Jimmy, Freddy the magic flute and Mayor Pufnstuf (right).

H.R. Pufnstuf was the answer to the question, “Who’s your friend when things get rough?” Pufnstuf starred in a Sid and Marty Krofft cult classic TV show which debuted during “the summer of love” in 1969 and continued in reruns as late as 1999. The show’s theme song assured us that Pufnstuff, Mayor of The Living Island, was “your friend when things got rough” because “he knew just what to do.”

(Take care with clicking on that link. I found myself humming bits of a cheery, half-forgotten, possibly drug-tinged theme song for an hour afterward.)

Jimmy, Freddy the magic flute and Mayor Pufnstuf (right).

In the series, “rough” was mostly occasioned by the evil Witchiepoo rather than interventionist bankers, inconsistent policy-makers, a rapidly mutating virus or a horde of bored new investors learning to day-trade. As little as we like it, we know that even the most brilliantly-managed, risk-conscious fund is going to suffer terrible losses if the market this fall goes to pot. (Sorry, another Pufnstuf joke.) The Great Owls, the funds with the most consistently excellent risk-adjusted returns, as a group dropped between 13% (Akre Focus, Amana Growth, Brown Advisory Sustainable Growth) and 35% (pretty much anything with “small” or “midcap” in its name) within just a couple weeks. The S&P 500 dropped 35%.

So far, those losses have proven fleeting as the fiercest declines in decades were followed by the sharpest rally. Sadly, we can’t count on that sort of rebound in the financial equivalent of “the second wave.” The losses sustained there can play with your mind, quite as much as your portfolio.

The question for us became, who’s your friend when things get rough?

Simple versus Sophisticated

One simple, perennial answer to that question is RiverPark Short-Term High Yield Fund (RPHYX/RPHIX). We profiled RPHYX most recently in 2017. Managed by David Sherman of Cohanzick Asset Management in New York, RPHYX offers an alternative to strategic cash and short-term debt funds. Mr. Sherman famously invests in orphan securities; profitable short-term investments that have very few logical buyers. Called and redeemed high yield bonds are an example. A corporation might issue a 20-year high-yield bond then, as its finances improve, it can “call” the bond; that is, announce to bondholders that it intends to redeem the bond early. That often happens when a stronger balance sheet allows a corporation to find a way out of onerous high-yield debt payments. When a bond is called, shareholders are generally entitled to one final monthly payout before redemption. On whole, high-yield managers would rather get their principal back right now so they can redeploy the cash; the gain for that last lonely payout is inconsequential to them. Mr. Sherman is willing to buy the bond from them, pocket that last all-but-guaranteed payment and redeem the bond.

Currently, he’s able to buy such ultra-low risk, ultra-short-term securities at a yield higher than the yield on a 30-year Treasury bond.

The fund is particularly attractive to investors in an environment with near-zero interest rates since his strategy is not particularly affected by interest rate moves. The Fed funds rate sat at 0.05% in May 2020, its lowest rate ever. That’s not necessarily an anomaly: the Fed maintained a fund rate under 1% for almost nine years, between 2008-2017.

Since inception, the fund has returned 2.97% annually, with returns of 3.41% during the stretch of a near-zero Fed funds rate. The fund has only had three negative quarters (-0.01 to -0.67%) in its history, it’s never had back-to-back negative quarters and its worst-ever drawdown was 1.09%, from which it recovered in a month (per Morningstar).

Its steady rise and minimal downside leaves it with the highest Sharpe ratio of any fund in existence: 2.68 over the past nine years while the next-best fund sits at 1.8. Since its inception, the fund has capture -2% of the S&P 500’s downside, which is to say that it tends to drift up as the S&P is falling. At the end of July 2020, Cohanzick laid out the case for Why this is the Perfect Market Environment for the RiverPark Short Term High Yield Fund. The fund surged to nearly $1 billion when interest rates last stayed this low and the manager closed it to new investors; during the short-lived rise in interest rates, assets migrated out and the fund drifted down to about $700 million. It would be subject to re-closure if renewed inflows jeopardized Sherman’s ability to execute on his shareholders’ behalf.

Another way of pursuing the same goal – low volatility, market-neutral returns – is provided by the MFO Premium fund screener. We looked for “alternative investment” funds that met three criteria:

1. five-year returns of 2% or more. That eliminated half of all alts funds. While you might think this is an awfully low bar, remember that you’re looking for an option for a potential bear market in both stocks and bonds.
2. an R-squared of 20 or less, relative to the S&P 500. The goal is to find funds whose returns are unaffected by movements of the stock market. An R-squared under 20 means that less than 20% of a fund’s performance is predicted by how “the market” did.
3. a maximum drawdown of 10% or less. That’s because it would not be reassuring to choose a fund “for rough times” only to discover that the danged thing occasionally loses 20 or 30% on its own.

Out of a universe of hundreds of alt funds, those three criteria leave us with a list of just 10 possibilities which I’ve sorted by their five-year returns. The highlighted funds qualify as MFO “Great Owls” for having achieved top-tier risk-adjusted returns in all evaluation periods longer than one year.

Infinity Q Diversified Alpha  (IQDAX) launched in September 2014, but it is run side-by-side with the firm’s older hedge fund. Like many hedge funds, the mantra is “we can do anything! Let’s see what works.” To describe the mutual fund as “an after-thought” is about fair. The fund’s website is virtually empty, the “investor shares” minimum is $100,000 and the expense ratio is 2.46%.

Arin Large Cap Theta (AVOLX) likewise. High minimum with a website that was out-of-style in 1994.

JPMorgan Opportunistic Equity Long/Short (JOERX) launched in 2014, with Rick Singh, a former hedge fund manager, at the helm since inception. Mr. Singh invests, long and short, in mid- to large-cap stocks based on his assessment of their valuation. He’s got the freedom to range from -30% market exposure – where the market falling by 10% would automatically boost his returns 3% – to 80%, with his next exposure last year being under 60%. His hedging has been successful enough that the fund’s bear market deviation is around 4%. It has a $1,000 minimum and a 2.3% expense ratio.

LoCorr Macro Strategies (LFMAX), a managed futures fund, launched in 2011. Managed futures work so well on paper; that vast majority of them crash-and-burn in practice. LoCorr, so far, has held on. In general, managed futures strategies identify a number of distinct asset classes then flip the switch to either invest in the asset class, or short it, depending on a variety of technical measures. The strategy here is to employ three different specialist sub-advisors, each of whom has their own strengths and specific approach. So far, their down years have seen losses of about 5% while their up years average a bit more than that. $2,500 minimum with 2.25% expenses.

Westwood Alternative Income Fund (WMNAX) launched in 2015. It uses a convertible arbitrage strategy, which sort of translates to “it buys convertible bonds issued by Company X then simultaneously shorts the common stock of Company X,” leaving it with modest, market-neutral gains. The expense ratio is just 0.77%, the investment minimum is $1,000 and the sales charge is avoidable.

JPMorgan Research Market Neutral (JMNAX) is a long-short equity fund with an 18-year track record. Most long-short funds are long-biased; that is, they act as if 60% of their portfolio is invested in stocks. That’s a fine idea of you’re competing with a 60/40 hybrid fund but less wise if you’re trying to free yourself from the effects of the market altogether. With an R-squared of just 3, JPMorgan manages that. The fund is a low minimum and it’s relatively easy to get around the sales charge; sadly, it also sports a 3.4% expense ratio. In effect, 60% of the manager’s gains are eaten by overhead expenses.

BlackRock Tactical Opportunities (PCBAX) has two words for you: “Trust us.” PCBAX is a multi-strategy hedge fund for the masses. And it is, on whole, really quite good. It’s overall correlation to the stock market is minimal and its beta is negative; that is, it tends to rise when the market falls. That might imply that it falls when the market rises which isn’t the case: over the past three years, the fund has returned 4.7% annually or just under half of the stock market’s return while harvesting virtually none of its losses. The key caveat is that the fund’s strategy changed in 2016, from tactical allocation to a focus on avoiding market risks. As a result, it’s long track record – dating back to 1988 – is largely irrelevant. That said, BlackRock is a multi-trillion manager. $1,000 minimum and 1.1% expense ratio.

Cognios Market Neutral Large Cap (COGIX) is a solid long/short fund with a market-neutral mandate and a distinctive strategy. They try to construct a “beta neutral” portfolio, which means that the size of the short portfolio is adjusted so that it contributes the same beta as the long portfolio. That allows, they believe, a more truly market-neutral portfolio. In consequence, they’ve never lost more than a fraction of one percent in a year and frequently post annual gains of 4-6%. You might review our 2016 profile of the fund for details. $1,000 minimum and 1.8% expense ratio after substantial waivers.

American Beacon AHL Managed Futures Strategy (AHLPX) is another managed futures fund. AHL is a British hedge fund firm whose parent company was founded in 1783. They use a quantitative system to toggle between long and short positions in commodities, equity, currencies, and fixed-income. Curiously, 2020 is the strongest performance since launch: they’re up 5.6% through the end of July.  $2,500 minimum and 1.9% expense ratio. American Beacon no longer sells directly to the public, so interested parties would need to work through a fund supermarket. That’s why Morningstar flags the fund’s availability as “limited,” which is usually a euphemism for “soft-closed.”

T Rowe Price Dynamic Global Bond (RPIEX) is one of a series of hedge-fund-like offerings that Price has been adding as the broad markets become less reliable. It’s a high turnover, go-anywhere fixed income fund with the ability to hedge currency and interest rate risks. The goal is “attractive” returns each year while “outperform[ing] equities and high yield in periods of market stress.” Low cost, low minimum, first-rate parent. The manager, Saurabh Sud, is a PIMCO alumnus who helped manage their Credit Opportunities fund.

Bottom Line

If I were really quite anxious about the prospects for the second half of 2020, where would I consider investing? I have had a position in RiverPark Short Term High Yield, nearly since the fund’s inception. I would be most comfortable looking at the offerings from Westwood, BlackRock, Cognios, and T. Rowe Price.

I would read rather a lot about managed futures strategies before considering either LoCorr or American Beacon. While these funds are both doing a fine job, their records are short and the same strategy in other hands has blown up with some regrettable consistency.

The two JPMorgan funds bear watching. Mr. Singh has done a very fine job though I would want to better understand his hedging since it’s challenging to reconcile a 60% net equity exposure with market-neutral performance. The Market Neutral fund’s expense ratio is troubling.

The bottom of the bottom line: get comfortable now with how your portfolio might perform over the next six months. While many starry-eyed day traders and shills see nothing but rainbows and unicorns, rather a lot of serious managers are deeply disquieted. Laura Geritz, principal of the Rondure Funds and former Wasatch manager, offered a powerful warning in her most recent letter to shareholders:

This hot, hot, hot market reminds our team of their interactions with their children and in the endeavors to teach our children about the risks and danger from the hot gas stove. Currently, when they walk by the stove, they will stick out their hands and parrot, “hot, hot, hot.” While they are able to … repeat the words we’ve tried to teach, they are failing to understand the connection to the consequences that will inevitably come … [when] there will be many, many tears.

It’s becoming more common to hear our friends and others talk about investing. The thing is, they often parrot some nugget or cliché of investing – calling out “hot, hot, hot” but their actions belie their understanding.

“Invest in what you know” … they either put all their investible assets into a single stock or daily/weekly rotate through Apple, Facebook, Tesla, Nikola, Google, Nio, and Microsoft. They don’t invest in what they know, they trade what they know – valuation agnostic.

And there will be many, many tears.

In the spring of 2019, MFO ran a two-part series on the investment implications of climate change: The Investor’s Guide to the End of the World and The Investors Guide to the End of the World, Part 2: Concrete advice. The former laid out the scientific consensus behind the human role in climate change and explained the four ways in which even the broad perception of climate change would affect your portfolio through a combination of physical, biological, regulatory, and reputational risks. We finished with three investment strategies (divest, invest, innovate) and two fund recommendations: Brown Advisory Sustainable Growth Fund (BIAWX) and Green Century Balanced (GCBLX). Since then, Brown returned 27% (versus 7% for its peers) and Green Century made 8.8% (versus 4% for its peers).

Our second article reviewed the investing recommendations of three major firms: BlackRock, the world’s largest investor, GMO and Morningstar.

This month we wanted to offer a short, research-based update. The first four updates concern the state of our understanding of the science of climate change. The remaining six look at the investment options and implications.

1. The world may have already passed peak CO2 production.

   “Climate researchers increasingly believe 2019 may represent the world’s peak output of carbon dioxide, with a combination of the coronavirus pandemic and a rapid expansion of renewable energy putting a cap on emissions years earlier than expected.

   ‘The milestone would signal a significant shift for the planet, ending decades of runaway emissions growth and signaling the beginning of a new chapter where CO2 levels start to fall.

   ‘It really shows us how close we are to turning this corner,’ said Kim Cobb, a professor of earth and atmospheric science at Georgia Tech and the director of the Global Change Program.”

   (Benjamin Storrow , “Global CO2 has risen for a century. That appears to be over,” E&E News, 6/1/2020)

2. The current “worst case” projections are less apocalyptic than they once were.

   “…the plateauing of carbon emissions is encouraging for several reasons. First, it suggests some dire scenarios by the U.N.’s Intergovernmental Panel on Climate Change—previously seen as inevitable, absent dramatic government action—are actually pretty unlikely. Second, it gives the world more breathing room to figure out how to decarbonize faster.”

   (Greg Ip, Coronavirus Is Buying Time on Climate Change. Will We Make Use of It? paywall, Wall Street Journal, 5/28/2020)

   Sadly, the same thing is true of the “most hopeful case.”

   “A team of 25 scientists from around the world published, July 22 in Reviews of Geophysics, [research that] showed that the planet would most likely warm on average between 4.7 degrees Fahrenheit and 7 degrees Fahrenheit (2.6 degrees Celsius and 3.9 degrees Celsius) if atmospheric carbon dioxide were to double. … that’s much smaller than prior estimated range of 2.7 and 9.1 degrees Fahrenheit (1.5 and 4.5 degrees Celsius) that had been the reigning benchmark for decades.

   The new, narrower estimate for climate sensitivity has huge implications, not just for climate science, but for how humanity prepares for a warming world. It shows that the worst-case-scenario is not as dire as previously thought, but also that the best possibilities are still quite grim. In particular, it means that it will be almost impossible to hit the main target of the Paris climate agreement, limiting warming to less than 2 degrees Celsius (3.6 degrees Fahrenheit) this century, by chance; it will require aggressive action to reduce emissions with even less margin for delay.”

   (Umair Irfan, “Scientists have ruled out the worst-case climate scenario — and the best one too,” Vox, 7/31/2020)

3. The scientific consensus on the human role has now reached 100%.

   “Scholars responded to the controversy by surveying the opinion of scientists. The results of eight such studies conducted between 2009 and 2015 showed a consensus on AGW ranging from 83.5% to 97%. But given the ingrained caution of scientists and their reluctance to affirm findings outside their own field, opinion surveys are likely to underestimate the consensus. The consensus among research scientists on anthropogenic global warming has grown to 100%, based on a review of 11,602 peer-reviewed articles on ‘climate change’ and ‘global warming’ published in the first 7 months of 2019.”

   (James Powell, “Scientists Reach 100% Consensus on Anthropogenic Global Warming” Bulletin of Science, Technology & Society, 11/29/2019)

4. The pandemic has had a dozen impacts, good and bad, on the global climate and efforts for climate change management.

   “As a result of the lockdowns around the world to control COVID-19, huge decreases in transportation and industrial activity resulted in a drop in daily global carbon emissions of 17 percent in April. Nonetheless, CO2 levels in the atmosphere reached their highest monthly average ever recorded in May — 417.1 parts per million. This is because the carbon dioxide humans have already emitted can remain in the atmosphere for a hundred years; some of it could last tens of thousands of years.

   Beyond carbon emissions, however, COVID-19 is resulting in changes in individual behavior and social attitudes, and in responses by governments that will have impacts on the environment and on our ability to combat climate change. Many of these will make matters worse, while others could make them better.”

   (Renee Cho, “COVID-19’s Long-Term Effects on Climate Change—For Better or Worse,” Earth Institute / Columbia University, 6/25/2020).

   Two points that Ms. Cho makes clear: (1) the substantial reduction in CO2 this year is close to inconsequential and (2) managing the pandemic might restore the citizens’ faith in science and in working today, and raise their caution about grandstanding politicians.

5. There are prospects for widespread financial failures in fossil fuel extraction companies.

   “The fossil fuel system is being disrupted by the forces of cheaper renewable technologies and more aggressive government policies. In one sector after another these are driving peak demand, which leads to lower prices, less profit, and stranded assets. The COVID-19 crisis is now accelerating this.

   Our analysis finds falling demand, lower prices and rising investment risk is likely to slash the value of oil, gas and coal reserves by nearly two thirds, increasing the risk and likelihood of stranded assets.”

   (Decline and Fall: The Size & Vulnerability of the Fossil Fuel System, 6/4/2020)

6. There is a huge amount of money to be made in post-carbon economy investments.

   “The low-carbon economy is emerging as a major U.S. employer, though COVID-19 is threatening that progress. In the power sector, zero-emissions generation like solar and wind was responsible for about 544,000 jobs in 2019, more than twice as many as the 214,000 jobs in fossil fuel generation. $1 million spent on clean energy in the United States generates more than twice as many jobs as $1 million spent on fossil fuels in the short- to medium-term.

   Emphasis on low-carbon technologies can help the United States to boost its manufacturing sector and secure a share in the booming domestic and global cleantech market. The U.S. advanced energy industry generated $238 billion in revenue in 2018, about 15% of the global total. That’s roughly equal to that of aerospace manufacturing and double that of the biotechnology industry.”

   (Devashree Saha and Joel Jaeger, America’s New Climate Economy, July 2020)

   Some analysts, by the way, believe that this will be another driver favoring the dominance of growth investing over value, since these advances will likely most benefit fast-growing tech companies.

7. ESG-screened funds, on whole, outperformed during the 2020 turbulence.

   “Earlier this year, Morningstar published a wealth of research on the nexus between ESG and risk. One study, “ESG Indexes Protect on the Downside,” concluded that 72% of Morningstar equity indexes that incorporate ESG screens lost less than the market during down periods for the five years through the end of 2019. It also found that the ESG indexes are more likely to select companies that are competitively advantaged and financially healthy, which undoubtedly contributed to their ability to reduce volatility.

   Obviously, much has changed in markets since the end of 2019. The rapid, violent sell-off in first-quarter of 2020 offers an excellent follow-up opportunity to look at the performance of our ESG-screened indexes. We found that 51 of Morningstar’s 57 ESG-screened indexes, or 89%, outperformed their broad market equivalents in the first quarter of 2020. This is consistent with the conclusions that Morningstar director of sustainability research Jon Hale outlined in his article, ‘Sustainable Equity Funds Are Outperforming in the Bear Market.’”

   (Dan Lefkovitz, “How Did ESG Indexes Fare During the First Quarter Sell-off? Morningstar.com, 4/8/2020).

8. The number of ESG-screened choices is huge and rising.

   Investors have a choice of 623 “socially conscious” funds and ETFs. Nearly 10% of those have been launched in the past year. New ESG funds are being registered at the rate of about five a month.

9. ESG funds represent two fundamentally different impulses: doing no harm versus making a difference. The former are generally designated as “ESG-screened” funds, the latter as “impact funds.”

   “Impact funds are often focused on specific themes, such as low carbon, gender equity, or green bonds (which fund new and existing projects with environmental benefits).”

   Karen Wallace, “Interested in Sustainable Investing? Here’s What You Need to Know About Sustainable Funds,” Morningstar.com, 2/11/2020).

   In some cases, “impact funds” are willing to accept somewhat lower short-term returns, especially in the case of bond impact funds, in exchange for fostering social or environmental goals supported by their investors.

10. There are great free tools to allow you to look before you leap.

    Morningstar’s sustainability assessment of equity funds is available on every fund’s portfolio page. Here, for example, is Fidelity Contrafund (FCNTX).

    MSCI recently made access to their ESG rating system available for thousands of funds and stocks. Where Morningstar’s ratings are titled toward environmental sustainability, MSCI’s offer a balance of factors. Here’s the top of their Fidelity Contrafund report.

    

I listened to Peter Navarro’s lecture, “The Modern Scholar: Principles of Economics: Business, Banking, Finance, and Your Life” (2005) on a recent return flight to the U.S. The discussion on budget deficits was timely. The planes, airports, and hotels had very few travelers. The hotel shuttle to the airport was not running. Coronavirus cases are increasing with vaccines not expected until early 2021. For reasons described in this article, I reduced my exposure in July for stocks from 25% to 20% by trading higher-risk funds that have risen this year for less popular funds such as value as well as funds to reduce downside risk.

This isFelix. She made numerous edits to this article for me.

Source: Felix

In Conservative Portfolios of Funds for This Bear Market last March, I explained my approach to investing according to the business cycle. This article describes how I am shifting from a “returning to growth” scenario to a more defensive one. My sentiment for the month comes from the investment team at Wealthspire Advisors in Another Ride on the Roller Coaster?, who wrote the following statement:

“…you have enjoyed a ten-year bull market and can now meet your financial goals while taking less market risk… Deciding to de-risk now, after the market rebound, is much more tenable than doing so earlier in the year. If your first trip on the roller coaster was not an enjoyable one, you are not obligated to withstand a second ride.” –  

Seeking Safety in Portfolios

As the markets recovered this year and coronavirus cases began increasing, I exchanged riskier funds such as growth, retail, telecommunications, pharmaceuticals, emerging markets, clean energy, and real estate for lower-risk funds such as those shown in the following table.  

Table #1: Defensive and Conservative Funds – YTD

Created by the Author Based On Mutual Fund Observer

The following chart shows gold, the Vanguard LifeStrategy Income Fund, and Hussman Strategic Total Income Fund compared to the S&P 500 following the start of the 2007 bear market. It took 5 years for an investment in the S&P 500 to get back to even from October 2007, and another year to surpass the conservative funds.

Figure #1: Fund Performance Oct 2007 – Aug 2013

Buy “Low, Sell High” or “Let Your Winners Ride”?

The following figure from Fidelity shows the winners and losers since March. If we are in a growth mode then “Letting Your Winners Ride” may be the best strategy. If the recession is going to be more protracted than many realize then it may be best to “Sell Your Winners” and buy the laggards. The second quarter Gross Domestic Product fell 9 percent compared to a year ago. The latter is my preferred option and I have sold “Large Growth” and added a Europe Fund and more “Value” Funds.

Figure #2: Fund Performance since March

The Bucket System

Investors use the Bucket approach to match market risk with withdrawal needs. I use a four Bucket Approach based on the Ulcer Index with “1” having the risk of money markets and short term treasuries and “4” having the risk of the S&P 500 or higher. Rank in the table refers to my Ranking System where 100 is the best and zero the worst. Rank is based on risk, risk-adjusted return, income, momentum, and quality factors. To reduce risk in July, I shifted funds from Bucket #4 to safer buckets. For diversification purposes, I have a bucket set up for International/Global Bonds and one for International/Global stocks. I have a separate bucket for Income because high-income funds usually come with their own set risks. Finally, I have two buckets set up to track the business cycle as “Inflation” and “Defensive”. The following table shows the automated results of about a thousand funds extracted using Mutual Fund Observer for the top Lipper Category for each of the buckets. By comparison, the Ulcer Index of the S&P 500 is 6.2 and the Martin Ratio is 1.1. As a general observation, the top-rated funds have an Ulcer Index less than the S&P 500 and a Martin Ratio close to 1.0 or higher. The detailed results of my Ranking System can be found in Mutual Fund Observer July 2020 Update at Seeking Alpha and the July update will be posted next week.

Table #2: Top Ranked Lipper Categories since January 2018

Created by the Author Using Mutual Fund Observer

Current Investment Environment

According to an Axios poll, Americans are beginning to realize that coronavirus is going to be around for a while. I think it is a matter of time before this sentiment is reflected in the markets.

This week’s poll findings suggest that Americans are grappling with the reality that the virus isn’t going away anytime soon.

According to the Federal Reserve Bank of Philadelphia’s second-quarter Survey of Professional Forecasters, labor markets and the economy are unlikely to return to 2019 levels until 2022 or later as shown in the table below.

Table #3: Economic Forecasts

Source: Federal Reserve Bank of Philadelphia

The price that investors are paying for a dollar of earnings (P/E) has increased to 28 as shown in the following figure.

Figure #3: Price to Earnings Ratio

Source: Stockcharts

Price to earnings ratios are biased by the effects of the business cycle and share buybacks. In the figure below, I show market capitalization (purple), consumer spending (PCE, green), and corporate profits (red). Quantitative Easing has inflated asset prices since 2012 while profits have been declining.

Figure #4: Profits (red), Consumer Spending (Green), Market Value (Purple)

I created the following chart at the St. Louis Federal Reserve FRED website to measure valuation. The green line is Warren Buffet’s favorite indicator of the stock market capitalization to the gross domestic product which some investors don’t like because companies have become more global. The Orange line is market capitalization divided by profits which the same investors may not like for the same reason. The Blue line is Tobin’s Q Ratio of Capitalization to Replacement Value. These metrics show valuations are high historically.

Figure #5: Stock Market Valuations

Created by the Author Using St. Louis Federal Reserve FRED

The following chart is from Liz Ann Sonders at Charles Schwab, “Running on Faith: Are Stocks Discounting Too Powerful an Earnings Recovery?” The chart shows that the market capitalization of Apple, Microsoft, Amazon, Google, and Facebook now represent nearly 23% of the S&P 500 market capitalization. Seriously?! One percent of the companies in the S&P 500 has a market capitalization of 23%. Seriously?! I don’t take comfort that the P/E of these 5 companies is only 60% of the 2000 peak.

Figure #6: Market Weight of Top Five Stocks

Insured unemployment is over 16 million people, and more companies filed for bankruptcy in the first half of 2020 than any year since 2012. This includes large companies such as well-known names like Hertz, Latam Airlines, Frontier Communications Corp, Intelsat, McDermott International, JC Penney, and Neiman Marcus.  

The following figure shows that banks are tightening lending standards and delinquency rates are rising. Financing by riskier companies and individuals will become more difficult or expensive. Note also the decline in private investments. Credit finances economic growth, and tighter credit will dampen economic growth.

Figure #7: Banks Tightening Lending Standards and Delinquencies

Created by the Author Using St. Louis Federal Reserve FRED

Federal Debt is nearly $24 trillion and the interest payments to finance the debt is nearly 600 billion dollars per year! Interest payments as a percentage of GDP are rising, but not near the levels of the 1980s.  

Figure #8: Federal Debt vs Interest Payments

Created by the Author Using St. Louis Federal Reserve FRED

The stimulus is likely to keep interest rates low for years. The velocity of the money supply and price pressures probability indicate that near-term inflation is likely to remain low and deflation is more likely than inflation. The falling value of the dollar and de-globalization may impact this in the longer term, raising concerns of stagflation.

With spare time traveling, I read 10 Major Investment Implications (and 32 charts!) of a Weak US Dollar by Bryce Coward of Knowledge Leaders. He makes a strong case for the dollar weakening further because the federal deficit is increasing as a percent of GDP and the Federal Reserve increasing money supply faster than the European Central Bank, among other reasons.  

Figure #9: the US and Eurozone Money Supply Growth

What this implies is a leadership change in markets, and I list Mr. Coward’s key takeaways:

• Technology, which has been THE leadership group over recent years, is highly unlikely to continue to lead if the USD weakens on a secular basis
• Areas of the equity market where investors are most underweight (value, international, smaller companies, EM) tended to do the best in a falling USD environment
• Hard assets outperformed stocks in falling USD periods
• Credit outperformed stocks in falling USD periods

An article from Fidelity points out the falling dollar may reflect investors’ views that international stocks, where coronavirus is more contained, may outperform US equities in the near term.

Secular Trends  

Lance Roberts provided the following figure in The Odds Are Stacked Against Investors In A Post-Covid Economy that shows that since 1871, the stock markets have returned a steady history of growth when adjusted for inflation. Using the S&P 500 Return Calculator, stock markets would have had approximate annual returns of 4.5% nominally or 9% with dividends reinvested since 1871, or 2.4% after inflation and 6.9% with dividends reinvested. The decades-long periods where the markets are falling are known as secular bear markets while the long periods when the market is rising are known are secular bull markets. US markets are currently well above the regression trend suggesting a long period of low returns will follow.  

Figure #10: Inflation-Adjusted Stock Market

Source: Real Investment Advice, Lance Roberts

Earnings per share are highly dependent upon the business cycle and so they are often adjusted to reflect longer-term trends which are referred to as cyclically adjusted price to earnings (CAPE) ratio. Mr. Roberts shows the inflation-adjusted market prices and the CAPE ratio since 1871. The cyclically adjusted price to earnings ratio is currently at historical highs. Two of the reasons for this are asset price inflation (high valuations) due to quantitative easing and low-interest rates.  

Figure #11: Inflation-Adjusted Stock Market, CAPE, and Reversions 

Source: Real Investment Advice, Lance Roberts

Ed Easterling at Crestmont Research shows the expected 10 year returns based on starting valuations at the beginning decade. This decade is starting with a historically high cyclically adjusted price to earnings ratio. The implication is that returns over the coming decade are likely to be in the low single digits or even negative. For more information on Market Valuations by Ed Easterling, I suggest reading Crestmont Market Valuation Update: June 2020.

Figure #12: Rolling 10 Year Stock Returns vs Starting P/E

Source: Crestmont Research

John Hussman Ph.D. and President of Hussman Econmetrics Advisors, in Fundamentally Unsound shows that according to the relationship of market capitalization to Gross Value Added that the historical relationship points to negative returns over the next 10 years.

Figure #13: 10 Year Stock Market Returns vs Gross Value Added

Source: Hussman Strategic Advisors

S&P 500 earnings for the second quarter are estimated to be more than 50% below those one year ago. The price to earnings ratio based on the second quarter is over 30 based on operating earnings. Including the CAPE and P/E, all five valuation methods show the market is highly valued.

Lessons from the Current Secular Bear Market

During the past 25 years since 1995, the Vanguard Wellington with about 60% stock and 40% bonds has performed as well as the S&P 500 (left), but with less volatility. Vanguard Wellesley with about 40% stock has done well. The link to Portfolio Visualizer is provided here. If you change the starting year to 1998 (right) to exclude the run-up to the Technology Bubble then the Vanguard Wellesley performed as well as the S&P 500 due to losing less during the recessions.

Figure #14: 25 Year Vanguard Mixed Asset Returns vs S&P 500

Created by the Author Using Portfolio Visualizer

The next chart shows the S&P 500 compared to international and global funds. For long periods, the S&P 500 has over or underperformed international markets. The US stock market has over-performed international markets for much of the past decade and valuations are higher in the US suggesting that some exposure to international markets may be prudent.

Figure #15: International Returns vs S&P 500

Created by the Author Using Portfolio Visualizer

Portfolio Strategies that Manage Risk

How do you manage risk? Graham suggested in The Intelligent Investor a guiding rule that the investors should never have less than 25% nor more than 75% of their money in stocks. Warren Buffet is a value investor who builds up cash as valuations rise as shown by Lance Roberts. Institutional investors have been increasing cash as well.

Figure #16: Berkshire Cash Holdings

Source: Real Investment Advice, Lance Roberts

As a simple example of managing risk, the chart below is based on switching allocations to Vanguard stock, bond, and mixed asset funds to maximize return for maximum volatility of 10% (red line). Over the past 25 years, it has returned as much as the S&P 500, but without the volatility. The link to Portfolio Visualizer Rolling Portfolio Optimization is provided here. Last month, I celebrated my birthday working internationally. At 65 years of age, the average life expectancy of a male is 84 years. Downturns matter to retirees, but also raise the risk to those who may need access to savings.  

Figure #17: Maximum Return of Vanguard Funds @ 10% Volatility

Created by the Author Using Portfolio Visualizer

Figure #18 shows the changes in investments for the same scenario. Allocations don’t change much except during recessions.  

Figure #18: Asset Allocation for Maximum Return of Vanguard Funds @ 10% Volatility

Created by the Author Using Portfolio Visualizer

Table #4 shows the statistics for the above scenario, a buy and hold strategy of equal proportions, and the S&P 500.  

Table #4: Managed Volatility Strategy vs S&P 500

Source: Created by the Author Using Portfolio Visualizer

Investment Model

Over the past ten years, I built an investment model as described in Rules-Based Investing – Rule #4 Pursue Investments Appropriate for the Business Cycle and Long Term Trends. The goal is to change allocations to stocks and bonds based on risks and returns measured in the business environment. One view of the model is shown below which represents allocations to stocks, bonds, and cash. The model began increasing allocations to cash and bonds in early 2018. The model also allocates up to 10% of the portfolio in defensive funds (red). The model is intended to reduce risk while keeping risk-adjusted returns high. It returned 9.9% while the S&P 500 returned 9.8% over the same time period. These funds are listed at the beginning of the article including gold but don’t necessarily include bearish funds such as inverse funds.  

Figure #19: Author’s Investment Model Allocations

Source: Author

Closing

Stock markets typically go up before presidential elections. My investment strategy at this time is to make modest returns with limited downside exposure until the recession has ended and there is a resolution of coronavirus. I believe there will be more attractive buying opportunities for US stocks in 2021 or 2022.  

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.

Value investing – the simple notion that it’s not a good idea to overpay for the stuff you buy – makes enormous intuitive sense. Two indisputable facts about value investors:

1. In the long run, they crush growth investors

   A July 2020 research note from the Bank of America reports that “from 1926 to now, value investing has handily outperformed growth investing, notching a gain of 1,344,600% versus growth’s gain of 626,600% over that same time period” (Matthew Fox, “Value investing has been ‘broke’ since 2007,” Business Insider, 7/14/2020

   As recently as the end of 2018, the since-inception record (1992-2018) for Vanguard Value Index (VIVAX) still trumped Vanguard Growth Index (VIGRX).

2. It hasn’t been “the long run” for a long time.

   Since emerging from the Global Financial Crisis (2007-2009), growth stocks have been on a tear often led by a small group of stocks whose valuations could be justified only if you assume that their corporate growth will extend unbroken for between 50-250 years. To get a sense of the magnitude of the divergence, I used to screener at MFO Premium to find both the best fund and category average in value and growth for the past 10 years.

   10-year Value	Gap	10-year Growth
   Smead Value SMVLX 12.8% Average: 10.1	760 bps	Invesco QQQ Trust 20.4% Average 16.2%
   WisdomTree US MidCap Dividend DON 11.3% Average: 8.7	980 bps	T Rowe Price New Horizons PRNHX 21.1% Average 14.1%
   SPDR S&P 600 SCV ETF 10.9% Average: 7.2%	600 bps	Wasatch Ultra Growth WAMCX 18.9% Average 13.2%

   It’s painful enough to note that the best growth fund in each size crushed the best value fund by 600-1000 bps.

   It’s more painful to note that the average, run-of-the-mill, no-possible-reason-to-own-it mediocre growth funds beat the very best value fund in its size category by 600 bps in the same period.

   Things have only gotten worse during the coronavirus pandemic with absolutely historic divergences of 2,000 bps between growth and value. Research Affiliates now tags the growth – value divergence at being at the 100^th percentile; that is, there has never been a more extreme split between the two (Rob Arnott, et al, The reports of the death of value may be greatly exaggerated, May 2020).

Value investors, especially dedicated value boutique firms, have suffered tens of billions of outflows, enough to threaten the survival of some small- to mid-sized firms. That’s especially troubling for a couple of reasons.

First, value investing’s absolute returns have been perfectly respectable. Booking 10% annual returns, which was easily achieved in all three value sizes, is exactly in-line with the returns of the US equity market over the past century. It’s only the dizzying returns available from growth strategies that make it look unattractive.

Second, value is quite capable of crushing growth in the decade ahead. One of our worst cognitive biases is assuming that the future is here; that is, we project whatever we’re experienced right now and assume that it will continue unabated.

Mr. Arnott of Research Affiliates argues that “the stage is set for potentially historic outperformance of value relative to growth over the coming decade” (May 2020). Their research on “broken asset classes” (June 2020) – that is, stuff written off for dead – concludes that value might outperform growth by 13-15% a year for much of the decade. The chief strategist for Bank of America (July 2020) offers seven reasons why value might surge, offering the 95% prospect of a substantial period of substantial value dominance.

The key is making sure that there are first-class value investors available to you so that you have the opportunity to profit from that turn.

FPA and Queens Road have entered a promising partnership to help guarantee it.

On July 30, 2020, the two announced a strategic partnership for FPA to oversee and market the Queens Road Funds and related institutional separate accounts. Two related developments:

• both Queens Road Funds will plan to offer an institutional share class with materially lower expenses with the goal of offering “below average” expenses in the Morningstar institutional class categories
• FPA Capital Fund will be merged into the new Queens Road Small Cap Value institutional class once the Queens Road funds have migrated to the FPA platform. As many as possible of Queens Road’s investors will be shifted to the lower-cost institutional classes.

Who wins from this integration? Off-hand:

These really are famously good!

Queens Road wins. Manager Steve Scruggs and his team have a remarkable track record of 18 years, consistently offering solid returns paired with some of the best risk scores for any fund in their category. Nonetheless, they’ve gotten little traction in the market which keeps them from being able to develop the economies of scale that would benefit their investors. Both the strength of  FPA’s institutional relationships and the inflow from the FPA Capital merger will help reverse that. And they believe that their styles and cultures are well-aligned. Mr. Scruggs noted, “we declined numerous offers from other firms who wished to partner with us. But when FPA suggested working together, we were immediately interested. We have followed FPA for several decades, and similarly embrace a long-term, value-oriented approach, capacity discipline, and shareholder focus.”

FPA wins. With the spin-off of their two international and world funds to Polar Capital completing later this year, closing FPA New Income (FPINX) to new investors, and eventually merging away FPA Capital, FPA is creating on-hand administrative and marketing capacity. The addition of the Queens Road funds allows them to use that spare capacity to generate additional visibility and assets. It also offers attractive options to FPA investors who might be growing concerned that the FPA lineup is thinning.

FPA Capital shareholders win. In the merger with Queens Road Small Cap Value, they move from a closed, underperforming fund that charges 0.92% to a really first-rate fund that will be charging 0.89%.

Other small, value-oriented managers win. To be blunt, the “go it alone” approach is a disaster waiting to happen. The long-term survival of independent managers is in the hands of two groups: professional advisors and online supermarkets such as Schwab and Fidelity. Neither group is hospitable to small, independent operations; both want to see hundreds of millions in assets, which demonstrate “viability,” before even engaging. But the hundreds of millions are almost impossible to secure without the active support of professional advisors and online supermarkets.

The ability to join with like-minded managers in an arrangement that maintains the independence of the teams while creating a critical mass of resources seems vital, especially now. In some ways, it was pioneered by Steve Romick’s own decision to bring his Crescent Fund to FPA in 1996 and is comparable to the highly-successful model used by Artisan to aggregate and support – but not constrain – “category killing” management teams under the Artisan umbrella.

For the benefit of interested parties, the Observer published an updated profile of Queens Road Value in July 2020 and we’re publishing a short profile of Queens Road Small Cap Value in this issue, August 2020. They are both exceptional funds, well worth your interest.