Tactical managers must maintain a big picture view, and then find ways to invest with that perspective over a multiyear time frame. One of the most challenging aspects of this task relates to the dizzying array of analysis and opinions we digest each day, particularly in a world where updates of all sorts are monitored on a cell phone within seconds of occurring.
In order to escape from the daily noise pollution, we must constantly step back and assess markets from fifty thousand feet, where the short term clutter is replaced by a clinical evaluation of different investing disciplines that we follow (business cycle analysis, technical conditions, valuation, monetary policy, quantitative evidence, and independent research evaluation). When viewed through this prism, we see the worrisome combination of an aging and expensive bull market, a slowing economic and earnings backdrop, and a technical profile that continues to deteriorate beneath the surface. To sum it up, we believe that the current macro environment suggests that a cautious approach to investing is best right now.
Given a guarded view of the markets, there are multiple ways for us to apply our view to our portfolio construction. The first is to simply alter the asset allocation of the portfolios that we manage. This requires us to alter the amount of equities, fixed income, and alternatives we hold in our portfolios to get in line with ever changing market conditions. Because we run flexible portfolios that use a high percentage of exchange traded funds, making targeted adjustments in the amount of equities and other risk assets (ex. commodities) is a simple way to lower the volatility. Amazingly, some investors won’t give themselves the ability to move the asset allocation of a portfolio due to their belief in an efficient market theory that we consider outdated and inaccurate. At Pinnacle we believe that markets are supremely inefficient by nature, and that giving ourselves the flexibility to change asset classes due to changing market conditions is grounded in simple common sense.
For investors who won’t stomach the risk of altering portfolio allocations, there are other methods to become more defensively positioned, some of which we use in our process as well. Sector rotation is another method that investors can utilize to alter the volatility in their portfolios. When U.S. equity markets are hitting a rough patch, investors have a tendency to rotate more money to defensive sectors such as Staples (XLP), Healthcare (XLV), Utilities (XLU), and Telecom Services (XTL). This makes sense since these sectors usually have lower inherent levels of volatility, higher dividend yields, and less cyclical earning streams. Of course, not every cycle is the same and investors need to be aware of nuances that might make sectors more or less attractive than the typical playbook. For instance, in the current cycle, we are underweighting both Telecom and Healthcare holdings. Telecom companies have arguably become more discretionary in nature, and Health care has enjoyed a big run up during the bull market, boasts a high concentration in volatile and expensive biotech companies, and generates a very high percentage of revenues and profits overseas. That leaves Utilities and Staples to be our preferred domestic defensive plays at this time.
When sector rotating, don’t forget fixed income, as rotating between fixed income sectors can have a major impact on portfolios returns. In the pre-Quantitative Easing world, our cautious stance would call for a large percentage of high quality treasury bonds that typically do well during bouts of volatility. We currently own a healthy percentage of long duration treasuries (TLO/TLT) to defend against the deflationary tendencies in the global backdrop, but we also have been careful to keep cash-like holdings at elevated levels due to the extreme low yield environment and the recent start of a fed hiking cycle. Cash holdings are liquid stability, and for those willing to stomach a very small amount of volatility, ultra-short bond ETFs (ULST) might also make sense. We realize that High Yield Bonds (JNK) are climbing in yield and have arguably discounted more bad news than their equity counterparts, but we are still leery to buy vanilla high yield indices just yet due to their high concentration in the energy patch, and a feeling that the recent widening in spreads may be signaling that things are about to get worse in the global economy.
Today’s investing climate is as challenging as ever, and demands that investors be willing to change with conditions on the ground. Combining asset allocation with ETF sector rotation strategies is our preferred method to navigate through this difficult market environment.