This article was originally published on January 22, 2019.
At the start of 2018, the main story of the markets was the synchronized global growth story. Couple that with the recently passed tax reform bill and you had analysts expecting earnings growth in the 20-25% range. For the first 9 months of this year, things looked very much like Goldilocks. GDP growth in the U.S. finally surpassed the 3% mark and everything seemed a-okay for the most part.
By the start of the fourth quarter, the underlying political and economic risks started to foam to the top. We all knew of these risks which included trade wars, the Federal Reserve, the executive branch, emerging market weakness, and growth slowing globally.
One of the key lessons we learned this year was the replay of the same 'type' of correction that occurred in late January and early February repeating - and not being more nimble when it began to happen. In January 2018, interest rates jumped causing a scare in the equity markets as yields jumped to multi-year highs. This caused a widening of spreads and other risk-off portfolio moves.
In September, the 10-year yield began another sharp move higher culminating in a peak of 3.25% in early October. This again spooked the equity markets and caused some dislocations that caused even greater risk off sentiment.
Lesson 1: Don't fight the Fed! Quantitative tightening finally mattered to the market
The increases in interest rates had already been decimating emerging markets but then began to spill into the developed markets of Europe and Asia. The U.S. was in isolation with a rising market throughout the summer. That compares to both the EAFE and EM indices which never saw a rebound from the declines in the first two months. Those indices just kept making new lows and never saw a bottom. The S&P finally played catch up and made a large move lower to close that gap.
Additionally, the market just dislikes the new Fed Chairman who is definitely more hawkish than his predecessor. That became more readily apparent in the back half of 2018 as he telegraphed many more rate hikes, gaining the ire of the President.
Lesson 2: Don't let near-term results cloud your judgement and derail your strategy
There are two behavioral factors that can really hurt your portfolios: fear and greed. Fear can be a massive deterrent and cause you to prevent losses by 'selling everything'. Conversely, greed can also throw investors off track by providing false confidence that can entrap us during good times.
Maintaining that balance between fear and greed can help reduce the chances of a massive move that results in catastrophic damage to your portfolio. Dalbar has done several studies on this over the last several years detailing actual investor returns compared to the indices. The large shortfall is mostly the reaction by individual investors to volatility in the markets.
During boom times, people want to participate in the wealth growth. That is why we have used the JP Morgan quote so often. "Nothing so undermines your financial judgement as the sight of your neighbor getting rich."
That is greed, pure and simple.
When the good times are rolling, it never ceases to amaze me how risk gets thrown out the window in favor of a want to participate. This needs to be avoided in favor of a long-term plan.
Lesson 3: Time to say goodbye. We hold on to positions too closely and need to let them loose quicker
Over the summer, valuations in closed-end funds were rich. No other CEFs show this better than the PIMCOs where PIMCO Dynamic Income (PDI) reached a record premium of 17%. The premium built over the course of much of the year rising from 3%-4% to that expensive level. PIMCO Dynamic Credit Income (PCI) also showed the same valuations when it rose to a premium for the first time since it IPO'd. The same valuations could be seen across much of the taxable bond CEFs as high yield and floating rate were going gangbusters.
We should not be afraid to hold cash at the opportunity cost of cutting off the income stream. It doesn't need to be a wholesale change. For instance, on PCI above, we didn't need to sell the whole PCI position, but cutting it back was probably the more prudent move. Another possibility is to hedge the position with highly correlated assets.
The sell discipline is much more difficult than the buy strategy. For many of my "clients", I simply buy at opportunistic discounts and then hold for long periods of time. As long as the valuation doesn't get completely out of whack or if the security isn't in a sector we no longer wish to hold, then we do not sell. But many would rather lock in the gains and redeploy elsewhere (this is where the Flexible Portfolio idea was born).
Lesson 4: Listen to intuition. It tends to be right
Adding portfolio insurance through hedging and other means seemed right during the summer, especially when you combine it with lesson 1. Still, when good times are rolling, it is often difficult to see the dark clouds on the horizon. For us, that resided in high yield bonds (and to a lesser extend floating rate) which continued to rip during the summer months. We wanted to reduce our stake substantially but had no place to go.
This gets back to the sell discipline, mentioned above. Cash should be a good alternative that is acceptable, especially now that it actually earns something.
Conversely, being more tactical on that intuition is important. We missed a great opportunity to go long NHF. I had the buy alert all ready to go a few weeks ago when it traded around an 18-19% discount. I failed to pull the trigger on it. That is on me.
When there is blood in the streets, it is very difficult to be the one buyer. The same goes the other way when markets are ripping and you are selling- only to watch your position go even higher and a feeling of regret sinks in. These behavioral traits are innate to us all but can be overcome. For some, it takes handing over the reigns to a trusted advisor to be that tool to overcome them. For others, it just takes practice and discipline- knowing when you are at one of those periods of time.
Recognizing that you are in this situation- whether buying amid a sea of red or selling in a roaring market- and working through the different scenarios in your head- can mitigate that to some degree.
Let's look back at the predictions for 2018:
These are the things that we think could see move the markets this year.
1. Valuations Start to Matter - They haven't for so long as the entirety of the market has melted up. This is what has been driving investors into ETFs as a low-cost mechanism into a broad basket of stocks at very low cost. HALF RIGHT
2. Value Will Outperform - Growth has outperformed value decidedly in the last couple of years. These indices tend to mean revert over time. We think value, led by financials, will be a good place to be in 2018. WRONG
3. Quality Will Be the Best Factor in 2018 - Higher quality tends to outperform over longer periods of time when measured from similar points on the business cycle. Given this stage in the cycle, we think we want to be in quality- both stocks and bonds- with actual earnings growth and defensive/sustainable business models. CORRECT
4. China Becomes An Issue - The debt accumulation from their shadow banking system is likely to have reverberations. The leadership is cracking down on the 'grey rhino' strategy and other debt-fueled issues. CORRECT
Predictions For 2019
I'll attempt to make some basic predictions - as I did last year. Many of which weren't hard to make- along with some esoteric ones.
1 - GDP grows in excess of 2% - Despite growing faster in 2018, and the market clearly expecting a recession, we think GDP will still grow at the post-recession average this year. This would create the longest expansion in U.S. history.
2- Yield curve inverts - We think the 10s minus 2s and 10s minus 3M will invert sometime this year. It will be a brief inversion but still meaningful and alert us to the fact that the cycle is likely ending.
3- Earnings Recession- similar to the definition of a recession, an earnings recession is two consecutive quarters of negative growth on the S&P 500 EPS number. This would be especially true if oil falls back to the low- $40s or even high $30s. We do not foresee an economic recession in 2019 but will definitely see a slowdown.
4- U.S. Dollar falls - We have been harping on the dollar a lot for some time saying we needed to see it peak before adding to international and emerging market stocks. We think that is starting to happen and will only accelerate throughout the year. EM equity will be the place to be.
5- Spreads tighten, then widen - After the widening from the post-recession lows, high yield spreads are on the decline again. They have already retraced half of their 'loss' (from 5.5% to 4.5%) and we think it will fall another ~0.75 - 1 point. After that, we think it will widen back out.
1- Social Media Shakeup - The Facebook (NASDAQ:FB) drama escalates further and Sheryl Sandberg exits the firm, possibly to run for public office. Peak social media is likely to occur and Twitter, Snap, and other platforms see reduced usage.
2- Stolen Identities - Similar to what we saw a few years ago with Equifax (NYSE:EFX), we will see a re-emergence of identity theft and large public company hacks. Personal data loss will be a big media item in the news.
3- Crypto rebound- I think we see renewed interest in the cryptocurrencies as the dollar sees weakness.
4- Political and policy shocks increase - Both political and public policy risks increase significantly as we progress through 2019. These can include trade wars, deteriorating fiscal picture, and policy missteps by the 4 largest central banks.
5- Amazon (NASDAQ:AMZN) splits into two- The much more valuable AWS is likely to be spun out and split from the retail operation. Down the road, I do think there could be multiple stocks with a media business also being created and traded separately to realize the full value of the underlying businesses.
While returns were nowhere near where we wanted them, there wasn't any big standout mistake (other than going to cash at the end of the third quarter) as virtually all risk assets were down. The strategy, while not perfect, did indeed work as the NAV declines were about one-third of the market with price about two-thirds.
Income is the main proponent. The Core portfolio suffered paper losses of approximately 8% during 2018, most of which occurred in the fourth quarter. But the portfolio generates over 8% in yield which meant a much further loss was avoided due to the high income. We do not see this as a permanent impairment of capital nor have we realized any income stream reduction.
We strive to educate members to focus on that income stream as it eventually overwhelms the market moves. But trying to avoid the price volatility and focusing on the income stream is easier said than done. It is never easy to watch the market value of your investments fall by 10% in a relatively short amount of time. The chart below (created by a member) reiterates that thesis as the market value of the investment (in this case $1M) moves substantially over the 16 years. However, the income production never ceases. That is very important. Over the time period, the value of the $1M placed into PTY oscillates from a high of nearly $1.5M and a low (during the financial crisis) of $380K. Think of the investment in a high-yielding closed-end fund as an annuity that doesn't consume all of your principal. Instead, you place it on the rollercoaster and the value can fluctuate but as long as it doesn't go to zero, you have principal leftover.
The market reaction in the last month confirms our view that the market was simply a correction/bear market, not a recessionary crash. The outlook may be hazy but a recession appears to be several quarters away. As such, the additional allocation to risk assets has helped recoup a lot of what was lost in the final quarter of last year.
The current yield on the Core Income Portfolio is now 8.24%. That is about 15% more income than it was at the end of the third quarter. The people who implement the portfolio today get that added income payout compared to late September. Is the portfolio 15% more risky than it was? Those that had the Core prior to October 1st could have added to their positions to increase their yield- essentially giving themselves a raise. Reinvesting coupons opportunistically is a great way for those fully invested to take advantage of lower prices and higher yields. If retired, you could pull from other sources and pool/reinvest distributions.
In reality, the market is simply assigning a discount to risk assets given the large amount of uncertainty that remains. Most of these are macro risks including slowing global growth, rising recession risks (especially overseas), trade war issues, political risks, and the new earnings season that is producing a string of under-performance reports. Investors are just requiring added yield/return in order to accept a certain level of risk.
To me, the strategy of the Core Portfolio, taking advantage of the best areas of the fixed income market through leveraged closed-end funds, is agnostic to macro events. The decline in risk assets- virtually all risk assets in the Core- in the quarter means that there wasn't a fundamental defect in our process or investment philosophy. While it is not assured that the market will reverse course and fundamentally re-rate the portfolio's value higher as these macro issues subside, we do foresee continued appreciation as we have so far in 2019. All the while, we are collecting our income payments and overwhelming the price volatility.
Opportunities and Outlook 2019
If you watch CNBC, Fox Business, or Bloomberg, you hear the same stories reiterated including the trade war with China, credit concerns, political stories regarding the President, Mueller investigation, government shutdown and debt ceiling 'talks', Fed tightening, worries about the length of the bull market and where we are in the cycle, and earnings under-performance. What would they discuss if those five primary items were mitigated in the next two quarters? Those impediments to the market, especially the trade war and government shutdown, if resolved, would likely help bring some of the $3T in net cash sitting on the sidelines.
We do believe that some of these overhangs are likely to go away in the next several months. Now that we experienced a sharp correction/mild bear market, President Trump is likely to do anything he can to prevent another and help buoy the market. It appears that is already the case with him accelerating the trade talks and likely to declare an emergency for the border wall to receive its funding and reopen the government. Those two actions alone could help bring about a much calmer environment in the markets in short order.
My largest concern is global growth- especially in Europe and China which I believe are both potential large hot spots, both politically and economically. The UK, France, and Germany have seen a marked rise in populism in the last 3 years that could shake the bedrock of the Eurozone. That leaves out Italy which is again in recession, with Germany likely not far behind. China remains problematic with a large debt burden and slowing growth and potential contagion for the U.S. and Europe.
While we do not foresee a recession in the near future, we do think the next downturn is likely to be one of these rolling contraction starting overseas. This will be something to watch closely, especially in Europe as that could spill over into the U.S. and China and crater this bull market. Credit concerns remain at the top of mind as corporate balance sheets, while healthy, remains bloated and a potential source of danger.
The Google Sheet with our positions and buy/hold/sell recommendations looks decidedly different than it did in late December. Back then, we had 18 out of 19 positions in buy territory with 3 that were rated "strong buy" [PCI, KIO, ARDC]. The strong buy rating is a rarity and typically only happens once in a blue moon. However, we utilize these formulaic ratings at 'strategic levels' to take the emotion out of the buying and selling decisions. Since then, all three positions are up sharply double-digits. Today, the sheet is more sparse with 5 buy ratings and has three sell ratings.
There are still plenty of opportunities available in certain areas of the market. We recently highlighted one in the floating rate space. It appears the market is herding for the exits as they believe the Fed will no longer raise rates this cycle. We do think they will likely do so again, likely in June, especially if the data is consistent to today and the markets continue to recover. In addition, the loan index sits at $96 which continues to be over $3 below where it sat in September. The implied default rate, while not nearly as high as it was back in mid-December, is still in the teens or 2008 levels. The actual leveraged loan default rate is just 1.6%. At the same time, discounts on senior loan closed-end funds were extremely wide with an average spread of 10.4%. These funds looked especially attractive from a double-discount (underlying bonds are trading at a discount and the funds themselves trade below NAV). This is a very attractive opportunity.
Our Current Focus
We continue to like the non-agency MBS (mortgages) space and have a large overweight to it. Those securities include PIMCO Dynamic Income and PIMCO Dynamic Credit and Mortgage. Both of those funds had allocations to the non-agency space in the high-60% range but have recently pared that back to take advantage of the sell-off in other assets classes.
Included in that space is DoubleLine Opportunistic Credit (DBL) which is a blend of different mortgage exposures including the non-agency sector. It was an opportunity we took advantage of when they cut the distribution by a massive 34%. The fund sold off by nearly 8% which was silly since all they did was eliminate the return of capital from the payout. If a shareholder wanted to maintain their former distribution yield, they could have augmented the income yield by selling some shares.
Western Asset Mortgage DefOpp (DMO) is a fund we've wanted to own for a long time but it traded at a ridiculous premium due to the payment of gains as it prepares for its liquidation (as a term trust). The yield seduced many investors- it pays nearly 10%. The fund has been seeing its premium decline slowly over time and it eventually reached near par in mid-November when we first bought shares. It paid a large special distribution in December and has since been rebuilding its premium. Now at a 12% premium, we have been redeeming shares and re-allocating to more beaten down areas.
In the space of high yield and floating rate, KKR Income Opportunities (KIO), is one of the funds that hit the 'strong buy' rating in the last. Although it has run strongly, we think it still has some juice left in it. The fund also has the added advantage that its managers can toggle back and forth between bonds and loans to whichever it deems cheaper. I would rather leave that decision to the managers who look at underlying trends all day.
Preferreds have been a terrible trade for most of this year. In the early part of 2018, they were clobbered by the rise in interest rates. They then were damaged by declining bank and insurance company sentiment, especially in Europe (a large part of preferred fund holdings are European banks). Near the end of the year, they were hit by tax loss selling and prices reached ridiculously low levels. While we preferred to play this from the individual preferred space (focusing on high quality, 6%-7% yielding, domestic issues), some funds look attractive as well. We have owned First Trust Preferred and Income (FPF) which has rallied strongly and is above the levels it traded before the bear market began. Cohen and Steers Limited Duration Preferred & Income (LDP) may be a better current opportunity with its 8.27% yield and rising NAV.
Individual preferreds from KIMCO Realty (KIM-K), Oaktree Capital (OAK-A), Ares Capital (ARES-A), Apollo Global (APO-A), and Hersha Hospitality (HT-D) are some of the issues we've recommended that still look attractive. Others like Pebblebrook Hotel (PEB-C) have already recovered.
In our Core Income Portfolio, we want to maintain a balance between the highly risky and the defensive. But we look for defensive positions that still produce a higher income return. One such position is the Guggenheim Taxable Muni Fund (GBAB) which yields over 7%. The underlying portfolio is primarily single and double-A rated munis with an extremely low default rate. This is a fund that saw significant appreciation in the month of November and is up nearly 9% during the market swoon. Yes, the fund ROSE nearly 9% when the market fell nearly 20%. Having these low or negatively correlated positions that still pay a strong yield can reduce that portfolio value volatility. Watch this fund and when it trades at below a 5% discount, we recommend grabbing some shares. That tends to happen when times are good which is typically when you want to add this type of fund in the first place.
It is our contention that the days of just buying and holding are over- unless you just want to own the entire market. Instead, you must be nimble and flexible in order for the current risks to be avoided. We still contend that we are facing a potential retirement crisis as the sequence of returns risk appears more extreme than at any other period in history. At the same time, millions of baby boomers are retiring or have just retired. This seems like a 'perfect storm' of conditions that could create a potential disaster. We hope we are wrong.
The early part of 2019 has been favorable, especially compared to the end of 2018. Still, there are a multitude of risks that we face and we should be cognizant of them while developing a plan to deal with that potential scenario. Having a plan, keeping emotions in check, and being flexible at the same time is essential.
An ounce of prevention is worth a pound of cure.
- Ben Franklin