Entering 2020

Right about now, each year, is when I settle in to pen a letter with "year-end" in its title. The past several turned out to be so voluminous that I broke them into several parts, with the hope that by delivering them in smaller, more digestible bites, I'd capture, and keep the attention of most, if not all, of our clients. 

Well, the year-end notes indeed tend to receive an above-average number of hits (compared to the regular posts), but, still, not nearly all of you take them in.

Of course I get it, as the feedback from many long-time clients -- who don't frequent the blog -- is that they’ve been with us through enough market cycles that they trust our process and are completely comfortable living their lives while leaving the investing details to us.

When it comes to our comfort level, which of course is critical (actions taken while experiencing discomfort are bound to be sub-optimal), I can say that (despite present macro uncertainty) we feel as comfortable, confident and as prepared as ever to tackle what’s (or whatever's) to come.

The following is not a "2020 Outlook", which is the title of a number of reports that have come my way of late via institutional research relationships, etc. A more apt description of the note you’re reading would be “2020 Nowlook”. 

Sure, every now and again I’ll share my musings on the maybes of the next few months; of, for example, how career, and/or political risk is likely to influence the decisions of appointed, and/or elected policymakers given the challenges facing them; and what that might mean for markets. In fact, much of what influences next year's outlook among the mainstream pundits is indeed speculation around US/China, UK/EU, UK/US, US/EU, and several more, trade deals. Consensus has it that positive outcomes in virtually all instances are likely, and will yield even more positive returns in world equity markets going forward.

But here's the thing, as you'll gather from the note and the accompanying videos below, right now, beneath the noise around trade, etc., there exists conditions that simply don't reflect the probability that politicians engaging in friendlier fashion the world over will keep the global economy humming. I.e., underlying conditions, while not screaming recession, certainly aren't pointing to smooth sailing ahead.

As for the mainstream prognosticators who argue otherwise, well, allow me to borrow from Benoit Mandelbrot's incredibly insightful book "The Misbehavior of Markets". 

"Financial economics, as a discipline, is where chemistry was in the sixteenth century: a messy compendium of proven know-how, misty folk wisdom, unexamined assumptions, and grandiose speculation. Most of it focuses on practical aims, such as making money or avoiding loss for whoever is paying for the research, whether a bank or a government."

A striking example of Mandelbrot's assertion is this on November 16th from JP Morgan CEO Jamie Dimon.

"This is the most prosperous economy the world has ever seen."

Well, okay, but within a month of its CEO telling the world its in its best shape ever, JP Morgan bought a monstrous amount ($130 billion) of long-dated treasuries and cut its loan book by 4% (that's significant btw). 

Well...uh... no, absolutely not! Regardless of any extenuating circumstances (such as the G-SIB scores I referenced in a recent post), any non-captured analyst will tell you that you never pile into long-term bonds amid the best economy the world's ever seen. Never!

You see, we absolutely have to do our own work, we have to independently crunch the data, make our own assumptions, develop our own hypotheses and execute our own strategies. As there's just no way we would feel confident (or at all comfortable) following anyone else's lead. 

So this, in one fell swoop, will serve as what we used to call our "Year-End Client Letter". This year’s is brief (relative to previous years) and to the point; as it summarizes our assessment of current conditions as well as our core positioning going forward --the two accompanying videos offer more detail on both topics. 

Entering 2020

As you’ll recall from our communications this summer, we designed our current hedges to provide substantial downside protection through the use of put options on the S&P 500 Index while paying for it by selling a call option on the same. The term for this strategy is “options collar”; which is a common hedging technique used by sophisticated individual and institutional investors.

We liked the timing, as the strategy captured the bulk of this year’s gain to that point without actually exiting the market, which would have created substantial tax liability for clients with taxable accounts. Plus, we “modified” the collar by purchasing a call option roughly 10% above where the S&P traded when we implemented the hedge, which would allow us to resume gains should the market via, say, aggressive Fed stimulus or positive trade war news continue to march higher.

Almost immediately upon applying the first collars the S&P took a mid-single digit % dip, which of course saw a big bounce in the value of the hedge. A number of clients immediately reached out to me and said, “you were right”, which was praise I had to politely reject, while making clear that a ~6% decline was not remotely what we were hedging against, and that there was little reason to believe that that was the beginning of the end of the present bull market.

To cut to the chase in terms of justification, our hedging portfolios has nothing whatsoever to do with near-term market gyrations, it has everything to do with what we view as the most precarious risk/reward setup since the recession/crushing bear market of 2008. And despite the market making its way to new all time highs, in some areas the setup has deteriorated even further, while in others we have seen some improvement.

The most alarming area of deterioration is where we see risk that the next downturn could very well rival the 2008 experience; which is a massive bubble in the corporate debt market. I’ve written extensively on the topic (here and here for example). We’ve also seen marked deterioration in CEO, CFO and manufacturing sector sentiment, as well as in many global industrial indicators. Where we’ve seen continued strength is in the consumer space.

Bottom line: Without going into great detail on the stuff you already know about the general setup for next year; i.e., populist uprisings, messy elections the world over, continued trade tensions on multiple fronts, and so on, we’re going to continue to play some defense going forward.

As for our strategy from here, rather than remaining all out correlated to an ongoing bull market in equities, it’s time to diversify our holdings in a manner that is less beholden to perpetually rising stock prices. I.e., it’s time to add asset classes that move independent of the stock market in general, which means adding ETFs that track select currencies, including gold (yes, gold is more a currency than it is a commodity), and essentially shorting (either through an inverse ETF, or put options, or both over time) junk bonds (read the two blog posts linked above and you’ll wholeheartedly agree with shorting junk bonds!).

As for our stock market exposure, in that we now formally track the macro conditions of the Eurozone and 20 additional countries, given the present global setup, we absolutely do not want to entirely take the old shotgun approach to our international exposure. While we will maintain a modest allocation to broadly diversified foreign ETFs, we will also be adding exposure to country-specific ETFs that capture what we view as idiosyncratic positive developments. Make no mistake, foreign investing is one area where presently too much broad diversification actually makes a portfolio less safe.

As for our U.S. exposure, we’re shifting to a more defensive overall sector weighting.

Here’s our new mix across U.S. sectors, along with just a word or two that summarize our narrative for each:

XLF Financials (5%): Broad financials exposure

KBE Banks (5%): Purely banks, no insurance company exposure, potential consolidation among regional banks

XLB Materials (8%): Trade deal, global fiscal stimulus

XLI Industrials (8%): Trade deal, global fiscal stimulus

XLE Energy (8%) Geopolitical risk, U.S. supply destruction, opec cuts

XLK Tech (5%): Idiosyncrasies

VOX Communications (5%): Idiosyncrasies, 5g

VZ Verizon (2%): 5g

T AT&T (2%): 5g

XLP Consumer Staples (14%): Defensive

XLV Healthcare (14%): Defensive, demographics

XLU Utilities (14%): Defensive

XLRE Real Estate Inv Trusts (10%) Defensive

As for hedging going forward; given that our new “core” allocation takes us into non-correlated (to stocks) asset classes, we won’t need to utilize as much put protection as we did for our current allocation. And rather than immediately implementing a “collar” we’re going to start by just purchasing put options 10% below the current level of the S&P 500. In testing our new allocation, we found that the combination of the non-correlated assets and the 10% out of the money put option actually produced a roughly 5 to 7% floor for the portfolio. While of course backtesting never guarantees future results (i.e., values could fall more or less than 5 to 7% in a rapidly declining market), this strategy provides meaningful downside protection.

Note that I said that we’re not “immediately implementing a collar” as part of our allocation mix going forward. In utilizing our “collar” strategy to hedge portfolios to this point we were able to book (with the -5% strike [price below the market when we implemented the hedge] put option) significant year-to-date gains, thus we were okay with limiting our upside potential in order to generate enough income to pay for the protection. Going into next year we want to be positioned to participate in the upside should the market continue to trade higher, without halting a portion of the potential gains as we did with our modified collar strategy. While we remain very cautious going forward, we recognize that the market could indeed continue to rally for a while longer even if the fundamentals continue to deteriorate. Therefore, for the moment, we are not interested in limiting the upside by selling a “call spread” to pay for the put. Instead, if indeed the market continues to rally into next year, we plan to strategically implement what is termed a “covered call”* strategy by collecting income for portfolios through the selling of call options on existing positions.

*In a nutshell; when implementing a covered call we choose a security (e.g., the tech ETF) that we believe has limited upside potential over, say, the ensuing month. We then sell a one-month call option, collecting the premium, with a strike price (potential future share price) above the present price. If the security trades below that price a month later we simply keep the premium (adds to our net return, or, you could say, offsets the cost of our hedge). Worst case scenario (which isn’t “bad” at all) for a covered call (specifically) is when the price a month out is above the strike price (plus the income we collected) and the stock is “called away”; in which case we sold it for a nice gain. We’ll then immediately buy back the same or a comparable security if we believe it continues to makes sense.

Note: Inside of taxable accounts; in the process of entirely rotating out of the current hedge -- assuming the market doesn’t decline between now and then -- we’ll capture what we call a tax asset (the loss on the collar), which, while recapturing (on your tax return [offsetting capital gains]) a notable portion of the decline in the hedge, will in effect allow us to rotate to the new core allocation with substantially less, if any, tax consequences.

Bottom line; while the above may seem complicated -- the important thing is that it’s not at all to us -- our objective is to manage your portfolio in a manner that allows us to capture a fair amount of whatever upside may be left in the present bull market, while protecting against the lion’s share of the inevitable (yes a future bear market is a given) fallout from the next recession/bear market.

The first video below is a recent update of our view of present general conditions, and the risk below the surface. The second is a more thorough (than the above) look at the whys and wherefores of our strategy heading into the new year.

Personal Note: All of us here at PWA would like all of you to know what an honor, and what a true pleasure, it is to work with such a great group of clients. Seriously, we often comment to one another how fortunate we are, how we view our clients as so much more than people we do business with; we view you, frankly, as dear friends who rely on us to responsibly grow and protect your wealth through what is forever an uncertain future.  

Happy Holidays to you and yours!!