As the famous investor Peter Lynch said, stock market declines are as “routine as a January blizzard in Colorado”. The key is being prepared in advance and willing to be opportunistic in the aftermath. Being prepared means positioning your portfolio early.
Clear Rock clients have been prepared for more difficult markets for some time now through conservative allocations to stocks and higher allocations to more stable and income producing investments in high quality bonds and uncorrelated alternative strategies. Our asset allocation strategy incorporates business and market cycle risks, underweighting high risk assets at the end of a cycle when expected returns are compressed and taking more risk when asset prices are low and opportunity to earn abnormal returns are high.
Clear Rock’s strategy incorporates levels of risk through “Protect”, “Normal” and “Capture” asset allocations. We’ve been focused on protection (i.e., in Protect mode) for over two years, reducing our stock allocation across all client investment objectives by an average of 20%. This conservative positioning has been rooted in our belief that cycle risks have been increasing and that the threat of a recession and bear market was growing. Market action of the past two weeks has proven this adjustment to be the right one.
It’s clear our approach has protected principal through this difficult period, the question now is, “Where are the opportunities?”. Digging through the rubble of yesterday’s market rout has uncovered a few interesting areas of value but also highlighted risks that remain in certain areas of the market.
First, Small and Mid-sized stocks have underperformed Large stocks for several years and were hit harder in the market downturn. The nearby chart shows the Value Line Geometric Index of 1700 US Companies which gives Small and Mid-sized companies the same weight as Large companies. This index shows performance of the “average” US company is down 30% from the 2018 highs! Despite their tendency to perform worse than Large companies in a panic selloff, small companies offer compelling long-term value in today’s market. We are accessing our investment here with an eye toward increasing exposure to small cap stocks.
From a valuation standpoint, Small and Mid-sized companies are much more attractive than Large companies. Below is the 30-year price-to-sales ratio (top) and price-to-earnings ratio (bottom) for the S&P 600 Small Cap Index. Both are trading at historically attractive levels.
In addition, an area of the market that looks more compelling now is lower quality, non-investment grade debt. We fully exited our positions in high yield corporate bonds and bank loans over a year ago after strong performance with the belief that the risk/reward ratio had become unattractive. This view was based on valuations producing paltry yields given the higher level of default and pricing risk these bonds carry. Over the past two weeks, high yield spreads have widened dramatically, from +3.13% in January to +6.55% today, and are approaching yields that are beginning to make us take notice and may entice us back into the category. Our hesitation is the quickness and magnitude of the correction reflecting increasing default risk, particularly in the energy industry, that still may not be fully priced in at these levels.
Before we begin moving back to “Normal” equity allocations which would reallocate an average portfolio weight of 20% back into stocks, we need to see three things occur:
1. Earnings Growth Visibility
• Unfortunately, growth estimate reductions due to the Coronavirus scare and oil price collapse have barely begun. Economists, strategists and analysts are paralyzed and waiting for new economic indicators as well as guidance from company managements to formulate their outlooks.
2. Credit Spread Stabilization
• Non-Investment Grade bond yields have backed up to their 30-year average, which has improved their risk/reward outlook.
• With high quality Investment Grade bond yields at historic lows (US Bond Aggregate now yields 1.30%), High Yield Corporates yielding 6.00%-plus look more interesting, especially on a relative basis.
• A headwind to spread stabilization will be uncertainty in the energy industry, which is a high 16.5% of the ICE/BofA/Merrill High Yield Index.
3. Large Company Stock Valuation Normalization
• As mentioned, small companies look attractive, but valuations on large companies (think Microsoft, Amazon, Google, Apple, etc.) still look stretched.
• Price/Sales for the S&P 500 is still above +1 standard deviation from the 30-year mean, albeit down from +2 SDs two weeks ago while Small Cap stocks are below average.
Going forward, as this crisis subsides, we’re also cautiously optimistic that the significant accommodative global monetary and fiscal stimulus will put a floor on asset values in the near term and possibly even set up stocks for a positive environment. The market volatility of the past few weeks reflects a great deal of uncertainty and underscores the importance of managing our client portfolios vigilantly. We will keep portfolios in line with long-term asset allocation targets looking to take advantage of opportunities the market provides.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer