Updated: Sep 15
This weekend’s reading is likely to be among the most important of these letters we write for the remainder of 2016. Most of you will enjoy learning that we are elevating clients’ portfolio yield yet again. However, it’s important that you understand why, so we can set your expectations for the next 1.5-2 years.
Dear Clients & Friends,
This weekend’s reading is likely to be among the most important of these letters we write for the remainder of 2016. If possible, please do not try to read this letter while standing in line for the cash register. Rather, please find a few minutes of undistracted time to read and absorb our opinions regarding the rest of this calendar year as well as 2017. Most of you will enjoy learning that we are elevating clients’ portfolio yield yet again. However, it’s important that you understand why, so we can set your expectations for the next 1.5-2 years.
We are very fortunate to have an extremely high read-rate for these weekend readings which we send out about 3 out of every 4 weekends. As such, most of you are aware that since October of last year, I have been quietly discussing a possible mild recession between then and the end of 2017. While the initial comments were relatively quiet, more recently, we have been discussing this recession much more vocally. Before I continue, let me be clear that we are forecasting a mild recession and in no way are we suggesting that a 2008 like crisis is likely to occur, not even remotely, at least not at this time. However, an economic shift such as this demands attention to portfolio structure and allocation.
I will go into detail below, but simply put, we plan to shift our portfolios even more dramatically towards dividend yielding and income producing investments. Since we here at MORWM are value driven to begin with, the majority of our clients’ portfolio yield exceeds that of the open market usually between 25%-50%, yet we are now going to lean even further. Although we are usually value driven, in early 2015, we actually shifted in the opposite direction towards growth due to economic and market conditions at the time. I am extremely satisfied we did that because while Domestic Large Companies (S&P500) were fairly flat last year, the growth component was up about 5.5% while the value component which has the better yields was down roughly 4% rendering the index flat for the year. Many of you may recall that while we made this shift, we did so with a great sense of hesitation because while we favored the total return of growth, we knew we were sacrificing dividends. In hindsight, it was correct move, and now we are swapping back…and then some.
Not only are we shifting back to our yield focus, but we are moving deeper in that direction and these are the changes we plan to institute across the board.
1. We plan to remove exposure to Emerging Markets which has very low yields.
2. We plan to remove US Small Cap which also has very low yields.
3. The replacements for both of these positions are Domestic Equity Large Cap dividend strategies which will elevate the yield from 1% to 7%!Is that too good to be true? No, it’s not, but we have to make some sacrifices to achieve this increase which we will discuss in greater depths below.
4. Lastly, we are almost ready to unwind the bottom fishing move we made last August when we shifted some of our bonds into stocks when the Dow fell below 16,000. For some clients, we executed a second round of bottom fishing during the selloff in early 2016 as well. Those positions are up anywhere between 5%-8% depending on how much we moved in August vs. February.The Dow is now close to 18,000 and at its next cross, the trade will be unwound, and the proceeds will be returned to the bond market.In doing so, the yield will increase from 1.9% to 3.5%.
Though I’ve mentioned 4 changes above, it’s the top three changes that represent the strategic adjustment in light of our midterm expectations, and its expressly those expectations which are the theme of this weekend’s reading. But before we get to my focal point, let’s briefly touch on advantages and disadvantages of these moves; as I said, the increase in dividend yield is not without sacrifice.
1. Advantage: Dramatic increase in income- we expect on average a 35% increase in income generated by client portfolios.
2. Advantage: Dividends paid from high quality companies are usually less exposed to dividend cuts during times of uncertainty, and stocks with a long history of dividend increases tend to be less volatile during recessionary periods.
3. Advantage: Peace of Mind- who doesn’t like consistent substantial dividends?
4. Disadvantage: Reduction in diversification- By removing small cap and adding to large cap, and by eliminating emerging markets and adding to developed markets, we are removing two areas within our portfolios which provide currency and geopolitical diversification.
5. Disadvantage: Possible sacrifice of growth- Small Cap and Emerging Markets are very aggressive investments.As such, while they don’t pay much in dividends, traditionally, their growth component tends to be higher than more mature Large Cap companies.If the US were not to fall into recession, if the Presidential Election proves not to be the circus we all expect, if everything goes well within the global economy over the next 18 months, we could miss some growth in these two areas.Though we are not reducing our allocation to the stock market (at least not now), this shift increases income but decreases growth.
6. Disadvantage: In some cases, we are increasing our tax exposure- Dividends are taxed immediately where’s capital gains are taxed only when realized. Therefore, we expect a small (extremely small actually) increase in the taxability of our portfolios.
We believe that the advantages far out weight the disadvantages and the most glaring reason is simply this: We at MOR Wealth Management will always prioritize managing risk over achieving reward, especially during a time period when Donald Trump could potentially become the most powerful man in the world. (This letter is in no way intended to project a political opinion. However, if any of our readers do not see the risk in having a president who has declared bankruptcy multiple times, and who’s foreign policy includes capturing the children of terrorists, I think you should call me.)
This concludes the first half of this reading, the second half is much less tangible but FAR more important, and it’s the same message I delivered to clients in October 2007. The message is simple: we need to start thinking like Yale’s endowment for the next 2 years. That’s it. That’s the message. Simple in design, but far more difficult to execute than it sounds. It is these large institutional portfolios that seem to outperform private clients over the long run even though they don’t necessarily outperform during up markets. The conclusion which must be drawn is that the institutional portfolios actually outperform during bad times. Taking this one step further, it’s not that they actually do better during bad times, it’s that they are far more disciplined during these bad times.
To illustrate this effect, allow me to put forth a very simple hypothetical scenario (please note we are using simple growth not compounding growth in order to keep the illustration as clear as possible.):
Imagine a charitable organization with an endowment worth 10 million dollars. Let’s further assume that this organization requires $500,000 per year in income in order to meet its obligations- feed children, help pediatric cancer patients and survivors, fund music education in underserved public schools; whatever their endeavors may be, we’ll assume they need to generate 5% in income. Let’s also assume that at the start of a 5 year period, the investment markets begin to wobble and aside from the continuous 5% income generation, the portfolio suffers a 10% capital loss in years 1 & 2, is flat in year three, and only in years 4-5 does the portfolio recapture the capital loss. In this scenario, there are two ways to observe and react to portfolio performance and I’ve tried to demonstrate the difference between disciplined, long term investors versus less patient investors.
From the perspective of the endowment directors:
In this example, you’ll notice that some of the numbers are intentionally greyed out in order to illustrate what really matters to the endowment board of directors and what really doesn’t matter. The endowment’s purpose (just like a private investor’s portfolio’s purpose) is to generate income to provide for the needs of themselves and others. Remember, we don’t spend our stocks or bonds or investment real estate. Rather, we spend the income these assets produce! This is among the simplest concepts within the investment realm, yet it is hardly ever considered. In fact, in my experience, the only type of investor that truly conforms to this discipline is the investor who owns real estate and absolutely nothing else. Here’s why:
If a real estate investor owns 10 properties and the income derived from the properties represents the individual’s retirement income, the only thing this investor cares about is whether or not his/her tenants can make their rent payments. This investor does not have his properties appraised every day, or even every week or every month- of course not. This investor does not sell his property just because people say the economy is slowing, of course not. This investor assesses 1) whether or not his/her tenants are gainfully employed and can continue paying rent, and 2) He/she assesses whether or not the real estate downturn is likely temporary, or more permanent because of water pollution, or changing demographics. Assuming the downturn is temporary, this property owner will monitor rent and wait it out because if he or she actually sold the property out of fear, the rent/retirement income would be cut off.
How can we correlate this example to our hypothetical endowment portfolio earning 5% income? Easy, if we together determine a bear market to be temporary, an endowment director has the discipline and patience to wait out the storm ‘as long as the income generated does not falter.’ On the other hand, a private investor may not have the emotional fortitude to sustain the necessary patience and this is what will ensue.
In this example, all we’ve changed is the color to illustrate that without a clear understanding of the goals at hand, and the discipline to follow through with the stated objected, a private investor may after a -10% net decline, liquidate his/her portfolio which will result in two problems:
1. Income (which is our spendable resource) terminates
2. The assets sold turns into cash which does not grow when the value of the sold assets begins to recover, thereby creating a permanent loss.This loss now has to be made up some other way, usually by reinvesting in ultra aggressive investments after the markets have recovered.This is what we refer to as “chasing returns” and we all know how that story ends.
The message here is to simply reiterate the importance of setting our short term expectations in consideration of our long term goals so that we can maintain discipline - the most valuable virtue in the investment process.
Our explanation is quite verbose, but our plan is fairly simple. Now let’s conclude with a good question that I’ll try to answer before its asked.
“If we prepare for a slowdown, and a bull market persists, will we give up substantial gains?”
The best and simplest answer I can give is “No” and here’s why: we are not reducing our exposure to the stock market. If the markets do not undergo a slide, and the stock market performs well over the next two years, so will we. The focus of our allocation adjustments is the movement from growth oriented stocks to dividend oriented stocks, but not a reduction in stocks altogether. Therefore, we must assume that our portfolios will also be lifted by a rising tide.
That said, we could sacrifice a small amount of gains due to the reduction of emerging markets and small caps, the more aggressive parts of one’s equity portfolio, as discussed above. However, at this time, we do not think the risk warrants the reward.
One final comment so that we do not cause undue stress. In late 2007 due to several notable concerns regarding global growth, we reduced risk considerably by removing 20% of our stock market exposure. (No, we did not forecast the global crisis that ensued) This time around we are not reducing our exposure to equities at all, nor are we predicting a crisis of any great magnitude. In fact, we remain mildly bullish for the remainder of 2016 and hope for mid single digit returns in total.
And now as I finally conclude the longest weekend reading to date, I’d like to honor all of the military personnel who work with MOR Wealth Management, active duty, reserve, auxiliary, and retired. Most importantly, I ask that we all take a moment today, Memorial Day, to remember all of our brothers and sisters who gave their yesterday for our tomorrow.
Love and Peace,
Matthew Ramer, AIF® Principal, Financial Advisor MOR Wealth Management, LLC
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