By David R. Guttery, RFC, RFS, CAM President, Keystone Financial Group-Trussville, AL
First, let me just say that every wealth management plan is implemented with guardrails that are unique to the client. These guardrails address limits and tolerances for risk, and codify such things as objectives, and the time with which we have to achieve those objectives. There is no uniform, one-size-fits-all solution to investing through strange and unique periods of time. Whether we are in a recession or not, one universal truth still holds, and that is investment portfolios that are used to implement holistic wealth management plans, should be individualized, and reflect the unique characteristics of the client.
So, these thoughts are at a very high level.
I have drawn reference to this graphic within previous articles. It is the economic cycle.
I have encouraged people to think of it in terms of changing seasons. Imagine how your behavior is incentivized by what you feel. As we move from left to right on this chart, and the seasons change from spring, to summer, to fall, to winter, and then back to spring, think about how that incentivizes your choice of clothing. During the summer, you’re wearing short sleeve shirts. During the winter, you’re wearing jackets. Clearly, as evidenced by economic metrics to which we drew reference within our last article, we are in the winter season of this cycle.
Therefore, the jackets that we are wearing consist of consumer staples, utilities, healthcare, mega cap pharmaceuticals, and energy. These are all durable areas of the economy. You will consume these products and services, durably, regardless of the economic state within which we find ourselves. Portfolios change from season to season. What should be in your portfolio now, should reflect the season that we are in.
I first saw this graphic 35 years ago when I was in school, and to my recollection, it has never been wrong. The key is understanding where we are in the economic cycle for this to be of benefit. Now having said that, I would also suggest that there is a deeper analysis to be made. At the present time, I would suggest that there is an equities part of this conversation, a fixed income part of this conversation, and then an alternatives part of this conversation. With the oddities that we observe today, and that we discussed within our last video, you really do need to think outside of the box, because historical anecdotes are of little value right now.
As for equities, this is what I call Warren Buffett thinking. Stop for just a moment and consider some very obvious things that are right in front of you. Who is the manufacturer of your razor blades? What company makes your toothpaste? Who makes your favorite bar of soap, dishwashing detergent, and favorite beverage? Who are the companies that make the things that you purchase consistently? Of all of the things that you consume in a given month, which are the ones that you could not do without? These are what I call economically durable products and services.
As I mentioned in my previous article, evidence suggests that 66% of American households are living paycheck to paycheck, and the personal savings rate is at a low level not seen since August 2009. In that kind of environment, I would suggest that discretionary things, that you don’t necessarily need, will be the first things to be paired away from monthly consumerism. Therefore, we can expect the revenues, and earnings of such companies to likely be lower during recessed periods of time. So, avoid those companies. Rather, focus on the companies that produce the things, and services, that you will consume durably.
Next, we must evaluate those companies in terms of financial health and strength. Which companies are trading at a low, and attractive forward P/E ratio? Which companies are paying a higher, and attractive dividend? It isn’t enough to identify the manufacturers of durable products and services, but you must further screen those companies for health, and positioning within their respective groups of peers.
This helps to build what I call the dividend put. Put, being a metaphor, simply suggests that if I can build a larger, and steady stream of dividend income into a portfolio, the more insulated that portfolio becomes from day-to-day volatility.
At a very high level, I have encouraged clients to think of it this way. If your overall return reflects a loss of 10%, but the things that you own are returning a 5% dividend yield over the coming 12 months, then in my mind you are down net 5%. The construction of the dividend put is a very real way to offset the volatility of a recessed period of time. Those dividends can be constructed by using the stocks of companies that produce things that you are consuming durably. Those products and services will be among the last things to be paired away from a budget during a recessed period of time.
I would also draw reference to the part of our last article within which we discussed observable actions by corporations today. Metrics regarding labor costs and worker productivity are very caustic right now.
There is ample evidence that corporations are trying to become leaner in this environment, not bigger. The most recent reading on second quarter annualized labor costs showed an increase of 10.8%, while worker productivity declined by 4.6%. We saw similar metrics in the first quarter as well.
So, what observable evidence do we have that corporations are attempting to become leaner in this environment? We have heard from process automation technology companies as well as information management companies that revenues are being driven by enterprise-level pricing as companies attempt to streamline their automated industrial processes, and the efficiency with which data is managed, in an effort to employ fewer people, remotely, and to replace the human element with automated processes. So, from a strategic hold standpoint, it would make sense to have narrowly focused holdings in such equities, while also maintaining large, nebulous footprints in the staples, utilities, pharmaceuticals and other such companies that I mentioned earlier.
Now, as for fixed income, I believe that every portfolio, regardless of the objective, and time, should have a component of fixed interest. Normally, this provides negative correlation against volatility, and buoyancy, through the inclusion of bond yield into the portfolio. As we discussed within our last article however, this is a very strange period of time. Treasuries and equities are positively correlated for the first time since 1972. Clearly, that was a very long time ago. Being positively correlated means they are moving in the same direction.
The two vs the ten year treasury yield curve is inverted to a degree not seen since the year 2000. An inverted yield curve simply means that you have prices that are going down as evidenced by rising yields. There are a myriad of reasons for this, but at a very high level it mainly comes down to there being a glut of U.S. Treasury debt on the global market. Again, we discussed this in greater detail within our last article.
For today’s discussion, it’s an important observation because we are not able to achieve negative correlation with market volatility by holding treasury securities for example that have historically given buoyancy to portfolios during times such as these. So, what do we do about it? At this time, we are focusing heavily on fixed income instruments that are issued by the same corporations that I mentioned in the equities part of this discussion. The health of these companies is critical when you’re considering their fixed income issues. Furthermore, we seek to hold maturities of less than five years, with single or double A credit quality, or better, in an effort to minimize duration, and maximize yield into the portfolio.
This does not guarantee against negative price movement, but so far this year, it has certainly been less pronounced than what we have seen from the treasury complex.
Lastly, we must consider alternative investments. Alternative, as the name implies, means something outside of the normal and customary box of standard investment tools. These can be real estate investment trusts, unit investment trusts, limited partnerships, and they can also include such things as structured notes, and market linked CDs. Very often, these alternative investments are limited to accredited investors because of their complexity. However, in certain situations they can be very useful tools for achieving the negative correlation, and the income for which we are seeking at this time.
Having said that, I would also suggest that there are some very obvious tools that I would include in this category that are often overlooked, but could nonetheless be very useful. For example, the products of insurance companies, including, but not limited to equity indexed annuities, and cash value building life insurance, can be viewed and external complement to what we may maintain as a sleeve of fixed income securities in a brokerage account. With universal life insurance for example, we have attributes including the guarantee of principle, the tax-sheltered aspects of life insurance, and a fixed interest rate that is very often higher than what you can find with traditional fixed interest products, and on par with the yield that could otherwise be generated from a sleeve of bond investments.
So again, you really have to think outside of the box in an environment like this. The yield curve is more steeply inverted than at any other point over the last 20 years. The dollar is on the verge of setting a new all-time record high against the global basket of currencies. Treasuries are positively correlated with equities for the first time in 50 years. The University of Michigan consumer sentiment survey is at an all-time record low.
The Goldman Sachs housing affordability index is at a level that we haven’t seen since the early 90s. As we mentioned in our previous article, because of the strength in the dollar, gold, is also positively correlated with inflation.
So, if you’re reading this, then I would strongly encourage you to work diligently with your source of holistic wealth management, to think outside of the box for solutions with which to meet such a strange period of time. In closing, let me just draw one last reference to the economic cycle chart that we viewed at the beginning of this article. In terms of clothes that you wear during changing seasons, there is always something to wear. In some cases, the choice of those articles of clothing is pretty obvious, but in a difficult period of time like this, you really must think outside of the box for creative ways to find warmth during a cold recessed period of time.
(*) David R. Guttery, RFC, RFS, CAM, is a financial advisor, and has been in practice for 31 years, and is the President of Keystone Financial Group in Trussville. David offers products and services using the following business names: Keystone Financial Group – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA / SIPC – securities and investments | Ameritas Advisory Services – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information provided is gathered from sources believed to be reliable; however, we cannot guarantee their accuracy. This information should not be interpreted as a recommendation to buy or sell any security. Past performance is not an indicator of future results.