Q3 2020: Healthier Than May Have Been Imagined

Healthier Than May Have Been Imagined

In conversations with people during the last several months, I have detected a state of mental fatigue as a common theme. Whether due to uncertainty, anger, social unrest, volatile investments, forced changes in daily life, death of family or friends, sudden or unexpected events, the accumulation of bad events this year has been taxing on even the most resilient of us.

If I may be so bold, I am guessing that a majority, if not all, of us have wished, at some point in the last eight months, to be done with 2020. And while we have all taken actions to cope and adjust to the current realities, it has been a trying year so far. And as we enter the final quarter of 2020, there is still a contentious election, millions without work, and a pandemic to contend with before we reach New Year’s Day.

I had a friend remark earlier this year that they would be happy if their portfolio was only down 10% and they had only gained 10 pounds in quarantine.  While that remark lightened the conversation and provided a brief chuckle, I think some of us may not have hoped for much more. But if we look at where we are today, despite all the bad news and events in the last nine months, our portfolios are much healthier than we might have imagined.

Portfolio Actions

Our investment committee has recommended that we sell some of our profits in equity holdings and take some risk off the table amidst the coming election uncertainty. A contested election could delay a definitive outcome for weeks or months and the potential of extended legal challenges warrant some caution. If politicians cannot agree on further stimulus measures, the recovery in jobs and asset prices could falter.

An ultra-accommodative Federal Reserve during the pandemic has led to a rise in equity prices, especially in large-cap technology stocks. Now, as government focuses on monopoly powers and anti-trust lawsuits against these same companies, a rotation into a broader mix of the highest quality companies, especially those with resilient operations makes sense. And depending on the election outcome, we are prepared to lean into companies with strong environmental, social and governance (ESG) track records.

Despite election and pandemic uncertainties, domestic investments remain the largest “core” holdings in our growth allocations. Within our smaller “satellite” allocations, a timely opportunity is developing in high quality, large companies in some emerging markets. Europe’s recovery is shaping up to be moderate at best, while some economies across Asia are showing far more robust recoveries. A weaker US Dollar could further benefit emerging market investments.

We are still in a fast moving environment, and between corporate earnings, Fed accommodations and possible stimulus measures, we are trimming where necessary, but still maintaining exposure to positive outcomes for asset prices. This is more of a tilt toward areas that can benefit from government activity and away from areas that may have further headwinds.

In fixed income allocations, a moderate duration exposure in government and investment grade corporate bonds will continue to provide relative safety and perhaps offer surprising upside return potential if other investments lag. The US economy’s recovery is uneven and far from guaranteed, with over three million lost jobs now categorized as permanent or long-term. If yields drop in response to a deterioration in economic conditions, bond holdings could generate a good total return and provide a ballast to equity price volatility.

Low income yields in bonds do not necessarily limit their effectiveness in portfolio allocations. If bonds are able to rise when other assets fall, then the negative correlation helps reduce portfolio volatility. And when equity asset prices drop far enough to represent a great long-term opportunity, then some bond allocations become the “dry powder” for taking advantage of opportunities and re-allocating into investment with greater upside potential.

Dry Powder and “Fat Pitch” Opportunities

In a year that by some measures may be among the most challenging in a generation, it is prudent to trim some risk exposure following a larger-than-warranted run up in asset prices. With rates near zero, the government is overtly nudging investors out of bonds and cash and into risky assets. And it has been working. New investors, day traders and leveraged investors have begun borrowing to buy stocks and using options to bet on short term upside outcomes. As with other periods in time, we are witnessing a rise in short-term speculation.

We often use the term dry powder in reference to allocations that will provide both 1) stability during volatile times and 2) can be used to purchase growth assets opportunistically after prices decline. Undervalued assets that offer above average long-term upside potential become “fat pitch” opportunities. A so-called fat pitch opportunity is one where the upside return potential is abnormally large relative to the risk of the position. These opportunities are typically the result of large price declines in asset values or from significant events like governmental policy shifts or massive spending programs.

Portfolio Positioning & Mental Preparedness

We have positioned portfolios to be ready for fat pitch opportunities. As markets climbed during the summer, we trimmed some gains. Despite low interest rates, we have maintained fixed income exposure that we believe will offer price stability and will be our “dry powder” used to buy future opportunities.

It is our intention to increase exposures to equities following any future declines. This disciplined approach leads to better long-term portfolio results. And it requires a strong stomach and willingness to buy when other investors are selling.

The way to be mentally ready to buy these opportunities  at a time when the economy looks weak and markets are volatile, is to be confident that you have the resources to live life normally through a market downturn, and to trust that the amount of capital being allocated (from safety to growth) is aligned with your life goals and tolerances. We have always accomplished this through our planning process, periodic meetings, and other communications.

As always, if you have any questions or want to review the plan of action, please call or email and set up a time to review your financial picture and our plan for the future.