Another Year Older, Another Year Wiser
The year just passed was unusually rough for tactically managed strategies generally and The Milwaukee Company’s (TMC) strategies, while outperforming many other tactical strategies on a relative basis, struggled to keep pace with a historically volatile market. Due to a market environment that surprised and, at times, shocked us, several of our portfolios behaved in ways that we had not anticipated.
Winston Churchill famously said, “Never let a good crisis go to waste.” In that vein, during the course of 2020 we’ve reviewed, revised and retooled our model portfolios in an effort to strengthen the risk management capabilities of our portfolios. Some of the outward changes include 1) higher allocations to foreign developed and emerging markets; 2) shortening bond durations; 3) reallocating perpetual bond funds into defined maturity date funds; 4) increasing allocations to Treasury Inflation-Protected Securities (TIPS); and 5) rotating into equal-weighted ETFs.
We’ve also refined the tactical-trading rules for several of our portfolios so that TMC’s strategies are better prepared for whatever awaits in the months and years ahead. Those changes include:
Shortening look-back periods for economic and market indicators to make strategies more responsive to changing market conditions.
Relaxed constraints to allow for greater growth potential.
Revamped the fund universes to which our strategies are applied.
Revisited and, where appropriate, modified the algorithms and indicators that drive strategic changes to target portfolio allocations.
In addition, we’ve restructured the way we combine our strategies when creating client portfolios by implementing a so-called core-satellite framework to customize strategies to match each client’s specific objectives and risk tolerance. In essence, a core-satellite strategy seeks to optimize asset allocation by separating the broad market trends (the core) from various flavors of risk management (satellites) and blending the two pieces with a rules-based construction process.
Our research into how best to combine our strategies has also led us to conclude that risk management can be enhanced by allocating a modest share of the investment accounts we manage to a “Counterweight Portfolio,” which invests in securities that have lower correlation with the securities used by our tactical asset allocation strategies. As a result, we expect the Counterweight Portfolio to serve as a hedge for these securities.
As of this writing, the Counterweight Portfolio consists of the following components:
Despite the unusually high volatility in 2020, which whipped markets to a degree unprecedented in modern history, TMC strategies fared reasonably well, as shown in the data table below, which highlights our balanced portfolios vs. two benchmarks. Our risk management overlays delivered either higher returns and/or superior risk-adjusted performances.
Our balanced oriented investment strategies are designed for investors with a moderate tolerance to investment risk who seek a balance between higher returns in the long term and the risk of a decline in the value of their portfolios in the short term.
The following table summarizes the risk and return statistics for our balance strategies in the fourth quarter of 2020:
VSMGX - Vanguard LifeStrategy Moderate Growth Fund; PSMB-PSMBX; ECS – TMC’s Economic Cycle Strategy; MTS – TMC’s Market Trend Strategy; VA4- TMC’s Volatility Adaptive Asset Allocation Strategy; CAAR – TMC’s Classic Asset Allocation Strategy.
As you will note, our CAAR strategy underperformed in 2020. However, over longer time frames, CAAR has been one of our best performing strategies. That said, CAAR’s strong start in 2021 suggests the changes we have made to CAARs algorithm will allow it to better adapt to market conditions such as those from last year.
Thank you for the opportunity to assist you with the management of your investments in 2020. We look forward to continue advising you in 2021. While I suspect that we are all pleased to put 2020 in the rear-view mirror, we’re more confident than ever that our strategies are uniquely positioned to help you achieve your financial goals and to weather future crises.
How Will The Biden Administration Change The Outlook For Markets And The Economy?
It’s hard to imagine a more investor-friendly four-year run than the Trump presidency. Deregulation, tax cuts, and a president pressuring the Federal Reserve to lower interest rates are just a few examples of the bullish changes that’s prevailed after the 45th President took control of the Oval Office.
Something substantially different awaits over the next four years, but exactly what is a work in progress. But change is certainly coming. In addition to bringing a dramatic shift in tenor to the White House zeitgeist, Joe Biden also has a markedly different policy agenda. Investors fear that a more progressive-minded set of priorities, supported by Democratic control of both houses of Congress, will usher in a distinctly market-unfriendly climate. Perhaps, but it’s premature to estimate to where stocks are headed on this basis alone.
Details matter, of course, and so at this early stage there’s more uncertainty than clarity on which Biden policies will become law and how or if the proposals will evolve during negotiations. Although the new administration has laid out goals in detail, that’s just the opening bid. Until legislation begins to wind through the razor-thin Democrat-controlled House and Senate, guesswork still dominates on what’s coming on a host of issues, from regulation to taxes and beyond.
The diminished Republican presence in Washington may play the spoiler, but the body politic seems inclined to favor Democratic priorities as long as a pandemic-induced economic crisis stalks the land.
A key point person pushing a new, ambitious round of economic stimulus on behalf of the White House is Janet Yellen, former Federal Reserve chairwoman, and who was confirmed this week as the first female Secretary of the U.S. Treasury Department. Two days before the inauguration she pressed Congress to “act big” on coronavirus stimulus, noting that with interest rates near historic lows the opportunity is ripe for borrowing and spending while debt-servicing risk is low.
Yellen has a point. As the nearby chart shows, net interest as a percentage of the economy is near the lowest level in decades despite the recent surge in federal public debt.
Meanwhile, the economy continues to struggle on several fronts, adding credence to the case for juicing the forces of growth. Unlike past economic challenges, the current troubles are due to the pandemic. Until this risk fades (perhaps by the second quarter if you’re optimistic), government assistance for the masses of unemployed (through no fault of their own) is productive and probably essential to lay the groundwork for a robust, sustained recovery in a post-Covid world.
Moody’s Analytics estimates that if Biden’s proposed $1.9 trillion fiscal rescue plan is enacted as written, it would lift total pandemic support to $5.2 trillion – nearly 25% of 2019 GDP, which would be well above what other nations spent.
Deficit hawks warn that the surge in spending will create challenges in the years ahead for managing federal debt. True, at least in theory. But as Yellen reminds, with interest rates so low, the debt-servicing burden is low – all the more so if inflation rises in the years ahead and reduces the real cost for the U.S. government.
Government finances aren’t equivalent to household balance sheets and so fiscal prudence doesn’t require paying down federal debt in total, at least not all at once or over short periods of time. If pandemic-relief financing can be locked in at today’s unusually low interest rates for the long run, the cost may be manageable. Then again, while low interest rates help, they don’t change the fact that rising government deficits must be financed by investors purchasing government debt, which may reduce the dollars available for consumption and capital deficit. Fortunately, foreign purchases of Treasuries has softened this factor in decades past and it may do so in some degree in the years ahead.
Over the long-term, however, deficits do matter. But in the near term, the stock market will focus, at least in part, on changes in economic growth and on that score Moody’s Analytics projects that President Biden’s $1.9 trillion fiscal rescue plan would give the economy a quick boost and real GDP would rise more than 7% annualized in this year’s first quarter and nearly 8% for 2021 overall (assuming the plan was signed into law as written by March). “This is almost double the growth that would be expected without any additional fiscal support,” the economic consultancy advises.
At this pace of growth, the economy would create 7.5 million jobs in 2021 (December to December) and 2.5 million in 2022 to fully recover the jobs lost since the pre-pandemic peak. By then, the economy will have returned to full employment - an unemployment rate of 4% to 4.5% and a labor force participation rate of more than 62.5%. This is about a year sooner than would be the case if there is no additional fiscal support.
That’s likely to be music to Mr. Market’s ears, at least for the near term and certainly relative to doing nothing. The pushback to this rosy outlook is that equities are already richly valued and so one could argue that most (all?) of the additional spending effect is already priced in to stocks.
Fair point, but more government action combined with the prospect of more pandemic relief later in the year as the rollout of vaccines continues may convince traders that the bull market party is not over just yet. Investors, on the other hand, may be better served sticking to their long-term investment plan than crashing a party so late in the evening.
US Stocks Continued To Lead Global Markets In 2020.
Betting against U.S. equities remained a losing proposition last year. For a second calendar year in a row, American shares topped the performances for asset classes, based on a set of ETF index funds.
Vanguard Total U.S. Stock Market (VTI) roared ahead by 21% in 2020, which is quite remarkable when you consider that the year just passed was hammered by a pandemic, pounded with a severe recession and roiled by an unusually divisive presidential election.
The resilience of U.S. shares surprised more than a few analysts and portfolio managers (ourselves included). But at least one aspect of market activity remained as predictable as always: the ebb and flow of leaders and laggards from a top-down asset allocation perspective.
U.S. stocks have enjoyed two straight calendar years of strong performance but recent history reminds that staying on top – or even posting a gain – year after year could be asking too much for any one slice of the global asset allocation pie. True, U.S. shares have increased in nine of the past ten calendar years. Note, however, that in four of those ten years Vanguard Total U.S. Stock Market (VTI) was a relatively middling performer. In 2017, for example, U.S. shares earned an impressive 21%, but that was well behind a broad measure of stocks in emerging markets, which dispensed a stunning 31.5% total return that year.
Predicting calendar-year returns is problematic at best. Think back to January 2020 and the level of optimism that prevailed. But as the world learned (again), stuff happens and otherwise reasonable forecasts can be quickly dispatched to history’s dust bin. Then again, if you were asleep for the past year and just woke up, the sight of U.S. stocks leading the performance party might strike you as more of the same and largely expected.
Nonetheless, the nearby asset class quilt is a useful tool for thinking about which way the broad market forces are blowing and how the directional biases could change. On that basis, investors who prefer to invest in market sectors with positive momentum may be tempted to bet the farm on U.S. equities. But with U.S. stocks already trading at or near all-time highs, such a bet is far from a sure thing.
For those who do decide to take some of their domestic stock winnings off the table, the next question becomes where to redeploy the proceeds. With interest rates so low (and short rates near zero), bonds are not the safe haven they are usually considered to be. Meanwhile, believers in mean reversion might be drawn to U.S. real estate investment trusts (VNQ), its foreign property equivalent (VNQI), and commodities (GSG). All three of these sectors lost ground in 2020. Of course, no one can say for certain when mean reversion will overcome momentum, but it’s an obvious place to start if you’re a value investor on the hunt for a bargain.
History Makes A Case For Asset Allocation.
In some trendy corners of finance it’s become di rigeur to question if not dismiss certain tenets of modern finance theory. Take asset allocation, for example. By some accounts, the idea of holding a wide-ranging mix of assets, some of which have fallen on hard times, is no longer a viable strategy. Why own something that’s delivered crummy results?
The problem with this thinking is that 1) it ignores the lessons of history; 2) discounts the possibility that there is wisdom in diversifying risk factors, even if it’s not patently obvious in each and every investment period; and 3) mean reversion hasn’t been banished to the scrap heap of history but predicting turning points is as slippery as ever.
As you ponder those points, consider a recent study that’s been submitted to the Journal Financial Economics. The paper offers a powerful rejoinder to claims that risk management by way of broad diversification – within and across asset classes – has faded into irrelevance as a practical tool for wealth management. “Stocks for the Long Run? Evidence from a Broad Sample of Developed Markets” studies the history of stock markets in 39 developed economies over a 180-year period through 2019 and identifies an overlooked risk factor: Long-run holding periods for stocks can be riskier than generally expected.
The paper’s authors establish the baseline, noting:
Investing in stocks appears to be a very attractive option for long-term investors. The historical equity premium in the United States is quite large (Mehra and Prescott, 1985). Conventional wisdom is that stocks are safe over long holding periods, and long-term loss realizations in the U.S. have been infrequent or non-existent (see, e.g., Siegel, 2014). Fama and French (2018a) estimate a low probability of loss and a high probability of substantial gain for investors with horizons of 20 or 30 years.
In other words, if you have a sufficiently long-time investment horizon, much of the risk commonly associated with equities fades. A comforting thought. But this assumption, often borne out in history, is softer than it appears, in part because it relies heavily on the U.S. stock market.
Academics debate whether the (mostly) continuous bull market in American shares over the generations is the rule or the exception. Looking at markets around the world through history suggests there’s more risk, even in the long run, than it appears. The implication: holding a multi-asset-class portfolio is more valuable in the long run than recent history suggests.
Preparing For Global Risks In 2021.
Last year was rough for global risk, arguably the roughest in more than a century, thanks to you know what. But risk never takes a holiday and so just because the world was pummeled with a pandemic in 2020 doesn’t mean it is smooth sailing for the year ahead.
Alas, no one has a clue what may be lurking in 2021, but thinking about what could go wrong in a big way is always a useful exercise. Consider, too, that the pandemic wasn’t unexpected or unprecedented. Global outbreaks of disease, after all, have featured regularly in human history, and more than a few scientists and health experts reminded the world of that history for several years running up to the Covid-19 outbreak. Few of us were listening or preparing, but that’s another story.
What should be on our radar for 2021 and beyond? The World Economic Forum’s annual report attempts to narrow the list of what could go wrong. “Among the highest likelihood risks of the next ten years are extreme weather, climate action failure and human-led environmental damage; as well as digital power concentration, digital inequality and cybersecurity failure,” advises The Global Risks Report 2021.
The estimates are based on surveys of the World Economic Forum’s members, comprised of business, political, academic and other societal leaders. Although there are many potential threats lurking, the challenge is identifying those that appear most likely, with the greatest potential impact and are likely to occur in the near term. By that filter, infectious disease and climate-related blowback lead this disquieting list, the respondents estimate.
One of those risks is already here, of course, and will remain a challenge on multiple fronts well into the 2021. “The immediate human and economic costs of COVID-19 are severe,” the report observes. “They threaten to scale back years of progress on reducing global poverty and inequality and further damage social cohesion and global cooperation, which were already weakening before the virus struck.”
Unfortunately, there’s no rule that says that an ongoing pandemic immunizes the world from another catastrophe. The good news is that some of the pain and suffering could have been reduced with better planning. Perhaps the main lesson of the past year is that the only thing worse than making a strategic oversight is doing so twice.