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Trade Alert

March 3, 2020

We made some changes to both our model portfolios on Friday 2/28/20. And while there where quite a few trades, the overall risk level from the stock bond mix hasn’t really changed significantly, more so we changed the types of stocks and bonds we wanted to be in going forward in light of some recent swings. As it turned out though, it’s a pity we didn’t increase the stock allocation much because as of Monday the stock market has been staging an amazing rebound (or dead cat bounce… only time will tell!). But then it’s typical that the highest point gain ever should come after the fastest 10% drop from a peak. Tuesday is showing markets back in the red as an emergency rate cut isn’t working. It’s that kind of a market now…

For the record, before and after this trade we are taking significantly less risk than the stock market. In February the Vanguard S&P 500 fund was down about 8.25% while our model portfolios where down about 3.1% for Aggressive and 1.8% for Conservative

As you probably noticed, stocks took a pounding and fell very fast and hard in the last week of February, largely because of growing fears that the Coronavirus outbreak will drag the global economy down significantly. This fear has also brought U.S. interest rates down to European levels, which we noted as a possible situation several times in the past and a reason to stay in longer term bonds at the time. 

In theory, a virus that still has caused fewer deaths globally than cigarettes cause every day in China shouldn’t have that much of a stock market impact. So even if there is a brief economic slowdown, it shouldn’t have much of an impact on earnings at companies over the next ten years, which is really the sort of timespan you should be looking at when you buy a stock. Much deferred spending today often just becomes future spending. It’s worth remembering that past similar viruses did not lead to major stock market events; even the 1918 Spanish flu, which killed perhaps as many as 50 million people globally, was almost a non-event as far as stocks were concerned or at least it’s impact was hard to separate from other economic issues at the time, like World War I. 

The reason this contagion may be different though is because today 1) stocks are expensive, and 2) we don’t have lots of room to fix economic problems. China now being a much bigger player in the global economy than it was during past health scares originating out of China is also a big factor to take into account.

We’ve discussed these issues of valuation and the lack of recession-busting options recently, but to sum it up: expensive stocks require good times ahead. This was the essence of the 2000 crash as the actual economy didn’t live up to the high prices of stocks at the time. 

Perhaps more troubling today, we’ve already got in place our tax cuts and low interest rates and government spending – the sort of mix that is typically used to give the economy a boost during a recession. Essentially, we’re deficit spending in a boom. So what are we going to do in the next recession? Go from a $1 trillion dollar deficit to a $3 trillion dollar deficit and cut rates to a negative 0.50%? 

There is also the issue of possible hidden problems lurking in the global economy that a sharp economic contraction will expose, even if briefly. Many people around the world today are not going about their ordinary business for fears of catching the virus. Much of this probably has more to do with the fear of being quarantined more than a worry about an actual mortality risk – because let’s face it, if you are young and healthy and can go to Italy for half off and with fewer tourists about that would be an appealing tradeoff for some, but not if there is the wild card of the risk of being quarantined for weeks in some makeshift camp. But now that flights are being cancelled for months into the future, even the virus brave are grounded.

There’s also likely to be a real drop in demand for commodities, like energy, and possibly a much sharper drop than in an ordinary recession and one that could leave heavy-in-debt energy-related companies scrambling to make debt payments. 

Ultimately the fear of a real 2008-style crash rests not just on high valuations but on rising debt defaults too, much like how falling home prices were the trigger to cascading defaults in what turned out to be a world of very shoddy real estate loans. And the concern is that some of these big corporate borrowers probably can’t handle a few months of sharply lower revenues. 

However, our trades here are not only because of the Coronacrash—several of these positions were already on the docket to be sold and we’ve noted the issues in past articles. The main reason was actually the sharp drop in rates related to the Coronacrash in stocks.

The benchmark 10-year government bond is now barely above 1%, down from around 3.16% in late 2018 before this long drop in rates started. We’ve now officially joined the European bond market, which should go hand in hand with low economic growth. While the relative value of stocks in such an environment is high, high priced stocks are not appealing in a slow growth economy. Nobody wants 50% downside just to upgrade from a 1% yield. Not in the short term at least.

More troubling to our portfolios is that we have relied on bond funds—notably long-term bond funds investing primarily in safe government debt—to lower the risk of our portfolios. Whenever stocks got rocky, we could almost bank on bonds doing well and vice versa. However, this relationship is nearing the end because ultimately we probably won’t go to negative interest rates in the U.S., simply because we borrow too much money for it to happen. If the Fed starts printing money to buy more bonds, it could happen, which is part of the problem in Europe.

The main thing we are doing here is cutting back on longer term bonds and shifting to investments abroad. We need some sort of bet to lower the risk of more stock losses and any foreign asset should do the trick, even though globally stocks have been going down as a group lately and in general they tend to move together. The reason is our dollar should slide as our rates ‘go European’ and our economy weakens. A 1,000 point drop in the Dow is going to hurt foreign stocks too, but over time if our dollar falls and valuations get closer there could be a major performance gap between here and abroad.

This could of course all represent an amazing buy-on-the-dip opportunity fueled by the temporarily low rates. But then being in long-term bonds only to see them slide sharply as rates go back to say 2% is not fun either. To be clear, we are taking on more default risk by adding say emerging market bonds and high-yield energy stocks and selling longer term U.S. debt, but hopefully this will not actually increase our downside significantly from here. If such a sharp slide continues, we may even trade again and increase our overall stock allocation. It is also entirely possible we could go in to recession mode with a 20%–40% slide and we’ll then be back to the high stock allocations we had in early 2009.

Aggressive Portfolio Trades


New Bond Fund Holding – 12%

This one is risky as emerging market economies may have trouble with debt in a global crisis but the high yields and benefit of a falling U.S. dollar should help. The alternative is safer foreign bonds (like in our holding BWX, which we are reducing), but lower default risk foreign bonds typically yield nothing. 


New Stock Fund Holding – 10%

After years of large cap growth outperformance, it is time for the market to swing back to favoring small cap value—an area we haven’t focused on here since the early 2000s. We used to own Vanguard Growth ETF—a large cap growth fund—and more recently had a small cap short position, which unfortunately wouldn’t work well for this purpose long haul, but the valuation call of preferring large cap growth years ago was right then. This fund is up only 4.52% annualized over the last 5 years compared to VUG Vanguard Growth, which is up 12.2% annualized. Now larger cap growth is overpriced, like in 1999, but with multiple trillion dollar large cap names, it is no wonder.


Reduced Allocation Bond Fund – 20% to 10%

This fund actually has done well considering so many of the bonds have a negative yield. Basically, it is a play on the U.S. dollar falling and/or rates falling even more, but we’d rather achieve this in higher risk-and-return emerging market bonds given the recent drop in rates. 


New Stock Fund Holding – 8%

We’ve been anti-commodity for more than a decade and have been shorting them off and on for about that long. Owning commodities was popular a decade plus ago and has turned out a disaster for investors. While we likely won’t ever own commodities directly as they are never a good idea for investors, energy companies have gotten so cheap in this recent slide after a decade plus of bad performance, it should work out even if we just collect the 5%+ dividends—nothing to sneeze at in a 1% world. There is risk here as many smaller energy companies are leveraged and oil demand will likely tank with this virus threat (as noted in our other trade commentary), but companies like ExxonMobil which have raised dividends every year for almost four decades should be a safe bet, even if we actually get some dividend cuts. Many will simply borrow to pay the dividend at low rates. 


New Bond Fund Holding – 6%

This is not going to be a long-term holding and the yield is low today and also there is still some credit risk in a slowing economy. Another negative is the ongoing popularity of short-term bonds. We fully expect to sell this one for something else in the next year or so, but we’re trying to cut back on longer term bonds after the big run. 


New Stock Fund Holding – 6%

Germany is not growing fast and is facing a possible slowly dying manufacturing economy and has lost much ground to high-flying tech-focused America and low-cost China. That said, the yields are high and the valuations relatively low and the government is currently running a balanced budget and may consider—more than any other country—significant fiscal stimulus (actual spending) because, frankly, the negative interest rates aren’t doing much to help. The reality is, if we were running a balanced budget our own economy would be almost as sluggish. Franklin has very low-fee single-country ETFs, but the trading volume is so low they are not popular like the higher fee bigger alternatives from iShares. Hopefully, this lack of interest will change and these funds won’t get closed as is the risk with low-asset-level ETFs that are not profitable to manage.


New Stock Fund Holding – 6%

This may be our biggest head scratcher. Why go into China now—ground zero of the virus and already hit by a trade war? However, while the short term can go poorly, China is still growing fast relative to other countries and its stock market has been in a decade-long doldrums coming off the stock bubble of the mid-2000s. There is also more potential for new government spending than in other major economies, like ours. Often the least popular move works out the best. Franklin has very low-fee single-country ETFs, but the trading volume is so low they are not popular like the higher fee alternatives, often from iShares. Hopefully, this lack of interest will change and these funds won’t get closed as is the risk with low-asset-level ETFs.


Allocation Change – 20% to 6%

As noted, this fund is invested in long-term bonds and has benefited significantly from the slide in rates over the years, especially the drop that started in 2018. This fund is up 9% this year, 19% last year. The ten-year return is 8.25% annualized. That is stock-like with less risk, but now the risk is going up and the likely returns down. One reason long-term bonds have done so well is that so few owned them relative to shorter term bonds. Everybody was piled up in short-term bonds waiting for the big move up in rates that never happened. We fully expect to be able to go back to this fund or something similar when rates move up even to say 2% on the ten-year bond. In fact, we are still keeping an allocation here.


New Inverse Fund Holding – 3%

This recent gold run-up will likely subside if we get more deflation from an economic slowdown or if the economy heats back up with low rates. There is also the situation that gold is still used in jewelry and that demand will drop in a global recession. The bull case is just more expectations of inflation that never come to being, but gold bugs don’t tend to care about bad long-term performance. We need to get out of DZZ—our gold bullion short—because the fund is too small and not well supported by the fund family (they won’t even return our calls!). This fund shorts with even more leverage than actual mining companies and could have real trouble in an economic slowdown, even if gold doesn’t fall sharply. 


New Inverse Fund Holding – 3%

We’re out of small cap shorting because the most overpriced part of the global market is larger cap tech stocks. That said, without a real market slide, this fund could down almost 100% over time, which is why it is only a very small allocation. If the market tanks, this fund will be sold and shifted to stocks for the eventual rebound. Frankly, it would be better to just short the actual QQQ ETF and even more frankly, if we could earn 3% again on longer term government bonds, we would just do that, but there are few good ways to reduce portfolio downside today.


New Inverse Fund Holding – 2%

Unlike almost all our other shorts, shorting commodities works even with these ill-conceived daily leveraged inverse funds. Our favorite was PIMCO CommoditiesPLUS Short Strategy Fund,  but PIMCO closed it on us right around when it would have become a great investment. Our longer term oil short (DTO) has almost always offered offsetting gains during stock weakness, partially because oil was often overpriced from speculation and the futures market typically priced oil more expensive in the future, giving the opportunity for a tailwind shorting. Adding to this, oil typically tanks in a recession when stocks sink. This new holding is more leveraged, unfortunately, but trades more frequently than the tiny DTO.


Sold 7% to 0%

This fund delivered us nice low-risk returns, but utility stocks have been sucked into this obsession with low-volatility stocks and are now too popular, not because of the utility funds per se but because of the massive low-volatility ETFs. Many utility stocks are now no longer low volatility or low risk—just look at the price swings in recent days. The yields were nice in a falling rate environment, but at the end of the day these are now expensive slow-growth stocks, that may actually take an earnings hit if power demand drops in a recession or, worse, a virus outbreak. 


Sold 6% to 0%

Italy just isn’t as out of favor as it was when we invested in this fund and is not the country to invest in during a slowing global economy—they just don’t have the money to do stimulus, though they are benefiting from the ultralow rates in Europe.


Sold 3% to 0%

Several years ago small cap value stocks were overpriced compared to larger cap growth stocks, which were cheap after underperforming in the 2000s. Unfortunately, there were no small cap value inverse funds, just small caps and in general these funds don’t offer any long-term value, but they can reduce downside in a slide. Ultimately, investors are better off just avoiding overpriced areas, not shorting. Not going to sugarcoat it… these funds have hurt us. We should have just owned even more long-term bonds.

Vanguard Communication Services ETF (VOX)

Sold 3% to 0%

This fund became a mess right around when it morphed into a tech fund, which we noted and used as a reason to sell it in our other lower risk portfolio. It was a loser even with Google and Facebook stakes and is now a risky fund for a market crash, unlike before, which is why it needs to go.


Sold 3% to 0%

Biotech stocks are still overpriced, even though they have slightly underperformed the S&P 500 with more risk. That said, this inverse fund won’t help in the long run or the short term as biotech may seem appealing to investors during coronavirus-type outbreaks. 


Sold 3% to 0%

The fact that this leveraged short fund has had a positive return since it launched in 2008 is amazing given the almost-certain negative returns of any leveraged inverse fund over time. The fact that it tends to skyrocket in price when stocks fall is another plus (it was recently up over 40% YTD). That said, the wind at its back has been generally higher oil prices in the future than the current (spot) market, making shorting futures slightly profitable with no change in the oil price. This phenomenon isn’t as good as it has been, but in truth, the main reasons we are trading this fund for another oil short are illiquidity and fund size.  


Sold 6% to 0%

Gold and silver are still bad investments, although for some reason millions of people haven’t noticed despite the prices still being below the levels they hit in 2011 (significantly below in silver’s case) while stocks have more than doubled. You still see gold coin ads everywhere (often sham collectable coins). That said, this fund doesn’t trade enough to use and is basically not supported by the fund family (they won’t call us back!), so we are switching to a more actively traded short on gold-mining stocks.

Conservative Portfolio Trades


New Bond Fund Holding – 15%

This is probably not going to be a long-term holding, the yield is low, and there is still some credit risk in a slowing economy (though less than our new corporate short-term fund). Another negative is the ongoing popularity of short-term bonds. We fully expect to sell this holding for something else in the next year or so but we’re trying to cut back on longer term bonds after the big run. 


Allocation Change – 8% to 12%

Europe is cheaper than the U.S. now and when you adjust for our deficit spending boosting our GDP, it’s not growing that much slower. There is more room for fiscal stimulus, especially in Germany. They also don’t have the worry of increasing socialism—they already have it! The dividend yield is higher and there could be a return boost if our dollar sinks, which might happen after years of riding high.


New Stock Fund Holding – 10%


New Stock Fund Holding – 7%


New Bond Fund Holding – 7%


Allocation Change – 19% to 6%


Allocation Change – 12% to 6%

In theory, we could hang on to this fund as mortgages haven’t declined in perfect lockstep with treasury bond rates, but at the same time, they are still not offering much yield as well as little benefit from further rate cuts. The expected return is so low from here though that we’d rather add a little risk and reward, plus we just added a short-term bond fund which doesn’t yield that much less.


Sold – 6% to 0%


Sold – 13% to 0%

Shortly after (VOX) became essentially a tech fund, this ETF did the same. It was mediocre even with Google and Facebook stakes and is now a risky fund for a market crash, unlike before when it was more of a telecom utility fund, which is why it needs to go now.


Sold – 5% to 0%

This fund has been a long-time staple here and remains underowned (though much larger than when we bought it). This low-fee fund owns zero coupon bonds, which are essentially default-risk free, but with the most interest rate risk possible in the bond world, even slight changes in long-term rates can lead to wild swings in this fund. This fund is actually slightly more volatile than the S&P 500. However, it tends to take off when stocks fall and has been a great hedge against stock market risk—better over time than any shorting strategy. The fund was up over 18% last year and so far in 2020. The ten-year return is 11.65%, compared to 12.90% for the S&P 500 ETF (SPY). That said, with a 1% ten-year government bond, the downside is higher than the upside by far, even though interest rates will probably not break 3% on the ten year for years to come. We will be back in this fund if rates climb significantly. It is possible this fund will do another 20%+ as rates go closer to zero, but 90%+ of the money has already been made here. At the end of the day, bonds are not stocks and this fund can’t match the S&P 500 over the next 10 years, unless the stock market is about where it is now in a decade.