused on income generation have equally been hurt.  Income strategies have lagged due to the prospect of potential dividend cuts from high dividend payers, lease payment delinquencies from real estate, and lower earnings and growth from banks due to low loan demand and low interest rates. 

So, the major broad equity indices, overweighted in large cap tech names like Amazon, Alphabet, Apple, Facebook and Microsoft, that rallied strongly, could maintain their positions while other sectors that lagged have the potential to “catch up” and recover as the world rallies into a post-pandemic recovery.

As seen from the chart below, some of the key income generating asset class sectors are still struggling to fully recover to levels seen at the beginning of the year.  High dividend strategies (DVY, the bold black line at the bottom) and real estate investment trusts (VNQ) have lagged the most while most classes of bonds (AGG, LQD, and HYG) have recovered (probably mostly due to tremendous buying support from the Fed).  The S&P 500 (IVV) leads the pack (the red line at the top).  As the economy recovers, the sectors that lagged the most have the most to recover.  [Note:  Due to the outsized support from the Fed, it is difficult to say if the Treasury bond market will maintain its strength; mathematically, this market has almost no potential for positive returns into the future – see my recent blog posts about bonds for more on this.]

There is certainly reason to have positive feelings about the future.  As I recounted in my October blog post Where Do We Go from Here?, the broad outlook given vaccine breakthroughs, fiscal/monetary support, and economies opening slowly with only potential limited pockets of targeted lockdowns is positive and consistent with a long-term strategic approach that captures the broad trends in the economy and the capital markets.                   

A "Real" Loser

I am an advocate of long term strategic investing.  The idea is that investment trends are likely to play out over a long term horizon and trying to outguess the markets in the short term has proven to be a tough act to beat.

However, a long term strategic approach does NOT mean “buy and hold” forever!  Case in point is the crazy situation with the U.S. Treasury market.  As I wrote in a recent blog post, Once Again, Why Bonds?, with U.S. Treasury yields so low, it is almost foolish to buy (or even hold!) that bond sector in this market.  When the 10-year treasury yield was at 0.75% and with an inflation rate of 1.3%, the “real” yield after inflation is negative 0.55%.  Moreover, with the Fed targeting an inflation rate of 2%, the “real” rate could be even lower if rates don’t rise from there.  Better to buy something with some credit spread or credit support in other parts of the bond market to get some positive “carry” with a prospect for higher return (with requisite more risk).

Short term Treasuries offer an even worse prospect for yield and return.  For an investor hoping to balance out their portfolio with an allocation to short-term (and “risk-free”) Treasuries, this investment thesis has been turned on its head! 

This dire situation is best told by looking at the current profile of the Schwab Short Term US Treasury ETF (SCHO).  Remarkably, it currently offers a 30-day SEC yield of 0.09% (essentially zero!) with a shortish duration of 1.94 implying some price sensitivity to a spike in interest rates.  This situation virtually locks in a 0% return with NO prospect for any upside return; not something that makes sense for most investors.

Additionally, it doesn’t even make sense as a diversifier in a portfolio since it does not have enough price sensitivity or negative correlation to offset equity market losses. The best case is that this investment will provide liquid cash-like returns (0%!) and perform “less worse” than other investments; why not just hold cash in a mattress, or in a bank where you at least get free FDIC insurance for $250k per holder per bank?

Long term strategic allocations of SCHO that were bought as a diversifying short term bond allocation no longer make sense in this current environment due to the distorted risk/return profile. The SCHO ETF still has $7.3 billion in assets under management, so it does serve a purpose, though a limited one.  SCHO should only be held as a cash proxy with the requisite give-up in yield, return, and diversifying properties

Where Do We Go From Here?

It has been said that Wall Street is very good at creating explanations for what has happened in the past, but is not very good at predicting the future!  With that thought in mind, I listened to a webinar sponsored by Wellington Management Co where they discussed their outlook over the 6 - 12 month horizon published in their write-up titled Politics, Policy and the Pandemic (click link for more info).

In summary, the authors state that there are three main factors leading the way. First, even though there have been some bumps along the road, we are moving in the right direction regarding COVID-19.  Treatments and vaccines are moving forward and there is reason to view this as a positive trend.  Secondly, there has been strong fiscal and monetary support to bridge the economy over this crisis and more is hopefully coming.  And thirdly, economies are opening slowly and there does not seem to be a prospect for another shutdown.

So, the writers are cautiously bullish with a positive tilt to their outlook.  Where are they placing their bets?

U.S. equities are a place to overweight your portfolio, they say.  The view is that the U.S is in a better position than other economies around the globe and tends to be less cyclical.  Also, interest rates are very low and are likely to stay low for a while.  So, a good investment thesis for stocks, but not for bonds; best to buy bonds with some credit spread to earn something and be compensated for the risk.  Finally, though the consensus view has been to favor value stocks that are historically “cheap”, the authors go in the other direction to favor growth since they feel a slow growth environment continues to favor the growth style of investing.

This all sounds very logical and reasonable to me and consistent with a long-term strategic approach that captures the broad trends in the economy and the capital markets.   

Once Again, Why Bonds?

Last August I wrote two blog posts explaining the interesting dynamics of the bond markets (Why Own Bond Funds? and Why Bonds? Part 2 ).  This post is an update to those posts.

Amazingly, the 10-year U.S. Treasury has been mired under a 1% yield to maturity for most of 2020 concurrent with the beginning of the global pandemic (see chart below).  Some of this is due to extraordinary actions by the Fed to keep interest rates low to fight off deflation fears and promote economic growth; regardless, this is the environment we find ourselves in.  From an investment perspective, why would anyone buy U.S. Treasury bonds when they provide almost no yield?

The answer to this question is best answered by looking at the pros and cons.  First, the pros!  Most importantly, in general, bonds have historically been negatively correlated to stocks and thus serve as a good diversifier to risky stocks in a portfolio.  In other words, when stocks go down, bonds would go up.  However, in today’s market bonds are much less negatively correlated to stocks than historically.  For example, in 2019 broad core bonds had a negative correlation coefficient of -0.31, whereas so far in 2020 the correlation coefficient core bonds to stocks actually turned slightly positive to +0.15.  Consequently, bonds still serve as a risk diversifier in a portfolio, but somewhat less so today than historically.

Secondly, not all bonds are the same and their features can be tailored to the needs of a portfolio.  There are many different types of bonds with different issuer and risk profiles, term structures, and collateral types.  For example, U.S. Treasury bonds are generally considered a risk-free investment; they will always pay the stated coupon and par value at maturity.  Corporate bonds, however, issued by corporations have “credit” risk and could default on their coupons or par value if they declared bankruptcy.  High yield, or “junk”, bonds are issued by corporations with less secure balance sheets and, because of their increased credit risk, provide a higher yield than investment grade bonds to offset the increased risk.

What are the cons?  As already noted, yields are so low that it is hard to justify holding a U.S. Treasury bond as an income investment, but higher yielding bonds like investment grade corporate and junk bonds could make sense if one is willing to take on some credit risk of the bond issuer. For example, the “spread” of high yield bonds on top of U.S. Treasuries today is about 5.00%; a decent premium to offset the risk of default.  With 10-year Treasury yields at 0.75%, junk bonds on average yield about 5.75%.

Also, since yields are already so low and the Fed has already strongly indicated that it would not support a “negative” interest rate environment, there is a “zero-bound” interest rate floor for interest rates.  This means there is almost no potential for upside price appreciation due to a decline in rates (bond prices move inversely to interest rates).  In fact, the current yield to maturity of a bond is an estimate of its potential total return over its horizon.  Consequently, the 10-year U.S. Treasury bond with a 0.75% yield to maturity is expected to return only 0.75% over the next 10 years; not something to be too excited about, for sure!

Other factors come into play when evaluating the usefulness of bonds, though.  From a supply and demand perspective, there are many bond investors, like insurance companies and pension plans, that will continue to buy bonds regardless of the cons listed primarily because they are managing their investments against liabilities that require regular interest payments and stable par value at maturity.  The underlying liabilities dictate the need for the characteristics that different types of bonds provide.  Likewise, individual clients who have a liability stream that they want to support will be willing buyers of bonds to cover that need.

There are alternatives to bonds, of course.  Cash comes to mind, but the yields on cash are even lower at essentially zero.  High dividend stocks are another alternative to bonds and they provide a large pickup in yield.  For example, a popular high dividend stock exchange-traded fund, iShares Select Dividend ETF (DVY), has a recent yield of 4.72%, but is much riskier than bonds and subject to price volatility and reduction in dividends.  Real estate, energy limited partnerships, and bank loans are other places to find yield but all involve more risk.

As always, a broadly diversified portfolio managed to an appropriate risk target is the best way to manage this bond conundrum.  Buy bonds, but buy them carefully and within a total portfolio context.

Q3 Tale of Two Markets

Just from looking at the performance of the S&P 500, one would think that 2020 has been an almost normal year for capital markets.  Unfortunately, the S&P 500 distorts the underlying weaknesses shown by the vast majority of stocks around the world; almost every other asset class sub-sector around the world is lagging with negative year-to-date returns.

The global pandemic has disrupted economic activity such that a new paradigm of winners and losers has emerged.  Normally conservative sectors like financials, energy, and utilities have struggled with weak performance while a handful of large cap technology growth stocks lead the broad markets higher.  Then, factor in troubling geopolitical and social issues during an election year combined with an over-accommodative Fed and one has a recipe for volatility.  The table below shows the relative performance of the major asset classes through 2020 Q3.

Q3 showed a continued attempt at a rebound from the carnage of Q1.  The S&P 500 (IVV) was up a strong 9.02%, but other broad equity markets continued to trail including small cap (SCHA) 5.01%, international developed markets (SCHF) 5.55%, and real estate investment trusts (SCHH) 1.15%.  High dividend equities (DVY, SCHD, SPHD) continued to suffer during Q3, as well, with much worse performance due to concerns about dividend cuts.  Some diversifying exposures did outperform, including momentum (MTUM) +12.71%, 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 +0.31% quarter-to-date, led by U.S. treasury exposures, and credit exposures recovered as investment grade corporate bonds (LQD) generated a +0.82% return.  High yield bonds (HYG) continued to recover from a very weak Q1 return with a Q3 return of 4.05%.

As I wrote on my blog post “De-Worsification” on August 20:

Some people in the industry talk about “de-worsification”, instead of “diversification”, as a situation where a broad collection of holdings actually hurts total portfolio performance.  This is certainly what we have seen this year.  We do not expect this situation to continue, of course, since excesses in the broad markets (both positive and negative) always revert to the mean over time.  The only question is timing.

Beats Me! Part 2

Nothing earth-shattering here.  The world is a risky place and the capital markets are volatile; we all know that.  Three weeks ago on September 2, I wrote a blog post on the phenomenal YTD performance of the iShares MSCI USA Momentum Factor (MTUM) exchange-traded fund; up +25% YTD at that time.  Its top holdings included high-flyers like Amazon, Apple, Microsoft and, of course, Tesla.

Well, what a difference a day makes (21 days to be exact!)  MTUM has lost 12% of its YTD performance and is now up “only” +13% YTD!  Still a great showing in a mostly dismal year for the much broader markets, but it goes to show the volatility embedded in the market leaders.  The top holdings in MTUM all took a steep dip over this time horizon (e.g., Apple -19%, Amazon -15%, and Microsoft -13%).  Even Tesla, due to Wednesday’s drop, is down double digits at -15%.  See chart below for more details, noting the steep declines starting at the 0% mark on Sept 2.

Is this just a short downward blip, or a prelude to longer term steep decline?  I could go on and on about the fundamental and technical indicators supporting either view.  But, the real answer is two words:  Beats Me!

OMG, MTUM!

As readers well know, I am a fan of passively-managed exchange-traded funds (ETFs).  The structure provides diversified exposure to baskets of investments according to a rule-based approach.  Carefully selected combinations of these broad asset groupings help provide a broadly diversified portfolio of investments targeted to a specific risk and return profile.

In a year like 2020, where the dispersion of returns from winners and losers has been very wide, it would be nice to have one strategy that has only big winners!  Such an ETF that narrows in on this goal is the iShares MSCI USA Momentum Factor ETF (MTUM). 

MTUM is a factor-type investment focused on large- and mid-cap US equities that show relatively higher momentum characteristics.  Momentum is broadly defined as a calculation of “excess return” compared to other equities in its universe.  So, this ETF simply buys stocks that have recently outperformed other stocks, rebalanced semiannually.  And, who wouldn’t want to buy investments that have performed well?  This is part of the behavioral bias on why academics show that the momentum factor over time outperforms investments that don’t exhibit positive momentum.

Examining the top 10 holdings of MTUM is instructive.  Per the chart below, MTUM’s top 10 holdings skyrocketed compared to MTUM itself (up 25% YTD, the bold black line towards the bottom) and the S&P 500 (up 11% YTD, the dark blue line just below it).  Obviously, the new household names like Apple, Amazon, and Microsoft lead the pack and each have huge gains of more than 40% on a YTD basis

But, the real story is MTUM’s top holding: Tesla (that I left off the chart because its gains have been so phenomenal).  Tesla’s gains have gone through the roof year-to-date, up an amazing +470%. MTUM was a good way to own Tesla, without making any kind of valuation decision - purely a momentum play!

So, the momentum factor and MTUM did its job this year; find the investments that produced excess return and hold them for at least 6-months until the next rebalance cycle.  No guarantees on how this will shape up over the next six months, but long term holders have garnered plenty of excess return to cushion any drawdown.

Bounty of Blogs

Over the past couple of years, I have written 116 weekly blog posts (this is 117!)  During this period, we have seen plenty of market ups and downs and matters of note!  I have found that I am never at a loss to write something about something.  Though at times I thought about being a journalist, I followed my passion to manage investments; writing a blog is just a side benefit!

After reviewing my posts over the past two years, are there any general themes or topics that I seemed to focus on?  Did I blaze new ground, or set myself up to publish a book with a compendium of related articles?  I think the answer is a bit of everything!

A lot of the time, I simply start with a graphical update of how and why the markets or sectors did what they did.  I am a “visual” type, and if I can create a compelling chart I can usually write something about it.  Over the past year, there has been a lot of dispersion of returns between in- and out-of-favor sectors and asset classes, and that has been a fun topic for me to tear apart.

Occasionally, I will get philosophical.  Back on December 31, 2018 I made a prescient pronouncement well ahead of the current COVID-19 pandemic that no matter how bad things get, we always seem to find a way to better our lot.  From my post titled, Thoughts for a New Year, I expound:

Markets will be volatile, but we expect to be compensated for bearing the volatility. As long as we are comfortable with our risk profile and have a long enough time horizon, negative returns will recover (or, at least they always have!!).  Accounts with more risk, over time, will out-return less risky accounts.

The book “The Rational Optimist”, by Matt Ridley, goes into great detail explaining how society has historically always figured out how to get past adversity.

And finally, I always try to educate and inform.  Some of my favorite posts dealt with investment planning for retirement.  I talked about When is $1 Million NOT $1 Million - when the assets are in a tax-deferred account and there is a large tax liability on it as withdrawals are made.  I wrote about modelling a hypothetical investment plan for a retired couple seeking a high probability of success titled Is There a Number for You? which, by the way, I also posted on the investment blog, Seeking Alpha, and got 1,700 hits!  I also took many stabs at presenting the “passive versus active” investment debate and how passive continues to outperform active management.

I will continue to post blogs because I think it may be interesting for my clients, potential clients, and friends and because it keeps me fully engaged in the capital markets and new ideas from thought leaders.  If anyone has any questions they would like addressed in my blogs, please give me a holler and I will put something together pronto! 

"De-Worsification"

The S&P 500 set a new all-time record high this week and most media outlets are trumpeting the news as notable.  It is big news, of course, except that this time the S&P 500 distorts the overall picture of equity market health.  Year-to-date through yesterday, the S&P 500 (IVV) was up +5.84%; certainly, a large accomplishment given the impacts of the pandemic.  However, it’s the story behind the headline that bears highlight.

As seen from the chart below, other major sub asset classes and sectors continue to struggle. On a year-to-date total return basis, small cap equities (SCHA) are down -5.26%, mid cap equities are down -4.52%, real estate investment trusts (SCHH) are down -21.20%, and the energy sector (XLE) is down a whopping -35.99% (all of the colored lines below the bold black line representing the S&P 500).  Other sub-sectors including financials, utilities, and high dividend stocks are still materially negative on the year, as well.

So, what is causing the S&P 500 to look so fine while the rest of the market continues to struggle in negative territory?  As I have commented in many previous blog posts, the make-up of the S&P 500 is inordinately overweighted in growth tech stocks with huge returns, including Apple (+58%), Microsoft (+34%), Amazon (+76%), Facebook (+28%), and Alphabet (+15%).  The perception and reality of these large cap tech growth stocks is that they are well-positioned to flourish in a work-at-home pandemic-plagued economy.  These stocks now comprise 23% of the index; their outsized mid-double digit returns causing the distortion.

Some people in the industry talk about “de-worsification”, instead of “diversification”, as a situation where a broad collection of holdings actually hurts total portfolio performance.  This is certainly what we have seen this year.  We do not expect this situation to continue, of course, since excesses in the broad markets (both positive and negative) always revert to the mean over time.  The only question is timing.

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