Investing in Bonds and Equities in Q4
There is a lot of coverage in this week’s commentary on the behavior of the markets in August. The third quarter will come to an end at the end of this month, and a couple weeks into the fourth quarter we will begin getting Q3 earnings results. The mid-term elections will take place about half-way through Q4. Some foreign policy matters will likely escalate between now and the end of the year. Some will likely quiet down. From a big-picture macroeconomic standpoint, I suspect there will be more substantive issues to deal with in 2015 than there will be through the remainder of 2014 (i.e. Fed policy adjustments, China clarity, etc. are all more likely to be 2015 events), but that doesn’t mean that Q3 earnings season or even a geopolitical event couldn’t move markets in the remaining few months of this year. I think this week’s commentary gives insight to what I am trying to do as an allocator in the present moment and even more so for the long haul. Off we go…
My top points of the week, noted with an asterisk (*).
1) August was another solid month for equities with Utilities (4.97%) and Healthcare (4.85%) leading the way. Airlines and semiconductors have been on a tear this year, up 54.1% YTD and 30% YTD respectively.
2) Since deciding to reduce my High Yield bond exposure earlier this year, we saw spreads move from roughly 330 basis points to 430 basis points. The space is now more attractive and has sparked my focus on opportunities to tactically adjust my bond positioning.
3) I’m waiting to see greater Capital Expenditures as a possible catalyst to extend this rally we are seeing. For earnings to continue to grow, smart investments in technology and equipment must eventually be made. It hasn’t happened yet, but I remain confident this phase will come.
4) Owning non-correlated assets in a portfolio is mathematically proven to smooth the volatility of our performance and, ultimately, improve performance over the long run. In general, most asset classes work together to mitigate the negative effects of volatility but only a few of these, such as Managed Futures and Core Bonds (assets we own) work optimally to protect our capital against tail risk.
5) Long-time readers know every October I travel to New York to meet one-on-one with my key money managers and portfolio strategists. One of the main questions I will ask is if Emerging Market P/E expansion is justifiable given the earnings growth and pricing power of the underlying franchises. I’ll be sure to share my findings with you …
* What sticks out to you about August results in the equity markets?
August was essentially a microcosm of the Year-to-Date results across various sectors and indices. The top two performing stock market sectors of the month were Utilities (+4.97%) and Health Care (+4.85%). The top two performing sectors on the year are Utilities (+15.4%) and Health Care (+15.88%). Telecom was the worst performer with a 1% drop on the month. (So it was not all the high-dividend sectors that rallied, though they mostly did.) Energy did rally over 2% in August but with the big hits in July is still down 1% for the quarter (though up over 11% on the year). From a more detailed perspective (sub-sectors or industries), the big fliers in August were Specialty Retail (+10.71%), Biotech (+10.44%), and Airlines (+8.78%). (1)
What “sub-sectors” or “industries” are leading the way throughout 2014?
The airlines are up a stunning 54.1% YTD. Semiconductors are up over 30%. Computer Hardware is up 28%. (Remember when people said desktops and laptops were dead?) And Biotech is also up 28%. (2)
How did international equity markets fare in August?
The MSCI EAFE index (primarily Europe and Asia) – developed countries – was down 0.42% leaving the YTD return right around 0%. The MSCI EM index (Emerging Markets) was up 2.3% in August with a 10% YTD return (1).
Thoughts on the bond market in August?
Look, it was a big month for bonds. The yield on 10-year treasuries dropped from 2.56% to 2.34% which meant nice price increases for most bonds. This was the biggest amount of price movement (up or down) on the year for any month besides January (1).The rally in municipal bonds has continued to outpace the rally in other interest rate sensitive sectors of the bond market.
What do you believe warrants increased attention for those who hold bond positions or even mutual fund bond positions in sectors of the bond market where there is heavy ETF issuance?
Well, what this question really means is ALL sections of the bond market, because there are now sizable bond ETFs in most sectors of the bond market. The challenge is areas of the bond market with large ETF composition that also have liquidity challenges. High Yield, Floating Rate, Emerging Debt, some Municipals, etc. are all examples (whereas Treasuries and Agencies probably are not). And the challenge is this: Are holders of bonds seeing somewhat artificially low price levels because during sell-offs ETFs are exacerbating the problem by having to sell their positions? My prima facie answer is that this is likely a real issue, and maybe even a real opportunity, but I want to get more color on it in my New York manager meeting trip next month.
* How do you currently feel about your High Yield bond positioning?
In hindsight, my timing of a large reduction in High Yield exposure proved to be quite good as we saw spreads move from roughly 330 basis points to roughly 430 basis points after I reduced exposure. I also am glad to not be at 0% now, because at these yields and spreads, the asset class is obviously much more attractive than it was prior to the move. I am not concerned about a massive sell-off in the space, nor was I two months ago when I began re-positioning. A massive sell-off would take a big boost in defaults (which I do not anticipate) and a dramatic rate spike (which I do not anticipate). My issues in reducing exposure were purely risk/reward based: I simply felt that it was a non-compelling proposition when yields were just over 5% (relative to the risk embedded in the asset class). I have a modest exposure now with slightly higher exposure for those taking income from their portfolios. I remain aggressively focused on what to do next in all aspects of my bond positioning, High Yield included.
Is it safe to say that your concern with the High Yield bond asset class is that you fear price drops when the Fed begins raising rates?
No no no no no no no. I suppose that could happen – in theory all of these bond instruments are interest rate sensitive and therefore could face price declines when rates rise, but that is NOT the issue I am focused on with High Yield. The job of the portfolio manager is to take risks that will lead to returns for clients. There is a risk premium associated with each asset class – an amount of return one expects to generate in exchange for the risk level they are taking. My position on the High Yield asset class is simply that at these levels one has to question if I am being adequately compensated for the risks I am taking. High Yield is actually far less responsive to general interest rate moves than many other aspects of the bond market. I will say it over and over again (and I am just using High Yield as the example to make this point): Asset allocation decisions come down to perceived trade-offs between risk and reward.
* You wrote quite some time ago about the idea that increased Capital Expenditures (CAPEX) from companies would possibly be the next catalyst for an extension of the stock market rally. Has this unfolded yet?
No, it really hasn’t, as I believe the data continues to suggest that corporate America is investing its cash (and by cash, I mean, HEAVY amounts of cash) in Mergers and Acquisitions and of course stock buybacks and dividend increases. I have no doubt that for earnings growth to continue we will have to see a greater investment in technology, equipment, and our capacity to generate productivity (think plants, machinery, etc.). We are experiencing an extraordinary energy renaissance in America, and U.S. manufacturing is recovering (but will require greater technological innovation to keep up since our labor costs continue to exceed foreign competitors). I am confident this capital expenditure phase will come, but not sure how robust it will be when it gets here. The degree of robustness will be determined by corporate confidence in the economy, and therein will lie the biggest self-fulfilling prophecy we will see in the economy for the next several years.
What of significance took place at Thursday’s ECB (European central bank) meeting?
The ECB on Thursday cut their version of the Federal Funds rate from 0.15% to 0.05%, essentially getting VERY close to our own Federal Reserve’s policy of zero interest rates. They further announced a form of quantitative easing, as well, which basically means they will begin buying assets with money that currently doesn’t exist. I would think everyone HAD to know this was coming. I think this is rank can-kicking for European policymakers. And I think it is inconsequential to U.S. fundamental values. Could it temporarily put a bid under European equities? Sure. But I am not buying …
* You talk a lot about the need for non-correlation with stocks in various asset classes you own inside a full portfolio. What are some asset classes that have shown low correlation to the stock market, and why is this important?
It should go without saying that if all stocks ever do is go higher and higher and higher, having a low correlation to equities with other asset classes in the portfolio is not only unnecessary, but probably undesirable. It is precisely because of the volatility of stock markets that we seek to “smooth” the returns we generate in our portfolio (which has the mathematical function of improving them) through other asset classes that have different risk and reward characteristics than equities. We know, for example, that Emerging Markets have an 85% correlation to equities, so while they diversify our stock exposures to a large degree (particularly in the growth engine of our portfolio), they are not of the “low correlation” variety that we may like to see with certain asset classes. REITs, for example (real estate investment trusts), have a 79% correlation to equities, so this becomes a bit better of a diversifier, but still reasonably correlated. Master Limited Partnerships (my beloved MLPs) have only a 55% correlation. Managed Futures actually have a NEGATIVE correlation (-.07%). Commodities are at 44% and Precious Metals are at 21%. Now, bonds are typically where people go to diversify their equity holdings. Some of the more credit-sensitive parts of the fixed income world (High Yield, 73%; emerging debt, 45%) have higher correlations to stocks, meaning they may have a great place in a portfolio, but they do not necessarily diversify tail risk or even normal cyclical risk the way we may think they do. More vanilla U.S. bonds (treasuries, high quality corporates) have a 0% correlation. Incidentally, all of these correlations are calculated over a 20-year time period! (3). There are some “newer” asset classes (unconstrained bonds) that I need to better understand their correlation to equities, and I plan to do so throughout the remainder of this year.
Do you see the non-correlations you have in your portfolios as being adequate should there be a significant market disruption?
The great lesson of 2008 for asset allocators like me is that when you most need non-correlation, it evaporates. When extreme tail risk and bad things happen, correlations tend to all go to 1.0 … That isn’t totally true: Treasuries, Gold, and Managed Futures all served as decent diversifiers in 2008 (gold not as much). But, essentially, I cannot run a portfolio for 40 years (I do think I can do this for another 30 years) with the presumption that every single day will be a 2008 like event. I prepare for it, mitigate those tail risks, but recognize that NON-CORRELATION is a weapon most used throughout cyclical up and down movements in the market, and over extended periods of time. It works.
*As you get closer to your annual New York due diligence week, what is another example of a particular question or topic you are wanting to explore?
(Long-time readers and clients know that I have been going to New York in early October for nearly 10 years to meet with my key money managers, portfolio strategists, respected thought leaders, etc. It has ranged from 20 meetings in a 7-10 day period to as many as 40 meetings. These intense, one-on-one discussions have given me the ability to hear contrary perspectives, to challenge my own investment theses, and to formulate strategy ideas and asset allocation decisions surrounded by highly credible thought leadership. We are in the business of intellectual capital at The Bahnsen Group, and I cherish this time each year.)
I plan to ask my Emerging Markets equity manager if he feels the valuations are simply not compelling now (price gains this year have resulted in much higher P/E ratios than we obviously had near the end of January), OR if he believes that the earnings growth we are generating in our portfolio and pricing power these franchises possess justify present valuations.
This next piece is not the quote of the week (which is below), but rather is a substantive excerpt that I think carefully delineates one school of thought (monetizing on what can go right in our market economy) vs. another school of thought (maintaining a permanent negativity and skepticism). The quote comes from Yahoo Finance columnist, Jeff Macke, and I think it is outstanding.
“Warren Buffett’s real secret, beyond the IQ and the emotional hard drive, is optimism. Berkshire is just a big levered up play on the economy. Trains, ice cream, Coke and banking. Buffett’s famous for saying ‘be greedy when others are fearful,’ but his real gift is believing in America and levering up on it. He generates cash betting against super catastrophic events in insurance and uses the money to bet against the collapse of the economy. That’s been his formula for more than 60 years. If you take nothing else away from Buffett’s notes, it’s that the richest man in the world got that way by betting against Doomsday. There’s a lesson in that for all of us.”
AUGUST MONTH-END RESULTS
|Gains in percentage terms|
Multiple or P/E Ratio
This refers to the valuation of a given stock or a stock index (like the S&P 500). If a company makes $10 of earnings per share, and is trading at $100 per share, it is said to have a P/E ratio (a price-to-earnings ratio) of 10. It is also called the “multiple” – the number that when multiplied by the earnings will equal the price.
QUOTE OF THE WEEK
“Skill is successfully walking a tightrope over Niagara Falls. Intelligence is not trying.”