Category Archives: Portfolio Management

Fixed Income, Nov 2017

In this post I’ll go over my fixed income (FI) allocation as well as sharing the outlook and plan for navigating the next bear market. Currently, FI occupies 22.3% of the total portfolio, not counting 5.6% in cash equivalent (3.6% of the 5.6% is the emergency fund in a CD ladder, the rest actual cash). It has fluctuated between 22 and 24% over the past year and I may deploy some cash by year-end to get closer to 24% again. Detailed breakdown is shown in the table below.

My general philosophy is to treat FI as another source of return, contrary to the Boglehead/Bernstein teaching of taking risk in equities only, but consistent with modern portfolio construction methods such as risk parity, max diversification, min correlation, etc. What I ended up with is a “bar-bell” in risk profile where stable value funds in passive is counter-weighed by leveraged CEFs in active.

The stable value funds are in the 401K’s and have a combined yield around 2.5%. $PCI/$PDI/$PFN are Pimco taxable multi-strategy CEFs, and $BGB is a Blackstone bank loan CEF. The current yields are 8.65%, 8.76%, 8.96% and 7.98%, respectively. These four are in tax-advantaged accounts. Pimco has paid a year-end special in the past but I’m not too hopeful this year. $NAC and $PCQ are two CA muni CEFs in taxable accounts, currently yielding 5.12% and 5.38%, respectively, federal and CA tax free (though $NAC has some AMT). The Pimco taxable CEFs in particular have had good capital appreciation with total returns exceeding that of S&P in 2016/17. When comparing with benchmarks, I expect greater out-performance from my FI vs. $AGG than individual stocks vs. $SPY.

Above is a correlation matrix between the total stock market ($VTI) and the CEFs from My rule of thumb is to assume a 0.4 correlation between the Pimco taxable CEFs and stocks. The muni CEFs show near zero correlation to stocks but don’t quite provide the negative correlation during a crisis. Therein lies the rub: the CEFs provide excellent returns during bull markets but are likely to drop along with stocks in bear markets. This lends itself to market timing where CEFs are swapped with treasuries, which is my plan for the taxable CEFs. The Pimco CEFs are “unproven” in bear markets. Even if they navigate skillfully, investors may still punish them, leaving exploitable discounts. These are opportunities not available in open-ended mutual funds. As for the muni CEFs, trading may not be worthwhile if the bear market is as brief and shallow as I expect. The $TNX (10 year yield x 10) chart below was shown two weeks ago. I’d like to re-balance “into” treasuries rather than “out of” existing holdings. The yield won’t go up in a straight line, however I’m expecting 2.8% first and then above 3% during this bull market.

The PortfolioVisualizer table also shows the volatilities of the CEFs which are on par with that of $VTI. When correlations vanish risk parity degenerates into volatility parity; when the volatilities are equal it degenerates again into equal weight. So the data is suggestive of replacing the cash portion of a Permanent Portfolio with $PCQ. I’ll write about this in a future post.

Towards the end of The Next Bear Market, I painted a rather bleak picture of an investment landscape where the equity risk premium has either diminished or disappeared due to “over grazing” by investors enamored with stocks and the performance assurance from passive buy-and-hold. Fixed income, properly leveraged, may offer a ray of hope in this new world. After all, the FI universe is far greater than equities both in size and variety. It may be the last refuge of active managers.

None of the above is investment advice, the standard disclaimer applies.

The Next Bear Market

My current bullish market outlook notwithstanding, I want to look ahead to the inevitable next bear market. To give some context, I have written about a “post-August moonshot” and a “12-18 months” maniacal phase leading to a target of 10,000 on the NDX and about 3500 on the S&P. Together these projections should provide enough contour of an anticipated top. I like to think ahead so as not to get caught unprepared when changes occur. Being early also gives me a claim to some originality of thought then the time does come.

Readers should know I’m a habitual violator of the cardinal rule of making predictions on the stock market: target price or time but not both. It’s a luxury reserved for a no-name blogger with zero reputation to lose. On the other hand, I have my own money on the line and disclose the transactions and results every week and every month. When real money is involved, doubt, conviction, hope and regret have nowhere to hide. It is not sufficient to make correct projections, there also has to be enough conviction to capitalize on them. In the end, the only arbiter is the balance in the account.

Big Picture

In terms of the big picture, the view that most resonates with me is that of of Chris Ciovacco. He has a YouTube channel and here is a clear enunciation of his views: we have broken out of a 17 year consolidation box and is embarking on a decade plus journey higher.

Another key understanding relates to the length of the current bull market which many put at over 8 years counting from the Mar’09 low. Putting aside the argument that a bull market does not start until the previous high is exceeded, cases can be made for both May-Oct’11 and Aug’15-Jan’16 being bear markets (source), which resets the clock on the current bull to less than 2 years.

The Next Bear Market

The model I follow does not have a good record of predicting bear market bottoms which tend to overshoot the model prediction (I don’t plan on giving details of this model on this blog). My current interpretation is for a regular bear of a decline of 20-30% in the S&P for a duration of 12-18 months. In (very) rough round numbers, that’s from 3500 back down to 2500 on the S&P. The important take-away is that I don’t expect it to be the comeuppance that many doom-and-gloomers are calling for. The 50+% decline of the GFC has scarred a generation which paradoxically means it won’t happen again until the memory fades.

Defensive Measures

Execution is what separates a practitioner from a prognosticator. With a 30% decline that may take 1-2 years to recover, both holding tight and some defensive maneuvering are viable strategies. In a blog post as far back as May’17, I discussed my defensive asset allocation for the passive accounts: 40% equities, 45% fixed income and 15% PMs. Within equities I removed REITs, small tilt and EM. The FI allocation is modified to include bonds, treasury in particular instead of stable value exclusively. Most of the passive accounts are in 401K or Roth so there is no tax consequence for making these adjustments. The exact allocation will depend on the availability of funds in each account but there has been no change in the overall direction.

In the active accounts, the consideration is more complex. It’s reasonable to expect a deeper drawdown in tech which is the vessel of the current bubble. That said, given the taxes (includes CA taxes for me) and uncertainty in timing, selling then re-buy in taxable accounts is not a slam-dunk proposition. It’s much more advisable to hedge especially if one believes the overall technology trends are still intact and the bear market is just a reset of expectations. There are several workable option strategies for both individual stocks and indexes that are similar to the inverse of what I’m using for the current bull market.

At this moment, I expect both treasuries and PMs to be bid during the next bear market. Treasuries may be something to “re-balance into” when the 10-year yield gets above 3%, while PMs will likely be the next bubble where gold gets up to $3500-5000/oz. In short, there will be plenty of sources of return to keep the portfolio growing during this phase.

Impact of the Passive Investors

In Some of You Will Sell or the Achilles Heel of the Arithmetic of Active Management I discussed two type of passive indexers: type A who buys no matter what and holds through the bottoms and type B who sells at the wrong time. Since emotions have been shown to conspire against investors the assumption is that on net passive indexers will achieve less than market returns due to poor timing of type B indexers. From the large number of type B indexers we can expect a sharp decline. Conversely, type A indexers will temper the depth of the market bottom and set the tone for a gradual recovery. This understanding should inform the profile of the hedges to be put on. Moreover, the P/E at the next market bottom should be elevated vs. historical averages which will prevent many from recognizing it until much later.

I remain convinced that active to passive is a secular shift that won’t abate in the next bear market. It’s not obvious that the average active mutual fund can out-perform in a bear market. The trend will continue until easy-to-exploit inefficiencies appear. Will it be some float based mechanism? Who knows. The deeper question is what happens to market returns in the mean time.

The Other Side of The Next Bear Market

In Diversification, Adaptation, and Stock Market Valuation, Jesse Livermore (pseudonym) at PhilosophicalEconomics poses a fundamental question about the equity risk premium. If buy-and-hold stocks is such an EASY way to achieve superior returns (remember the next bear market will be shallower and briefer than most doom-and-gloomer will have you believe), then why should it offer superior returns in the first place? If the equity risk premium should decrease or disappear, we should expect the baseline P/E level to increase and future returns to be commensurately diminished.

My current projection of the 10-year equity return is under 4.5% nominal. Coupled with 10-year bond yield under 2.5%, things do not look good for current and recent retirees. Based on these numbers, I predict that the 4% rule will fail for the Jan 2000 cohort, see the 2000-2016 case study at EarlyRetiremenNow. This is preventing me from fully embracing the optimistic views of Chris Ciovacco. It’s possible that the current QE fueled bubble is pulling forward some future returns, further suppressed by higher future baseline P/Es.

Popularity sows the seed of its own demise in financial markets even for a high-capacity strategy like market cap indexing. If too many people try to make a living from market returns, then there won’t be enough to go around. The democratization of investing may distribute equity returns more fairly but at the expense of making them anemic for everyone. One can argue that economic expansion and productivity gains will save us but I’m not so sanguine given demographics and the move from DB to DC retirement plans. Let’s hope an answer emerges soon. In the mean time, there’s an exciting and hopefully profitable ride ahead of us.

On Bubbles

Charlie Bilello from Pension Partners pointed out that the CAPE is now over 30. His piece is balanced and well written as always but it won’t prevent others from using the data to once again proclaim that the market is expensive and that we’re in a bubble, etc. So far so good and I might even agree. But if the implication is that there is impending doom then I have to beg to differ.

Many writers, the eminent Larry Swedroe among them, have argued that the historical context of the P/E ratio has evolved. I find no reason to doubt them, so let’s take the shorter term relative movement as an indication of multiple expansion or contraction. In 1921-29, the CAPE ratio went from 5 to 30, for a gain of 6X. In 1982-2000, the CAPE ratio went from about 7 to 44, another 6X. The CAPE low of 2009 was about 12.5. Now I’m not about to forecast a CAPE of 75 (although within the realm of possibility, cf. Japan 1990), but surely an increase of mere 2.5X can’t be the end of this bubble if it can be called such? If this is indeed the coming-home-to-roost of all the QE by all the central banks since the great financial crisis then we will have much, much further to go. To say otherwise is to say “this time is different”.

I have been saying on this blog since last November that we’re entering a generational bull market. Currently the model is seeing a consolidation low in July, flat in August, but a truly maniacal phase for 12-18 months thereafter.

Speaking of bubbles, the Collaborative Fund recently published The Reasonable Formation of Unreasonable Things. Here are a couple of gems:

The majority of your lifetime investment returns will be determined by decisions that take place during a small minority of the time.

Bubbles are not anomalies or mistakes. They are an unavoidable feature of markets where investors with different goals compete on the same field. they would occur even if everyone was a financial saint.

It’s a hallmark of thought-provocativeness that the readers may draw different conclusions from the ones the author intended. It reads to me that one of the article’s main purpose was to warn long-term investors of the dangers of irrational pricing during bubbles. Pointing out the difference in goals and time frames was a beautiful rebuttal to EMH which sometimes is used to justify “buy at any price”. But to me the greater take away was the importance of the bubbles — rational, inevitable, and the driver of long term returns that those smooth, monotonically uptrending curves from a fantasy land called Excel would have you overlook.

Two recent articles by Jason Zweig (here and here), speaks to the difficulty of riding a bubble: specifically, a money manager Samuel Lee and his experience with Ethereum. Except in this case, the final chapter, or more than likely the second act, has not yet been written. Jason Zweig is too good a writer and has too much understanding to express an opinion other than saying it’s really hard. So here I would like to give myself some pointers that I hope to follow:

  • Participate — showing up is half the battle, especially when others are calling it a bubble.
  • Don’t be greedy. Position size control is paramount. Set a volatility limit as well as a position limit.
  • Do not envy those in earlier with a lower cost basis, nor those in later with a larger position.
  • Take profits, often. It’s impossible to catch the exact bottom or top. Play with the house’s money.
  • Do not take positions to justify a point.
  • The majority of the portfolio should be in an allocation that one would have in the absence of bubbles.

The last point is an import one for me. My speculative positions are benchmarked against cash, not the 60/40 much less 100% stocks. Why would it be otherwise if the bubble is expected to be short lived? Taking profits, even partially, forces one to re-evaluate the whole position.

We live in interesting times. I see three bubbles in progress or developing that require very different treatments. In cryptocurrencies, I have taken a position and am simply content to sell a little bit as prices rise. In PMs I have a 15% baseline allocation but trade around the cycles. Exposure can be increased by being in silver, miners, 3x ETFs and options while maintaining the same nominal allocation. In stocks and Nadaq in particular, I’m willing to increase the overall allocation along with highly leveraged option positions. These are in contrast to their neutral allocations of 0%, 15% and 45% (for all equities), respectively.

The next year or two should be very interesting.

Investing Philosophy

I’ve been meaning to update the my portfolio post which is linked under the “portfolio” navigation tab, but I’m in the process of deploying cash as part of the on-going correction. So I figure I’ll write a separate post about my investing philosophy.

Below is a list of the basic tenets that I try to follow:

  • Long biased
  • Globally diversified
  • Minimize taxes and expenses
  • Diversify sources of return
  • Strategy diversification
  • Market timing according to cycles of years of duration or longer
  • Use options to generate income and smooth the ride

The first three bullet points are in the “main stream”. As a rule, I don’t have a regular “cash” allocation in either passive or active strategies. Instead, there is a separate emergency fund component in the total portfolio. I’m also far more comfortable being long than short. In the passive accounts at least, I maintain a 50/50 US/international split in equities, although the composition such as large/small US equity or international developed/EM can be fluid. To the third point, I maximize tax deferred contributions every year, including back-door Roth. All assets in the passive accounts are tax-advantaged with the exception of physical PM bullions. In the active accounts, the taxable fixed income CEFs are in tax advantaged as are about half of PM miners and bullion funds. Expenses are minimized by using best-of-breed funds for each asset and doing everything myself. In passive accounts, that means Vanguard index funds/ETFs or equivalent. For individual stocks, I use InteractiveBrokers where the commission is usually under 1 basis point, and partially covered by the interest from security-lending. My expense ratio for holding stocks is at least one order of magnitude less than that of the lowest cost index funds.

The fourth point “diversify sources of return” motivates me to look beyond the traditional stocks and bonds. It’s the reason I have a significant allocation to leveraged fixed-income CEFs (target 24% of active). Taxable multi-sector CEFs have equity like returns and volatilities but are no more than 40% correlated to equities (e.g. VTI, correlation is period dependent, cf. Leveraged muni CEFs provide tax-free income and even lower correlation to equities (same comment as before). In contrast, sub-sectors within equities are correlated to whole at 90% or above. In the context of mean variance optimization, assets with reasonable returns AND low correlations are extremely valuable in portfolio construction. This is contrary to the Bill Bernstein view that one should take risks in equities and fixed income is for safety — a view that unsurprisingly leads to equity dominated portfolios and equity dominated risk profiles. Note that when the fixed income allocation is viewed across my entire portfolio, the risk profile is a “bar-bell”: stable value funds in passive and leveraged CEFs in active. Diversification is also a reason behind my overall 15% allocation to PMs which I discussed here. The blog post by Charlie Biello is highly recommended — I think of it every time I read a straw man attack on gold along the lines of: gold is thought of useful as an inflation-hedge, data shows it is not; therefore gold is useless. Another often-heard objection is based on the inclusion of gold’s return data just 1975 when gold ownership was again legal despite data from PortfolioCharts shows gold’s ability to lower volatility from multiple starting and ending dates. From a portfolio construction perspective, the only requirement for the inclusion of gold is the low correlation to other assets. I haven’t seen any evidence or prediction that this correlation is going to change in the future.

The fifth point “strategy diversification” speaks to my adoption of both passive and active approaches. The passive/active debate is all the rage in financial media today. Passive is clearly winning and the shift is far from over. Lower fees is undoubtedly beneficial to the investing public. However in so far as the democratization of investing makes it easier to invest and funnels more capital to assets, their valuation must rise thus suppressing future returns. A recent post from the always-insightful PhilosophicalEconomics discussed from a similar perspective. As passive grows in dominance, another danger is the synchronization of investor’s emotional response to market declines. This is a major reason I employ both passive and active strategies so as to be able to hedge from within the active accounts when the time comes. I also try to avoid the most obvious pit falls in active, i.e. high fees, lack of diversification, to at least give myself a shot at beating my benchmark.

The sixth point “market timing” is perhaps the most controversial. My reasons were laid out this post. The primary objective is to avoid large draw downs in preparation for early retirement within 10-12 years. If my portfolio should suffer a 30% draw down, there would be a significant impact on the quality of retirement or alternatively the retirement date. I haven’t been able to find a static asset allocation that provides adequate protection while simultaneously provide a high return – that pretty much captures the main dilemma facing all investors. A more diverse allocation can reduce the size of the hedges necessary but no static allocation can ever be truly “all weather”. I believe the solution is market timing but only at the right intervals. The tools I rely on are a specific equity pricing model and technical analysis. A second objective of market timing is to enhance returns. I have been say since last November that we’re entering a blow-off phase in the stock market; the view reinforces my long bias and allows me to increase my equity exposure from a baseline of <50% overall. My current projection for the market top is S&P 3000+ sometime around Q4’18 to Q1’19. I also see PMs in a bull market which gives me license to go above a baseline allocation of 10% gold bullion to include silver and mining equities that are leveraged to gold. My current view is that PMs will top after equities, probably later in 2019. Gold should be over $3500 and has a good shot at $5000/oz.

Lastly I use options to enhance returns. More opportunities are provided by directly owning individual stocks than an index as the parts will move more than the whole. I’m a premium seller since it’s known that realized volatilities are lower than implied volatilities. I predominantly sell margin/cash secured OTM puts on stocks I’d like to own while use technical analysis for entry points. From time to time, I also use options for leveraged longs as discussed here.

So there you go, these are the seven tenets that guide my investing decisions. People attach an almost religious fervor to their chosen investment approach, so I’m not out to convert anyone. It is a human condition that no amount of back testing or modeling can predict the actual returns which will only be known at the end of our investing lives by which time it’s too late to change. I have made peace with my path and will accept anything that comes my way.

A Correction May Be Upon Us

The long waited correction may be finally upon us. The 1%+ drop in the S&P on Mar 21st was the first in over 100 days. The bounce on the 22nd was anemic and accompanied by low volume. Most of today (23rd) was spent in positive territory but sellers took over in the last two hours — a very tell-tale sign. As in the chart below, we have broken below the trend line from the November election. Given this evidence, I’m of the opinion that an intermediate correction of months in duration has started.

I’ll go out on a limb again in trying to forecast a duration and depth of this correction. My model is signaling a bounce in April and a resumption of decline in May with a hard drop and bottom into July. I have little confidence in the exact path but a correction of 4+ months in duration will match that of the rise, a symmetry that would be appealing. The Fibonacci levels for this “Trump rally” aligns nicely with regions of minor support/resistance. I don’t trade at those time intervals but it’s interesting nonetheless. Given the nature of the in-flows of this rally, and that the market is never kind to Johnny-came-latelies, there is a high probability we’ll retrace all the way to the November bottom and more. I would go so far as saying that the “Brexit” bottom of 1991.68 is also in play.

Why do I bother with this kind of predictions and what do I plan to do with that information anyway? First and foremost it’s to develop a feel for the market and secondly to build confidence in the model. I’ve been clear on my approach to market-timing. My main goal is to be able to avoid the “big one” and ensure that my family is provided for. The skills that I’m honing are essential in deciphering the macro trends.

Since the inception of this blog, my most significant market timing move, in terms of duration and amount of capital, was the avoidance of nominal bonds. 35-40% of my passive portfolio has been in stable value funds paying 2 or 3% per annum. It’s been a good move — AGG has lost 3% since Aug’16. Compared with that that my pruning of stocks is rather opportunistic. In full disclosure, my pace of selling picked up in Feb/Mar, but it was not due to my market view. The main reason was the rotation in my fixed income allocation precipitated a desire to limit dividend payouts. This morning I closed out the MCD/DIS option spreads mentioned in this post, along with a couple other positions to give me a 12.7% cash position in my active portfolio. I don’t have plans for more sales; instead there are 7-9 buy candidates. My longer term view remains that we are in a full-blown bull market; but first, we’ll have to wait out this correction.