By David Snowball

Dear friends,

Welcome to spring. Meteorological spring, anyway, that brief interval when the Quad Cities are wedged between end of snow and the beginning of flood, between the end of hockey and the start of minor league baseball, between the days when you can’t imagine the end of winter and the ones where you can nearly taste the arrival of spring.

Celebrate it all, since it’s the only year we’re getting this year!

March Madness.

It used to refer to a basketball tournament. Who knew?

What color is your swan?

The investing world’s most famous swan is black. The Black Swan: The Impact of the Highly Improbable is a 2007 book by Nassim Taleb who places the black swan – a rare, unpredictable event with potentially dire consequences – in the context of financial markets. Mr. Taleb explores the ways in which we talk about, think about and react to unforeseen calamities.

Nouriel Roubini, professor of economics and former head of the President’s Council of Economic Advisers, does not discount the importance of black swan events, but he does argue that there’s a far more common threat. He calls these white swan events. These are the disasters that we can see coming from a mile away, and yet are surprised by their arrival.

In my 2010 book, Crisis Economics, I defined financial crises … as “white swans”. According to Taleb, black swans are events that emerge unpredictably, like a tornado, from a fat-tailed statistical distribution. But I argued that financial crises are more like hurricanes: they are the predictable result of built-up economic and financial vulnerabilities and policy mistakes. (“The white swan harbingers of global economic crisis are already here,” 2/19/2020).

Mr. Roubini points out the obvious: the US has picked fights with four foreign opponents.

For starters, the US is locked in an escalating strategic rivalry with at least four implicitly aligned revisionist powers: China, Russia, Iran and North Korea. These countries all have an interest in challenging the US-led global order and 2020 could be a critical year for them.

He argues that all four favor asymmetric warfare: not challenging the US military directly, but working to damage cybersystems, political and trade alliances, and global financial institutions. Disruptions to the global oil supply, manipulations of China’s vast holdings of US Treasuries, an economy reliant on trillion dollar annual deficits and real interest rates at zero, ill-contained epidemics which become pandemics …

Beyond the usual economic and policy risks that most financial analysts worry about, a number of potentially seismic white swans are visible on the horizon this year. Any of them could trigger severe economic, financial, political and geopolitical disturbances unlike anything since the 2008 crisis.

In an interview this week with Germany’s Der Spiegel, Dr. Roubini argued “I expect global equities to tank by 30% to 40% this year. My advice is: Put your money into cash and safe government bonds.”

I wonder how he earned the moniker, Dr. Doom? (He’s not to be confused with Marc Faber, author of the Gloom, Doom and Boom Report although the latter does rather agree with the former: “In recent reports I have explained that I was reducing my equity exposure to around 20% of assets and increasing my cash holdings. I want to warn my readers not to be complacent. If the Coronavirus is going to be as bad as I believe it will be, I would not be surprised if all asset prices declined.” Nonetheless, he still holds US Treasuries as the last, best safe haven.)

I’m neither endorsing nor discounting the “30-40%” risk. I’m not competent to do so. The fact that serious people are raising the prospect does, however, warrant a bit of reflection on our part. That is, we need to array and assess our options. Generically, there are three:

1. pretend nothing’s happening; alternately, run around like chickens with our heads cut off. Following the financial media too closely will surely lead you to one or the other. My suggestion: extend your financial media hiatus by a few more months, power down and read a book.
2. reassess our asset allocation. We know that bear markets in stocks have greater drawdowns than bear markets in bonds, though the latter can also last for a decade. If your financial plan is, say, 50-70% equities, consider whether 50% equities will give you a bit of peace.
3. ignore your portfolio until 2030. Ed Studzinski’s reflections this month on the stock market are unusually concise and, as ever, thoughtful. Ed reminds us of the old advice, to buy stocks as if the stock market might close for the next 5-10 years. That is, you’d still own your stocks but couldn’t sell them. That possibility would lead you to invest no more than you could afford to lose for the next decade, and would probably encourage you to target the best companies you could find. Those might well be boring companies that dominate stable niches, who will likely grow slowly and steadily, year after year.

If the latter appeals to you, so might this month’s profile of YCG Enhanced Fund (YCGEX). We’ll continue to try to highlight investors who are really good partners in really turbulent markets. If you’re feeling antsy, MFO’s list of Great Owl Funds – funds ranked in the top 20% in their categories, for conservatively risk-adjusted returns, for all evaluation periods 3 years and older – is a good place to start. The list is free and sortable by a bunch of criteria.

Thanks!

Mutual Fund Observer is, of course, 100% reader-supported.  Each month brings about 25,000 readers and, except at year’s end, about a dozen contributions. Thanks to folks, often gloriously repeat offenders, who make contributions to MFO in February: Nancy, Hjalmer, Wilson, Jon and the folks at Gardey Financial Advisors and the good people at S&F Investment Advisers in L.A.

Thanks, most especially, to the folks who’ve committed to making a monthly contribution that PayPal: Brian, Matthew, Gregory, James, William, and the other William.

We tried to mail a thank-you note and tax receipt to Tom Kilian, but the mail bounced. We hope you’re well, sir!

We also received a freakishly small check – $11.63 – from the AmazonSmile Foundation which covers October – December, 2019. We’re grateful for the goodwill that lies behind the check.

If you’d like to support the Observer, please do so. It’s not hard and doesn’t have to be much. Folks interested in accessing the fund screeners and other tools at MFO Premium should go there rather than using the regular PayPal/check option.

Looking forward to seeing you on April Fool’s Day!

 

 

By David Snowball

A tradition dating back to the days of FundAlarm was to annually share our portfolios, and reflections on them, with you.

Four rules have governed my portfolio for the past 15 years or so.

1. I maintain a stock-light asset allocation.

For any goal that’s closer than 10-15 years away, stock investing is speculation. Stocks rise and fall far more dramatically than other investments and, once they’ve fallen, it sometimes feels like they can’t get up. Equity income funds are typically very conservative vehicles, and yet they took four years to regain their October 2007 peaks. International large cap core funds took seven years to reach break-even while domestic large-cap core funds were underwater for five-and-a-half years. The worst-hit categories languished for nine years.

Research conducted by T. Rowe Price and shared here, on several occasions, led me to conclude that I wouldn’t gain much from a portfolio that exceeds 50% stocks. My target allocation is 50% income (half in cash-like investments, half in somewhat riskier ones) and 50% growth (half in firms domiciled in the US and half elsewhere). Based on a review of 70 years of returns (1949-2018), this allocation would typically return a bit over 8% annually, would lose money about one year in six but its average loss would be in the 4-5% range.

2. I value thoughtful, experienced investors who are risk-aware.

Passive strategies are efficient ways to capture a market’s total returns. That’s true in both rising and falling markets. I’m not particularly comfortable with blindly riding the markets down, so I’m not particularly comfortable with passive (especially cap-weighted or, worse, debt-weighted) investing.

While the returns of a portfolio seem highly variable, even great investors (Mr. Buffett, for example) have long periods of “not beating the market,” risk characteristics of a strategy seem pretty consistent. Funds with lots of day-to-day downside deviation in normal markets have to have dramatic downside in abnormal ones.

The key is finding folks who have managed well in turbulent markets before, who have thought clearly about the role of risk (or volatility) in their portfolios, and who communicate clearly enough that I know what they’re thinking. That gives me the confidence I need to ignore rough patches.

3. I do not care about “beating” the market or anyone else.

There is no stupider or more destructive obsession in the investing world than this: so how often does your guy beat the market? This is the fantasy football version of investing: we win not by winning but by adding together a bunch of random, unconnected data points and declaring the person with the biggest piles o’ points won.

Earth to Investors: Fantasy Football is Fantasy. It’s not a model for managing your money. In personal finance, you win if and only if the sum of your resources is equal to or greater than the sum of your needs.

If you beat the market 10 years in a row and the sum of your resources is less than the sum of your needs, you lose.

If you trail the market 10 years in a row and the sum of your resources is greater than the sum of your needs, you win.

My guess is that winning requires investments that you understand and can stick with in the long term, ideally calibrated to a calculation of your long term needs. In my case, for example, I win if my retirement portfolio returns 6% per year. If my 6% returns “trail the market,” I still win. If I “beat the market” but make less than 6%, I lose.

4. I need funds I can afford to buy.

My salary in my first year as a professor was about $14,000. I will retire without ever reaching $100,000. That’s not a complaint, that’s a constraint. For most of my life, I’ve invested in funds with low minimums or those willing to waive their minimums for investors using automatic investment plans.

So, here’s the non-retirement portfolio, ranked in order of their weight in the portfolio.

FPA Crescent (FPACX), a free-range chicken and quite possibly the fund that’s appeared in more of our data-driven articles than any other.

Seafarer Overseas Growth and Income (SFGIX), Andrew Foster’s excellent emerging markets fund.

1. 1. Rowe Price Spectrum Income (RPSIX), a fund of TRP income-producing funds.

Grandeur Peak Global Micro Cap (GPMCX), the smallest stocks selected by one of the world’s best global small cap stock firms.

Artisan International Value (ARTKX), which I bought at inception 17 years ago. Its management team was split in two in late 2018, so I’m watching a bit more closely.

RiverPark Short Term High Yield (RPHYX), my substitute for a saving account. Ridiculously high Sharpe ratio, often the highest of any fund in existence.

Matthews Asian Growth & Income (MACSX), traditionally one of the two or three most conservative ways to invest in Asian equities.

Brown Advisory Sustainable Growth (BIAWX), my newest fund and the first that’s dedicated to sustainable investing.

Matthews Asia Total Return Bond (MAINX, formerly Strategic Income), about the only fund giving dedicated access to Asian credit markets, which tends to be nicely out of sync with domestic ones.

Grandeur Peak Global Reach (GPROX), the flagship fund for one of the world’s best global small cap stock firms.

Currently, my portfolio is overweight in international stocks, 40% rather than my targeted 25% and underweight in US stocks, at 18%. That’s driven by two forces: (1) managers who have the freedom to invest in the US or elsewhere have, with some frequency, been chosing “elsewhere.” (2) My automatic investing plan isn’t yet active for my only pure US fund.

2019 moves:

1. cut RiverPark Strategic Income, consolidating that account with RiverPark Short Term High Yield. Strategic Income is a fine fund, but it wasn’t providing enough differentiation with RPHYX. That reflects the fact that David Sherman manages both and that he’s moving Strategic Income to its most defensive stance which increases the overlap with RPHYX.
2. cut Intrepid Endurance. I love the absolute value orientation and the discipline of holding cash when the stock market is not offering any discounted stocks worth owning. Don’t love the considerable turnover in the management team and the very poor communication about the matter. In part I moved the proceeds to FPA Crescent (FPACX) which espouses the same absolute value discipline (rather more successfully) and in part I …
3. bought Brown Advisory Sustainable Growth (BIAWX). The managers have an entirely remarkable track record, both in managing risks and in generating top tier returns. As the magnitude of the world’s climate challenge has become clearer, I felt ethically obligated to transition assets into investments that aren’t endangering us all.

2020 moves:

1. continue monitoring the role of Matthews Asia Growth & Income. It’s a very good fund and I’ve owned it for a very long time. That said, I have more exposure to Asia than to North America.The money might be better used …
2. continue building my BIAWX position. Since I only added Brown in 2019 and tend to build over time, I probably need to be a bit more vigorous here. That will also help rebalance my foreign:domestic equity split.
3. continue ignoring financial pornography, screaming heads, click-bait and other appeals to my worst instincts. Between rising market volatility, rising political frenzy and international challenges occasioned by dictators and viruses, that’s going to take some discipline.

And my retirement portfolio?

It’s mostly housed with T Rowe Price and TIAA. Like most of you, my choices very constrained by my employer’s choices. In both cases, there’s a target-date 2025 fund at the account’s core. In my T Rowe Price account, I added funds offering exposure to emerging market value stocks (T Rowe Price Emerging Markets Discovery) and international small caps (T Rowe Price International Discovery). In my TIAA account, I have rather 20% in the TIAA Real Estate Account. It invests, mostly, in commercial real estate and has been returning 6-9% a year with minimal volatility since the mid-90s. Other than for a pounding it took in 2008.

Bottom line

I don’t aspire to getting rich through investing. I would like to be sure that the sum of my resources is greater than the sum of my needs. My definition of winning, above.

I also don’t want to spend my life fretting about my portfolio, or fruitlessly chasing after The Next Hot Thing. My average holding period for a fund is creeping up toward 20 years, which reflects both my strategy (research carefully, choose well, walk away) and my priority (my family, my community, my friends, reading, learning, reflecting …and gardening, now that it’s spring).

I don’t pretend that my needs are your needs, or that my strategy need to be yours. The most we can do is to remind folks that investing is important, that understanding your investments is important, and that discipline is important. Which investments, which discipline … that’s your call.

By Edward A. Studzinski

The typical American of today has lost all the love of liberty that his forefathers had, and all their disgust of emotion, and pride in self-reliance. He is led no longer by Davy Crocketts; he is led by cheer  leaders, press agents, word-mongers, uplifters.

H.L. Mencken, “On Being an American” (1922)

On balance, it is somewhat hard to believe that in a few short weeks, we have gone from the domestic markets hitting new record highs, albeit with a continuing narrowing of breadth, to what is a full blown correction, with the markets now off by more than ten percent. And as we look to Monday, the first trading day in March, the question is have we reached a floor, or is this going to continue on for some time, wiping out performance gains for all of this year and go on to erase all or a substantial part of 2019’s profits.

What triggered the sell off this past Monday, which was a global event? More than likely, it was fear of the unknown. The current known unknown is the corona virus and what its potential impact will be on  . . . everything? The simple answer, or at least my simple answer is, that we don’t know. Nor is there any good way to handicap things. For years, we have been moving towards a much more interconnected world and effectively, an integrated global economy. We can now see the downside of that when, globally, countries and their health care systems are at different levels of quality. There is effectively no ability for there to be a consistent and timely global response across borders to a health care crisis.

Jason Zweig of the Wall Street Journal had an interesting column the other day, “The Pros Have to Sell Stocks Now. You Don’t” (February 20, 2020). He made the point, in his usual elegant fashion, that retail investors had the luxury of sitting back and not being panicked or forced into liquidating investments. He felt that much of the carnage taking place could be attributed to the actions of professional investors, who were focused on preserving their jobs rather than doing what was best for their investor clients. After all, the consultants will be searching for someone to blame for the losses suffered by their clients. Without that pressure, the individual should be able to assess whether his strategy is still appropriate and if not, how it should be modified.

What should you do as an individual investor? My efforts are going in to assessing, as suggested many years ago by Mr. Buffett, that one should look at the investments in one’s portfolio one by one. Would you be comfortable owning them if the market were to close for one or more years, so you would be owning them as a truly long-term investor? As with the prospect of hanging, that analysis does a good bit to clarify the mind. One can see what is real, and in many circumstances, apply a much more draconian assessment to things like leverage and cash flow. And especially important is the consideration of the exposure of your investments to unintended consequences.

For example, it is now apparent that having sole source supply of the fine chemicals needed to manufacture certain pharmaceuticals only in China, is perhaps not such a wonderful thing. We had some hint of this last summer when certain drugs for hypertension were in short supply due to an inability to source the raw materials to make them. In sum, you are going to have to examine, redo, and rethink many of what were your assumptions, which are now not so certain. And it won’t take much to see how certain industries like travel may be impacted.

Why not just sell everything and go to cash? Well, aside from triggering some permanent losses of capital, there are businesses that will continue to chug along and do quite well. Besides, if you sell everything and go to all cash, how will you know when to reinvest in equities? You won’t.

Rather than belabor the obvious, I am going to close with one quote from the Depression, when Franklin D. Roosevelt said in his 1933 inaugural address, “The only thing we have to fear is fear itself.”

 

By Charles Lynn Bolin

In this third of a six part series on the Six Rules of Investing, I look at risks and the ability of the investment environment to withstand shocks. This article is divided into four sections: 1) The Investment Environment, 2) Looking for the “Known Unknown” Risks, 3) Investment Strategy For Uncertain Times, and 4) Funds for Uncertain Times.

In February 2002, Donald Rumsfeld, the then US Secretary of State for Defense, stated at a Defense Department briefing: “There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.”

Donald Rumsfeld, US Secretary of State for Defense

It is easy to identify risks leading to recessions after they have occurred, but each recession is different.  Nassim Nicholas Taleb, author of The Black Swan (2007), criticized the risk management techniques of the financial industry in the book and warned about the coming financial crisis. According to Wikipedia, Dr. Taleb “advocates what he calls a ‘black swan robust’ society, meaning a society that can withstand difficult-to-predict events.”

Many of these risks are known by some people, who often point them out ahead of time. In this article, I look for the lesser known risks or risks with uncertain consequences that corporate executives, economic organizations, and investment managers are currently raising.

The Investment Environment

A mortgage loan officer told me in 2007 that a financial crisis was coming and it was going to be bigger than people had ever seen.  At the time, subprime loans were not mainstream in the financial media. I researched what he told me and shifted my 100% stock portfolio to 40% stocks.  The experience shifted my philosophy from “buy and hold” to managing risk according to the business cycle. I have since read dozens of books on economic and financial forecasting, statistics, investing history, and portfolio management.

Chart #1 is the Investment Model which is intended to maximize return of $100 invested in January 1995 by adjusting allocations based on the business cycle. I roughly follow Benjamin Graham’s guidelines of never having less than 25% invested in stocks and never more than 75%.  The dashed blue line is the index underlying the Allocation Index before a 20% and 75% cap are applied. It shows improvement in the Investment Environment since September 2019.  The Allocation Index (blue) is now at 25% stocks. The red line is the percent of indicators that are negative showing there is some improvement.  The Investment Model estimates that risks are high, but the investment environment is improving so continue being cautious.

Chart #1:  Investment Model

The Investment Model attempts to take into account the “known knowns” of risk such as financial stress, yield curve, high yield bond spreads, percentage of banks tightening lending standards, margin debt (leverage), inflation, recession probability, volatility, profit growth, economic policy uncertainty, and valuation.  What it does not do is take into account many of the “known unknowns” which occur less frequently and are harder to measure. 

Looking for the “Known Unknown” Risks

In this section, I list the major risks and concerns from a number of sources. As investors, we don’t need to run for the hills, but we need to recognize that this decade has many risks that were deferred from the global financial crisis or are exasperated by it.

1. Recession risk

The risk of recession has diminished but not been eliminated.  According to CEOs: Recession Biggest Business Risk in 2020, recession is now classified as the major risk by corporate executives both domestically and globally:

• • US: For US CEOs, a recession rose from being their 3rd biggest concern in 2019 to their top one in 2020… For two years in a row, US CEOs cite the issue [increased competition] as their 2nd top external worry… It [trade uncertainty] ranks as the 4th biggest worry of US CEOs, tied with its affiliate issue: global political instability.
  • Global: For the 2nd year in a row, CEOs and other C-Suite executives globally rank a recession as their top external worry in the year ahead… CEOs globally rank uncertainty about global trade as their 2nd biggest external worry in 2020… For CEOs globally, fiercer competition rose from being their 4th top external worry in 2019 to their 3rd in 2020.

CEOs: Recession Biggest Business Risk in 2020, Newsmax finance

One of the concerns over recessions is expressed well by Joachim Fels and Andrew Balls at PIMCO which is with interest rates already low there are fewer tools in the toolbox to fight the next recession:

Yet again, the Fed and other major central banks have helped to extend the global expansion by adding stimulus in response to rising recession risks. However, last year’s easing of monetary policy comes at a price: Whenever the next economic downturn or major risk market drawdown hits, policymakers will have even less policy capacity to maneuver, thus limiting their ability to fight future recessionary forces.

Seven Macro Themes for 2020

The Global Risks Report 2020 by the World Economic Forum is rich in data and charts.  Below is the chart of major Economic Risks.  The Global Shapers Community is the World Economic Forum’s network of young people (large circles) driving dialogue, action and change, while the Multi-Stake Holder (small diamonds) consists of leaders from the business, government and non-profit communities.  It is interesting that the Shapers find most topics of higher impact and likelihood than the Multi-Stake Holders. Most are well known, but “critical infrastructure failure” deserves highlighting as it shows up later in the Top Fund Objectives.

Chart #2:  Top Global Risks – Economic

2. Excessive corporate debt and low quality

Lance Roberts makes several good points in “MacroView: The Next ‘Minsky Moment’ Is Inevitable” including Chart #3 which shows that corporate debt is at its highest level in over 70 years. The benefit is that companies have lower costs from low interest rates. The risk is that interest payments have to be paid from cash flows. In recessions, this increases the risk of a company having to file for bankruptcy. 

Chart #3:  Corporate Debt to GDP

Another problem with corporate debt is that the quality is lower as described by Jeffrey Gundlach, co-founder of DoubleLine Capital:

The credit worthiness of corporate debt is the number one risk that should concern bond investors. Gundlach issued his strongest warnings ever over the leverage taken on by U.S. corporations and the unrealistically favorable ratings that debt has been given.

Foreigners have been buying U.S. assets, he said, but that is unstable. If the economy weakens, those investors will want to “get out.” A lot of “potential selling” could happen, Gundlach said.

Gundlach on the Biggest Risk Facing Bond Investors and the Likely Next President, Robert Huebscher, Advisor Perspectives

The Organisation for Economic Co-operation and Development (OECD) also acknowledges the risk of low corporate debt quality:

In every year since 2010, around 20% of the total amount of all bond issues has been non-investment grade and in 2019 the portion reached 25%. This is the longest period since 1980 that the portion of non-investment grade issuance has remained so high, indicating that default rates in a future downturn are likely to be higher than in previous credit cycles…

In 2019, only 30% of the global outstanding stock of non-financial corporate bonds were rated A or above and issued by companies from advanced economies…

3. Excessive leverage

Lance Roberts highlights the high level of speculative leverage in Chart #4 from “MacroView: The Next ‘Minsky Moment’ Is Inevitable”.  This leverage supports the markets until investors decide to reduce it as they have been for the last year or two. This metric is included in the Investment Model, but worth highlighting here.

Chart #4:  Free Cash in Margin Accounts

4. Monetary policy and federal debt

Lance Roberts wrote MacroView: The Next ‘Minsky Moment’ Is Inevitable which shows that central banks have been increasing their balance sheets since the 2008 financial crisis to the point that global central balance sheets are now $21T which is roughly equal to the size of the U.S. economy.  Mr. Roberts also wrote, “MacroView: Japan, The Fed, And the Limits of QE”, comparing the U.S. to Japan as summarized below:

• • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates
  • An underemployed younger demographic
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases

To support this view, in the chart below, the U.S., Japan, and Italy have the highest debt to GDP ratios of the countries with at least $1T in GDP.  Secondly, U.S., Japan, and Brazil have the highest budget deficits as a percentage of GDP.  In other words, the U.S. and Japan have the highest government debt loads and are getting into further into debt at a faster rate than other large economies.  Currently the debt is increasing at about $1T per year in the U.S. 

Chart #5:  Government Debt/GDP vs Deficits

The velocity of money is how economists measure how fast money changes hands in an economy.  In Chart #6, we see that the velocity in the U.S. is 1.4 (dark red line) compared to 0.6 in Japan (light red line).  The suggestion is that incremental easy money is less effective when there is so much already in the economy.  The black line projects that at current rates, the velocity in the U.S. could reach that of Japan in another 10 or 15 years.  Note that the Japanese stock market, Nikkei, peaked in the early 1990’s and still has not returned to its former level.  The chart also shows that since 2009, asset prices have been inflated in Japan along with those in the U.S.

Chart #6:  U.S. and Japanese Velocity of Money

5. Trade and geopolitical tensions

An excellent condensed view of geopolitical risk is provided by Blackrock, in Geopolitical Risk Dashboard, where they place global trade tensions as the most likely to occur with the highest consequences. Gulf tensions, U.S./China competition, cyberattacks, North Korea, Terror Attacks, and Latin American events are also likely to occur, but possibly have less impact on global investments. Geopolitical risks have been brought to the forefront by the conflict with Iran, China, and North Korea.

Chart #7:  Geopolitical and Trade Impact and Likelihood

From the Global Risks Report 2020 is a chart of major Geopolitical Risks. The Global Shapers Community is the World Economic Forum’s network of young people (large circles) driving dialogue, action and change, while the Multi-Stake Holder (small diamonds) consists of leaders from the business, government and non-profit communities.

Chart #8:  Top Global Risks – Geopolicitical

6. Inflation

This economic cycle — now entering a second decade — has been unusually long and shallow. The late-cycle, dovish pivot has also been unusual, and there are few signs of the traditional late-cycle limits of economic overheating. As a result, we don’t see a slide into recession as the primary risk — but a stubborn mix of slower growth and rising inflation. The potential for such a regime shift is one reason why we prefer short-maturity U.S. Treasuries, and see inflation-linked debt as attractive.

2020 Global Outlook, BlackRock Investment Institute

The biggest concern that I read about the risk of inflation is that it is under-estimated by investors. One measure of inflation, the Consumer Price Index, has been rising for the last five years and is now at 2.5%.  The Federal Reserve has expressed a willingness to let inflation run a little higher than its 2% target. Vanguard points out that an aging population is deflationary in the long term, but that trade conflict may drive prices higher.

In The Risks In 2020 Seem Evenly Balanced, Gerard Minack from Evergreen Virtual Advisor provides the following chart which shows that labor costs are rising, but at historically low rates compared to the unemployment rate. Labor intensive industries such as health care and utilities are more susceptible to inflation from higher labor costs.  Higher labor costs are great for workers and spending, but reduce profits.

Chart #9: Rising Wages

 

7. Weaker dollar

The dollar is heavily influenced by interest rates. If the global economy improves and the U.S. continues to slow then the dollar may weaken.  Currently, the dollar is a safe haven and retains its strength.  This may change at some point this decade which will benefit inflation protected bonds, U.S. multinational corporations, gold, commodities, foreign fixed income and emerging market equities.

8. Societal risks

From the Global Risks Report 2020 lists major Societal Risks including infectious diseases, food and water crises, involuntary migration, and social instability.

Paul Donovan from UBS, described the stock market drop on Monday, February 25^th, as “fear of fear of the virus”.  John Hussman, president and principal shareholder of Hussman Econometrics Advisors, sums up coronavirus well in Make Good Choices:

Apart from counting the novel coronavirus as one of the many factors that could prompt an episode of risk-aversion, I prefer to avoid discussing the financial aspects of a public-health crisis. Suffice it to say that market valuations are extreme and risk premiums are more compressed than at any other point in U.S. history. It’s misguided to imagine that the extraordinary full-cycle market risk that is already baked in the cake would somehow go away if coronavirus was to abate (which is my hope).

The Schwab Center for Financial Research looked at past epidemics and how they have impacted the stock markets. They provided Chart #10 which shows the impact of past epidemics.  The stock market usually recovers within 3 to 6 months as the epidemic is contained.

Chart #10:  Impact of Past Epidemics

Investment Strategy for Uncertain Times

While global growth may be improving, the current investment environment is susceptible to many potential shocks.  When economies are growing slower, they are usually more susceptible to external shocks. This section reviews general topics on where to invest in the current environment. 

1. The coming decade

Given slow economic growth, high valuations, trade tensions, low interest rates, high debt and low quality debt, how should we invest starting the 2020’s? Cautiously, in my opinion.  The following view comes from Capital Management:

What should investors expect for the next ten years and how should we think about positioning for what could be a lower return environment? While we don’t know what the future may bring, the longer this liquidity fueled asset price bull market continues, the more extended valuations become. With low interest rates, modest economic growth and smaller benefits from globalization it is possible that we could be facing lower returns in both risk assets and interest-sensitive sovereign debt. We believe that a prudent, risk-aware approach focused on absolute returns with an eye towards preserving assets in down markets is preferred.  “Are We There Yet?”, Carl Kaufman, Bradley Kane, Craig Manchuck, Osterweis Capital Management

A common theme for assets over the next 5 to 10 years is shown by “GMO 7-Year Asset Class Forecasts: An Amazing Capstone to a Risk-On Year” in Chart #11.  U.S. large and small cap companies are expect to underperform due to high valuations. Bonds are also expected to underperform.  International stocks, especially emerging markets, are expected to be better performers.

Chart #11:  Expected Seven Year Returns

Chart #12:  Elevated U.S. Valuations Relative to International

2. Investment risk

Financial Industry Regulatory Authority (FINRA) has this to say about risk:

Although stocks have historically provided a higher return than bonds and cash investments (albeit, at a higher level of risk), it is not always the case that stocks outperform bonds or that bonds are lower risk than stocks. Both stocks and bonds involve risk, and their returns and risk levels can vary depending on the prevailing market and economic conditions and the manner in which they are used.

I created Chart #11 to look at how Fidelity funds performed during the 2007 recession when the S&P 500 lost about 42% using Mutual Fund Observer’s down market statistics.  These are the funds that outperformed the S&P 500.  The chart represents the average return for the past 12 years compared to the Ulcer Index (Risk).

Chart #13:  Performance of Fidelity Funds Since the 2007 Bear Market

3. Allocation

BlackRock Investment Institute’s 2020 Global Outlook is an interesting read as they have a wealth of information including risks and, of course, the shorter term 2020 outlook. BlackRock is positive on the following assets:

• • EM equities as beneficiaries from the global recovery.
  • Value due to its pro-cyclical nature and a steepening yield curve.
  • Quality as valuations have modestly cheapened including global firms that stand to benefit from improving trade activity.
  • Short term U.S. Treasuries
  • TIPS due to cheap valuations relative to current inflation levels – and potential for more price pressures due to wage pressures, an uptick in activity and longer-term deglobalization.
  • Global high yield, supported by stable monetary policy and the prospect of a growth inflection.
  • Hard-currency EM debt against a backdrop of dovish EM central banks, an improving growth outlook and a stable to somewhat weaker U.S. dollar.
  • Local-currency EM debt

2020 Global Outlook, BlackRock Investment Institute

 

4. Diversification

Jurrien Timmer, at Fidelity makes the case in 2020: Play the Middle, Protect The Tails for protecting against both deflation by owning longer duration bonds and inflation by owning gold and inflation protected bonds.

Daniel Loewy and Karen Watkin of AllianceBernstein wrote Five Multi-Asset Strategies for 2020’s Challenges.  They advocate two straight forward strategies of considering investing in Europe and emerging markets and holding on to longer duration fixed assets. Strategies that some investors may be less familiar with are investing in alternative strategies such as funds that benefit from volatility and merger arbitrage strategies. Examples of funds that that reduced volatility in my portfolio this past two weeks are The Merger Fund (MERFX), IQ Merger Arbitrage ETF (MNA), iShares Gold Trust (IAU), and AGFIQ US Market Neutral Antibeta Fund (BTAL).  They also advocate strategies that are based on fundamentals like valuations, balance sheets stimulation and inflation.

Funds for Uncertain Times

Each month, I extract data on about a thousand funds from the Lipper database using Mutual Fund Observer screens.  I rate funds and objectives based upon risk, risk-adjusted return, income, momentum, and quality factors including bond quality and stock price to earnings ratio. Table #1 contains the top Lipper Objective along with a representative component of the factors. The objective of this ranking system is to build a low-risk portfolio with high risk adjusted returns.  The way to read the table is that the S&P 500 had an Ulcer Index (Risk) of 4.4 and an average return (APR) of 21.7, a risk adjusted return (Martin Ratio) of 1.6% for the past two years.  I look for funds with lower risk and higher risk adjusted returns in each of the nine buckets. 

Table #1:  Top Performing Lipper Objectives – 24 Months Ending February 2020

Table #2 contains the top funds for each of the Top Lipper Categories for mutual funds at Vanguard, Fidelity and those available at Charles Schwab, along with closed end funds and exchange traded funds.  I use the ranking system to assess my own funds in comparison to top funds as identified in Table #2.  I make one or two small changes each month when appropriate.

Table #2:  Top Performing Funds by Top Performing Objectives

Closing

I have been positioning my portfolio optimistically and cautiously for a slow growth, high risk environment.  This month, while the S&P 500 was down 7%, my portfolio was down 1.5%.  The dip has been a good laboratory to see how my funds will perform in a down market. In March, I will use Mutual Fund Observer to identify potential funds to replace one or two of my riskier funds.  I find the new Mutual Fund Observer Portfolio Tool (MFO Premium access required) to be one of the best “keep it simple” tools for the individual investor. It gives me a quantitative method for pruning funds that no longer fit into my “sleep at night” lifestyle.

Disclaimer

I am not an economist nor an investment professional. I became interested in economic forecasting and modeling in 2007 when a mortgage loan officer told me that there was a huge financial crisis coming. There were signs of financial stress if you knew where to look. I have read dozens of books on business cycles since then. Discovering the rich database at the St. Louis Federal Reserve (FRED) provides most of the data to create an Investment Model. The tools at Mutual Fund Observer provide the means for implementing and validating the Investment Model.