Clients and friends of our firm,
As the remaining Dog Days of Summer simmer by, market volume has slumped and the market is… dare I say it?… stable. Other than the short-lived Brexit-induced volatility spike in June, the lack of volatility in the market has been particularly pronounced this summer. The market has been downright boring. Objectively and historically boring. A measure we use to track market volatility is the VIX, or Volatility Index. The VIX is known as the “Fear Gauge” because when investors rush to protect themselves in troubled times, the VIX spikes. The VIX illustrates how relatively calm the market has been. In July, the VIX fell below 12 for the first time since 2014, and in August the VIX touched a low of 11.02. At 13.99 as I type, the VIX remains well below its long-run average of 19.79.
So, the market is calm. That’s good… right?
Vacation is over. After Labor Day we expect volume to pick up. And with the renewed volume comes volatility. The September-October period is typically the most volatile period of the year for the market. We are concerned that the low VIX numbers referenced above signal investor complacency. Unwarranted complacency in our opinion. Not us. We’re not complacent. In fact, we’re a bit on edge and actively taking specifics steps to protect our client portfolios.
We don’t particularly like the current setup. Investing in the stock market inherently carries risk. Any number of unforeseen events whether of global impact (think 9/11) or company-specific (think Enron or more recently, Valeant) can quickly unravel hard-fought investment gains. But, over the long-run we have been well rewarded for taking prudent risks. But that risk / reward relationship is getting murkier as we enter the Autumn of this aging Bull market. Despite a lack of earnings gains or marked improvement in the economic picture, the market continues to grind higher. Eventually something has to give. Either corporate earnings need to rise justifying higher stock prices, or the market needs to fall to correct itself. As a result, we see an equity market with limited near-term upside, but substantial downside risk.
While stocks flirt with record-highs, interest rates are near record lows. Interest rates are typically a good economic indicator, forecasting future growth and inflation. Earlier this summer rates plunged to new, all-time lows, taking out the lows set during the Great Depression. The bond market is saying the prospects for the economy are not very good, and possibly very dire.
So given our views on current risk / reward, and the potential warning from the bond market, what is the right course of action? Our chosen course perhaps can be best described as “laying up”. Golfers will understand that immediately(1). For those of you who don’t follow the game, a player lays-up when he plays a significantly shorter shot than he is capable of hitting in order to avoid trouble; usually water, a bunker, or some other hazard. The player forgoes the glory and potential lower score for the safety of eliminating the risk of the hazard. It’s not always time to lay-up, but mature, champion golfers know when it’s time to be aggressive and when it’s time to throttle back. At this point, we’re choosing the latter.
So, specifically what does that mean? First, we’re not categorically hitting the eject button. We’re not selling everything and going to cash. We don’t see a situation like we did last August when we published our “Hurricane Warning” in belief that the market was in imminent danger of a sharp reversal (a belief that was quickly proven correct). But we do see that it is time to materially eliminate risk from our portfolios. This means we are actively reviewing our positions and selling any securities for which we cannot make a rock-solid case for holding. Further, we’re pursuing the following actions in our clients’ accounts:
· Conservative bond strategy: We are increasing our allocation to Wilbanks, Smith, & Thomas (WST) strategy to a target of 15% near term. This year, the WST fund is up 8.3% year-to-date, but the real beauty of this partner’s strategy is its downside protection. WST has a proprietary approach that rapidly exits the market in the event of an uptick in volatility. The proof? In 2008 when the stock market dropped more than 38%, the WST fund eked out a 2% gain.
· Covered calls: We are aggressively stepping up this program. By selling covered calls we enact a minor hedge for a portion of our equity positions while generating additional income. If you would like to understand more about covered calls, please let us know. Meanwhile, see the link in the footnotes for a more detailed description and video from Investopedia(2)
· International exposure: We’re now seeing comparatively better value from select foreign markets. Among the markets we like are India and Israel. India has a fast growing economy with a GDP growing more than 2X faster than U.S. As a mostly service economy, lower oil prices are a positive for India. Meanwhile, Israel has a diverse, thriving economy. In addition to the typical investment risks faced by any country, Israel bears a very real threat of hostilities from its Arab neighbors. Still, we feel we are adequately compensated for the risks of some exposure to Israel. On weakness, we will look to add to our holdings. This adds diversity as well as potential outperformance as compared to U.S. markets.
· Short positions: We are moderately increasing the size of our short positions. As many of you know, short positions perform exactly the opposite of traditional stock holdings(3). Thus, as the stock price falls, we benefit (and vice versa). Maintaining a portion of our clients’ portfolios in short positions helps to smooth performance and cushion the blow in the event of a severe market decline. We typically short the stocks of companies in which we believe there is a disconnect between the price of the stock and reality. Netflix is a current example. Although we like Netflix the company and are subscribers, NFLX is a terribly bloated stock in our opinion trading at more than 300X trailing earnings. In the event a market decline, or a general disappointment in results from Netflix, the disappointment is likely to be reflected in a severe decline in the price of NFLX shares. Note that we are not able to take short positions in most IRAs and tax deferred accounts.
One final note on account positioning in this environment; for IRAs, 401(k)s, and other tax-deferred accounts, it’s fairly easy to reduce risk by simply selling securities as there is no tax impact of taking profits within the account. For regular, non-tax deferred accounts however, we require additional scrutiny to balance the relationship between taking profits (and creating a tax bill for our clients) and reducing risk.
To toot our horn, our track record on significant market moves has been pretty darn good. A brief review:
· In March of 2015 we said “It’s Time to Take Profits”. Less than 60 days later (7/20/15 to be exact) the market peaked for the year.
· In July 2015 we continued the theme stating, “We see little reason to chase the market higher given its current valuation.” The market peaked that same month.
· In August we made perhaps our best call putting out a “Hurricane Warning”. The following week the market plummeted.
· On January 18th of this year we reversed direction and said “It’s Time to Buy”. The market (S&P 500) is up 16% from that point.
Our prior market commentary can be found here: http://www.blackwellboyd.com/blog.
Absolutely not. As Yogi Berra said, “Making predictions is hard, especially about the future.” But in making forecasts we believe it’s key to understand the risks of being wrong. In this case, the risks are quite acceptable. If the market moves higher near term there will be some lost opportunity. We may kick ourselves for missing out. Still, even so, this is a prudent move. Again, we see further upside gains as limited… for now. Meanwhile, downside risk is substantial at this point. Risks that could potentially derail the bull market are lining-up like jets on a runway. We would welcome a healthy and orderly correction for the market that could extend the life of this bull market. But “orderly” is a word that cannot always be applied to market moves. “Turbulent, panic, and chaos” are just as likely to be the descriptors, particularly as the media has a propensity to exacerbate the situation with its coverage.
Will we see that this Fall? On golf courses the distances are measured and the hazards are clearly defined. It’s all very neat and precise. We know there is a lake 200 yards away. But the equity markets take a trained eye to spot the potential water hazards and out of bounds markers. We are laying up in advance.
(1) One of the greatest movie scenes about NOT laying-up comes from “Tin Cup”. This has little to do with investing, but for your entertainment see: https://www.youtube.com/watch?v=fMOSRJKG9As
(2) For more information on covered calls, see: http://www.investopedia.com/terms/c/coveredcall.asp
(3) For more information on short selling, see: http://www.investopedia.com/university/shortselling/shortselling1.asp
(4) These materials have been independently produced by Blackwell Boyd. Blackwell Boyd is independent of, and has no affiliation with, Charles Schwab & Co., Inc. or any of its affiliates (“Schwab”). Schwab is a registered broker-dealer and member SIPC. Schwab has not created, supplied, licensed, endorsed, or otherwise sanctioned these materials nor has Schwab independently verified any of the information in them. Blackwell Boyd provides you with investment advice, while Schwab maintains custody of your assets in a brokerage account and will effect transactions for your account on our instruction.