SENT on Sun, Mar 22, 2020 at 5:54 pm MDT
Taming the Bear: When the Going Gets Tough, the Tough Go Shopping
The worst week in the U.S. stock market since the dark days of October 2008 warrants a follow-up to last week's Client Letter.
You make most of your money in a bear market, you just don’t realize it at the time.
--- Shelby Cullom Davis
This statement must seem like a paradox when your portfolio balance is declining at an alarming rate on a weekly basis. But "money is indeed made" in a variety of ways during financial market upheavals like this one. And doing so doesn't require any particular market-timing skills or short-selling prowess, but it does require a disciplined and consistent approach to portfolio management, a focus on the longer term, and a certain amount of courage and conviction.
The long-term returns that accrue to us as stock market investors - roughly 10% compounded annually since the 1920's - are our reward for tolerating volatility, for enduring the bear markets that historically have occurred about every five years and that will continue to occur in the future. So at a very basic level, we earn these returns by staying invested in the stock market through thick and thin, by passing the stern emotional tests that the financial markets subject us to every few years.
Even better, though, we don't have to take these tests sitting down, so to speak. We don't have to sit idly by, helplessly watching the bear ravage our nest eggs. We can take advantage of these opportunities, simply by adhering to our Investment Policy Statements in two ways:
1. Portfolio Rebalancing:
There is no doubt that periodic portfolio rebalancing back to a target asset allocation - a mix of cash, bonds, stocks and so-called alternative asset classes that is appropriate for your risk tolerance and investment time horizon - increases portfolio returns and reduces portfolio volatility over the long term. These win-win benefits are rare in the world of portfolio management, in which reducing risk almost always comes at the cost of lowering expected returns.
While quantitative estimates of the benefits of portfolio rebalancing vary among academic studies and among rebalancing frequencies and triggers, it is clear that these benefits increase according to: (a) how well-diversified your portfolio is, and (b) how disparate asset class returns are. And returns among asset classes have obviously been very disparate during the last few weeks, with cash maintaining its value, with very high-quality bonds maintaining their value and in some cases appreciating, and with lower-quality bonds, commodities, U.S. stocks, and foreign stocks all declining in roughly that order in terms of magnitude of decline from smallest to largest.
Given this and given that the S&P 500 on Wednesday reached the level that I had mentioned in last week's Client Letter as the first point at which I was looking to rebalance client accounts out of cash and high-quality bond overweights and into stock underweights, I stuck to the plan, sold the firm's entire position in the Mortgage-Backed Securities iShare ETF, which had generated a small positive return so far in 2020, and bought with some of the proceeds foreign, value-oriented stock ETF's.
Why did I decide to buy foreign, value-oriented ETF's rather than U.S. stock exposure? A few reasons:
- As I mentioned last week, "Our stock market was arguably one of the most expensive in the world going into this bear market, and has to my frustration held up better than many others so far."
- As I also mentioned last week, "Bear markets have a way of correcting previous excesses, misconceptions and overconfidence. I suspect that this bear market, before it's over, will disabuse investors of the notion that FAANG or MAGA stocks (whichever acronym you prefer) will always outperform and that all market dips should immediately be bought". The perception that the U.S. stock market - led in particular by its large-cap growth stocks like Microsoft, Apple, Google, and Amazon - will always outperform its foreign counterparts has yet to be punctured.
- It has been consistently argued during the now-defunct bull market that the stock buybacks that have fueled our stock market's outperformance and its overvaluation relative to most foreign markets are just as valuable to investors, and are just as sustainable as a source of "income" to investors, as dividends. This argument is, however, predicated on the continued ability and willingness for corporate America to issue low-cost debt to fund these repurchases. Despite the Fed's best efforts so far, corporate interest rates are rising rapidly, and many corporate managers are cutting back on stock repurchases in any case to conserve cash. In my opinion, this let's-issue-low-cost-corporate-debt-to-fund-share-repurchases practice that prevailed in this past bull market will be another "excess and misconception" that will be corrected in this bear market. Before it's over, we could easily see the Fed have to step in to buy corporate debt, and the government have to take equity stakes in bailed-out companies, but in return to ban or severely limit stock buybacks. In fact, we're already seeing backlash to this practice among both Trump and Democrats alike, another reason to invest in stocks abroad where stock buybacks are far less prevalent, if permitted at all.
- The foreign value stock ETF that I currently favor, and that is rapidly moving up the ranks of firm-wide investments by market value at Five Seasons, now yields 7.4% on a trailing basis. (In fact, if you're a dividend-seeking investor picking through the rubble of the U.S. stock market for high payers, check out this article I posted to LinkedIn on the types of payouts currently available in British stocks). Granted, we will no doubt see some dividend cuts abroad, as we will here in the U.S., but I'm more than comfortable holding a tax-efficient, low-management-fee fund whose underlying investments combined trade at less than book value and whose top 5 holdings are Toyota, HSBC, and 3 global drug companies (Sanofi, GlaxoSmithKline and Novartis). And from a price perspective, this ETF is now (almost unbelievably) trading a mere 15% above its absolute low trade at the depths of the last bear market on March 9, 2009.
That's all I have to say about that.
--- Forrest Gump
2. Swaps Within Asset Classes
Another way to "make money" in bear markets while maintaining the discipline of your target asset allocation is to swap one investment holding for another within an asset class. An example of this would be to exchange U.S. stock funds for international stock funds, something I did across many client accounts on Tuesday. Or you might consider migrating from U.S. large-cap stocks to U.S. small-cap stocks, something I'm starting to contemplate, given that our largest holding is the S&P 100 iShare, which has served its purpose as a relative safe haven during this bear market. Or you might consider shifting your equity exposure towards factor-based, a.k.a. smart or strategic beta, investments, which on the whole have been a disappointment in recent years, and away from market-cap-weighted funds. All of these portfolio moves may also come with the side-benefits of harvesting tax losses while avoiding "wash sale" rules, as well as lowering fund management expenses and increasing tax efficiency.
But by far my favorite way to take advantage of swap opportunities within asset classes is via the wonderful, but quirky, world of closed-end funds. While Barron's described the price action in the closed-end fund world in December 2018 as "The Crash That Almost Nobody Heard", I did, and the price action this past Tuesday and Wednesday in that investment backwater made 2018 seem like a walk in the park. Several of the CEF's on my watchlist settled on Wednesday at discounts to their net asset values that exceeded 30%, discounts that we haven't seen since 2008, and even then, only fleetingly.
While we initiated, or added to, positions in 8 different bond CEF's for clients in the middle of last week alone that included municipal bond funds and junk bond funds, by far our largest commitment of capital was to funds that invest in emerging markets debt, i.e. bonds issued by foreign governments and their related entities, mostly in less-developed economies. Why? Let's take a look at the emerging markets debt CEF that I bought the most of this week for clients as an example:
- This fund has a 5-star rating from Morningstar, is managed by a well-known Wall St. firm, and has a reasonable fund management fee considering it is actively managed. I care not at all about the first characteristic, somewhat about the second, and considerably about the third. Regarding the second, having a fund manager with deep pockets can be useful in unexpected ways in the CEF world.
- The fund uses very little leverage, which is very unusual among bond CEF's. The use of leverage got many CEF's in trouble in 2008 when their source of borrowing dried up. This fund's lack of leverage makes its net asset value (NAV), or the underlying value of its assets, more stable than it otherwise would be.
- As of year-end, the majority of the fund's bonds were investment-grade, and the bonds' issuers are spread around the globe, in a sense providing geographical diversification against the coronavirus.
- I bought the vast majority of clients' current holdings in this fund on Wednesday at an average price that was a little shy of a 25% discount to its closing NAV that day, a price that also translates into a trailing yield of almost 8%. The fund has rarely traded at that wide of a discount since its inception in 1993, and has occasionally traded at a premium since then.
On a more general note, according to Investopedia, closed-end funds have been around since the 1890's. In my mind, that makes them particularly well-suited to holding illiquid, low-quality types of bonds like high-yield munis, junk bonds, emerging markets debt, and bank loans. They've stood the test of time, unlike ETF's that invest in these forms of debt, many of which that have attracted the bulk of their investment flows since 2008, and that are under extreme pressure currently as a result, perhaps another "excess and sign of overconfidence" that will unravel in this bear market.
This too shall pass. And so will these opportunities.
Be well, and stay well.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.