A common saying in our industry is, “Hope is not an investment strategy.” This means it is risky to invest your hard-earned nest egg into something you hope will happen. In the world of investing, the thing hoped for often does not pan out.
But the world finds itself five or six months into the worst pandemic in 100 years and in the midst of the sharpest recession in nearly 100 years. Yet, surprisingly, stocks globally rose sharply in the second quarter and are down less than 10% for the year. If an investor was hiking the Appalachian Trail and started on January 1, finishing yesterday, he or she would have little realization of the turmoil that had taken place while they were off enjoying nature.
How can this be, given what we know?
- Millions of people around the world are out of work.
- Global economies remain in deep recessions.
- The coronavirus continues to spread.
- There is no vaccine.
The action in the stock markets seems completely divorced from what is going on in the real world. However, experienced investors know that the stock markets tend to focus not on what is happening at the moment but rather on what is likely to happen in six to nine months. So, the sell-off we saw in March was severe because the pandemic came out of left field and investors did not know how to factor the effects of the virus into their analysis. Then, as countries began to get the pandemic better under control and the central banks intervened, investors decided that the market outlook was too negative and began to scoop up stocks at bargain prices.
Investors who bid up stock prices in the second quarter appear to be hoping for three things:
- The worst of the pandemic is behind us.
- A vaccine is on its way.
- Central banks around the world will continue doing whatever it takes to try to keep financial markets stable.
As the table below shows, even though stocks rebounded strongly in the second quarter, they remain in negative territory for the year. Some areas of the stock market fared quite well in the first half, namely technology, while energy and financial services stocks are both down more than 20%. There was strong participation in the second quarter rebound, but overall, the strength in the market is in a very narrow segment of the market—technology.
The table below shows where various stock and bond indices stand as of the end of June:
What is FSA Doing?
From a position of maximum defensiveness in late March, we began to prudently shift assets back into stocks and bonds beginning in late April. Currently, all six strategies have been re-invested, although we do maintain a modest amount of cash as stocks have stalled and been unable to break above the levels they hit on June 8. The chart below shows the journey for the S&P 500 index for 2020. While one can see that it has been an impressive rebound in the second quarter, the advance became choppy in June. We want to see stocks break above this resistance level (above the upper black line) before moving the portfolios back to a fully invested position.
Within the portfolios we have a number of well-managed diversified funds that we can hold for the longer term because they tend to move with less volatility than the stock market. In addition, we have tilted the portfolios toward funds that are more growth-oriented—favoring technology and health care stocks. On the fixed income front, we are predominantly invested in high yield funds rather than government funds.
Outlook for the Second Half
While many investors see to be hoping that smooth sailing is ahead, we are somewhat more pragmatic. With trends turning higher, we want to participate and have the portfolios invested once again; however, we are cognizant that the second half of the year could be quite challenging. We think that significantly higher prices for stocks and/or bonds could be difficult since investors react violently to any negative news on the virus front.
The other important influence on the markets for the second half of the year, which has received little attention so far, is the presidential election. Stocks could react quite a bit as the polls shift back and forth favoring the Democrats or Republicans. Historically, when investors begin to sniff out that the incumbent might get replaced, stocks tend to struggle. It doesn’t happen often that an incumbent gets voted out of office, but it does happen.
The bottom line is that we will let the market trends dictate how we invest. If the stocks and bonds can maintain their current upward trajectory, we will remain invested. If the end of the summer leads to more panic and choppiness, we will reduce our exposure accordingly.
Many investors may be basing their investment strategy on hope, but at FSA we will continue to let our safety-first process determine our course of action.
Keep in mind that because we manage clients’ portfolios individually, the holdings in your particular accounts may differ somewhat from the averages.
Income (Strategy 1)
Our first foray back into the bond market in mid-April was to use funds that can shift among different types of bonds that are in favor. Then, as the recovery continued to carry on, we added several high yield bond funds, as well as funds more influenced by interest rate movements. By the end of June, these portfolios were 70% invested, with 30% held in money market funds.
Income & Growth (Strategy 2)
We moved quite cautiously in getting these accounts back into the markets, allocating first to a tactical bond fund, then a merger arbitrage fund. As the stock and bond markets continued to recover in May and June, we added equities, high yield bonds, and high-quality bonds. As of the quarter’s end, the portfolios held 40% in equities and 40% in bonds, with 20% in money markets.
Conservative Growth (Strategy 3)
Beginning in late April, we began to prudently move back into the stock and bond markets, beginning with very defensive funds, then adding more risk as the rally continued. At the quarter’s end, the portfolios were 60% in equities and 30% in bonds (both high yield and high quality), with 10% in money markets.
Core Equity (Strategy 4)
As stocks rebounded in April, we sold the inverse funds we acquired in the first quarter, which left our core funds unhedged and capable of participating in the rally. We later added several large-cap growth funds as this was the area of strongest growth. As we move into July, the portfolios are 85% in equities, with 15% in money markets.
Tactical Growth (Strategy 5)
Our most actively traded strategy has managed reasonably well through all the market volatility. In April and May, we sold the inverse funds while adding several funds, primarily in the large-cap growth space. At the end of June, Tactical Growth accounts held roughly 75% in equities, 5% in precious metals, and 20% in money markets.
Sector Rotation (Strategy 6)
This strategy benefited from its design to stay more invested so that it held equities throughout the second quarter rebound. Also, it has consistently picked up various technology sectors which have been the standout performers this year. As of the July rotation, this strategy holds internet, electronics, technology, biotechnology, retail, and basic materials.
Please remember to inform your advisor of any changes in your life that could affect your investment objective and how we manage your money.
Ronald Rough, CFA
Chief Investment Officer
Disclosures are available at https://fsainvest.com/disclosures/market-update/.