RCM Managed Asset Portfolio - Q1 2020
I Initial Thoughts
First some initial thoughts on where we currently are. At the beginning of April 2019, the U.S. still finds itself in the midst of a global pandemic. If we can take the growth of COVID 19 cases in other countries as a model for where we are headed, we probably have less than a month to go before the number of new cases starts to decline. China, South Korea, and Italy had an intense two month period of social distancing. Until the number of new cases starts to recede in the U.S., markets will find it hard to judge the severity of the slowdown, as seen by the historic volatility we have been experiencing. When this happens, we will probably see a rebound of equities before contending with the other unknown variable, how the corona virus will have affected the earnings and in some cases credit-worthiness of companies going forward. One of the biggest levers businesses have to lower costs is laying off workers. And if that occurs–and there is no reason to expect that it wouldn’t–the damage will probably have been large enough to send the U. S. economy into a recession.
II The Economy
Last quarter we discussed the signs of a slowdown based on our reading of the labor market (See RCM email from Tim Webb on 1/8/20). Despite the outperformance of the market last year, there were definite signs of economic weakness. I will discuss three indicators that foretold possible signs of trouble. One was the bottoming of unemployment over the last year. Low unemployment is often touted as a sign of economic success. And it is, but it also brings with it its downsides because it also shows that the supply of labor which grows the economy eventually runs out. This is true not only for the current time period but other time periods as well. If there is not another leg down in unemployment to go, eventually there is nowhere for unemployment to go but up.
Another indication that we were in a slowing economy was the slowing growth of heavy weight truck purchases by trucking companies. It’s a good indicator because rigs, and investments in them, often reflect the confidence managers have. And by last year purchase of new rigs was already in a downtrend. As you can also see once the trend turns and swings in a downward direction, it goes on until reaches a historical bottom for truck purchases, around 300,000-400,000 trucks, at which point, like in all other times, we will be in a recession. We are probably there now.
A third indicator to show we were in a slowing economy was housing. Housing had been one of the stalwarts of the US economy last year but there were also selective signs that housing was slowing. As seen below we were recently at a peak in new single family home purchases but fell off last year. Historically, once the number of sales peaks and begins to recede, it generally pushes us into recession and it does not turn around again until it first bottoms below 300,000 single family home sales.
These three data points that I have cherry-picked are but indicators, but I believe the market with its -30% drawdowns already recognizes that we are in a recession. Knowing this brings us to the next topic in this letter–namely, why we have positioned your portfolio in the way that we have.
III Markets and Your Portfolio
In almost all cases your portfolios have performed better than their benchmarks. This relative outperformance is partly because we had been raising some cash in our active equity programs throughout the latter parts of last year as the market began to run up. And as the market turned down, the volatility of these portfolios was lessened because, of course, cash has no volatility. We also used this cash to buy a slot of long dated Treasuries in the Strategic Knight as the downturn steepened. And this helped as well.
In our mutual fund and ETF programs we became more conservative in our allocations, halving exposure to the underperforming small, mid caps, and highly reducing exposure to emerging markets. In their place we allocated to bonds where appropriate, or are in other instances we were simply sitting in cash.
In terms of the bond program, we had likewise become more conservative, completely exiting the large positions in preferreds in ETFs and Mutual Funds and bought mortgage bonds, which have the smallest drawdown risk, aside from government bonds.
When will it be time to buy stocks again? Working through expectations of a recession for the stock market is generally a months-long process, full of ups and downs. After the growth of new COVID 19 cases goes down there will be a second variable to contend with and that is the economic impact the pandemic has had on businesses, and therefore the creditworthiness of marginal companies. As one would expect as equities fall, the high yield spreads of these marginal companies has increased.
One indicator that signals when investors can be confidently aggressive on equities and riskier bonds will be when these credit spreads begin to narrow again. Bond investors are not so interested in making money as they are in not losing it. And when you see bond spreads narrow, it is a good indicator of their confidence and their willingness to invest in what they consider to be safe ventures. You can see from the chart below that the economy generally enters a recession when BB credit spreads have exceeded 10 percent. We are there now. The sure signal for being aggressive on equities is when credit spreads recede definitively from their peak.
IV Final Comments
While we expect things to possibly get worse before they get better, our programs are designed to benefit from business cycle changes. We take a very rational approach and not an emotional one. And while you cannot perfectly time the top, you can roughly see where they may be headed. The market, even with its volatility, gives you many opportunities to recognize this. Forward economic signals, such as the ones I have discussed, give you the opportunity to do this. Markets aside from equities, such as the bond market or the VIX, give you an opportunity to do this. And finally the ability to value companies allows you to know when things get overheated and when there is an opportunity to buy aggressively again. The key is to preserve capital in bad times, and deploy it aggressively when times become better. In other words, lose less than the market on downturns so you can make more when the markets are about to turn upward again.
There will be signs that things will get better. Eventually things do get better. When that happens we will be able to aggressively put more of your money to work, because we were able preserve it when we needed to.