From Straight Up to Sideways to "Time to Play Defense" - Q2 2020 Portfolio Managers' Quarterly

Current Positioning

In late June, we moved entirely out of the high yield market, in response to market weakness and emerging economic expectations.

With respect to market weakness, key points include a mid-June "exhaustion gap," wherein S&P 500 prices opened and closed below recent highs—a signal that fewer buyers were willing to take positions.

Another barometer for fear and risk in the market, the VIX, also signaled some call for concern around the same time. Though trending down, the VIX had remained relatively high, with premiums on puts remaining elevated despite the market advance during the quarter. Then, in mid-June, the VIX broke its downtrend from its March highs, suggesting further hedging in the market and a potential for another market sell off.

On the economic front, many states have logged relatively "good" economic data as they have reopened. But remember the pandemic's impacts run deep.

Consider unemployment, for example. Jobless claims have been trending lower but remain at historically high levels and continue to trend far above the peak of claims during the 2008-09 recession. The number of jobs wiped out totals all those gained over the course of an entire decade following the Great Recession.

Historically, a trend of more than 300,000 in weekly unemployment claims is correlated to a recession. With weekly claims in excess of 1.4 million, we think the stock market may not be pricing in the long process that will be required to get employment and consumer demand back to the pre-pandemic levels that support an economic expansion—since as the consumer goes, so does the economy.

Still, for now, market pricing reflects expectations for a V-shaped recovery, and monetary and fiscal support may hold up markets for some time.

However, we think a U- or W-shaped recovery is more likely. Always remember, risk can be repriced very quickly as growth and earnings trends become clearer. The rebuilding process will take years, not months, with many fits and starts. We expect many trade opportunities along that path.

If systemic damages in the economy, labor market, and corporate profits become clearer—and growth stagnates after an initial recovery—a potential 33-50% downward retracing of the gains since the March crash is possible. Into late 2020 and early 2021, a test of those March lows is even possible.

It's important to remember that stock market returns were flat in the decade of the 2000s. Now is too soon to gauge the likelihood that returns the 2020s will be similarly constrained. But what is abundantly clear, to us, is the need to accommodate that possibility, particularly for investors with shorter rather than longer time horizons.

We believe a tactical approach—with a firm willingness to shift to defense—can be an important source of non- or low-correlated returns, with respect to other assets held in investors' broader portfolios.

That's true with respect to downside risk protection—but it's also true, in our view, with respect to potential risks to traditional bond assets. For example, say an uptick in Treasury issuance (which requires commensurate inflows) is challenged by a weakening dollar. That could put upward pressure on Treasury yields and deliver losses to investors using Treasuries for risk-mitigation on an ongoing (as opposed to tactical) basis.

Or, in another potential problem, zero yields on Treasuries could mean no capital gains and no dividend income—therefore removing much or all of the "hedging value" of Treasuries in traditional bond allocations. Yet another concern for "traditional" bond allocations is less diversification potential (given compressed yields) going into a potential flight to quality.

Now is the time, in our view, for hedges of an alternative nature—to ensure investors aren't "stuck" without adequate downside protection.

"Strategy Snapshot"

This quarter, we're starting a new component to our quarterly letter: a brief section that "zooms in" on a particular aspect of our approach at BTS. Our "Strategy Snapshot" this quarter focuses on why we sometimes complement high-yield bonds with other "risk on" assets, as we did for parts of the second quarter.

As you likely know, we see high-yield bonds as a potentially strong proxy for stocks—while, in our opinion, being better suited to medium-term, momentum-based trading, given that high yields are often a bit slower to respond to market-shifting news than are stocks. But high yields are not the only "game in town" with respect to fixed-income assets of a "risk on" type. As noted above, we employed convertible bonds and high-yield municipal bonds this quarter.

Convertible bonds typically have greater upside potential than high-yield bonds, because their potential convertibility to equity shares could lead to theoretically unbounded upside. (The theoretical upside on high yield bonds, by contrast, is limited by their maturity date.) Historically, convertibles exhibit more downside volatility than high yields—but not commensurately more, given their return potential.

The "problem" with convertible bonds is simply the size of the market—simply not large enough to give enough trading liquidity, particularly in the event of a rapid, tactical shift into or out of a "risk on" position. For that reason, our typical allocation to convertibles might be in the 3-5% range (in the context of a 100% "risk on" position). At that level, we see benefits with respect to both potential returns and potential liquidity benefits due to asset-class diversification within the BTS portfolio.

The same liquidity concepts apply to high-yield municipal bonds. These tend to be much more correlated with traditional, corporate high-yield bonds than to Treasuries (as are the relatively "safe" municipals most investors are familiar with). Also, high-yield municipals aren't necessarily "bad" or "broken" muni bonds. Like convertibles, they have downside volatility to take into account, but the return profile can be highly attractive. At BTS, we see this asset class as another potential 3-5% of a "risk on" portfolio.

Other examples of complementary assets we might employ during a strong upward trend include emerging-market debt (which is, historically, highly correlated to high-yield bonds) and even dividend-producing growth stocks.

Closing Thoughts

The second half of this year will continue to test the strength of the markets as the economy reopens and we begin to see the fallout of the damages to the economy and labor market brought about by the pandemic.

Until a vaccine is developed, many activities that were normal pre-pandemic won't occur and entire industries will have to rethink their business plans. The amount of time and resources it will take to retrain and repurpose employees from industries devastated by the virus may not be practical given that many companies have barely survived this pandemic.

Another hindrance to the repurposing of people who lost their jobs is that spending is usually slow during the first stage of economic recovery, as companies try to build up cash to defend against subsequent pullbacks.

We will also have to contend with the potential of a very volatile fall. Without a vaccine, the fear of a second wave of the virus will play heavily on investment. We are already seeing infection accelerate in states that have opened their economies earlier than others, such as California and Texas. This virus will also run headfirst into what very well may be one of the nastier elections in recent history with important issues such as police brutality, social justice, and economic inequality at play.

Thank you for the opportunity to be of service, as we seek to continue to navigate these highly uncertain times. We will continue to seek to protect against the downside while "probing" and participating in risk-asset market advances as they occur.

Sincerely,

Vilis Pasts Matthew Pasts, CMT Isaac Braley

Co-Portfolio Managers

DISCLOSURES

This commentary has been prepared for informational purposes only and should not be construed as an offer to sell or the solicitation to buy securities or adopt any investment strategy, nor shall this commentary constitute the rendering of personalized investment advice for compensation by BTS Asset Management, Inc. (hereinafter "BTS"). This commentary contains only partial analysis and should not be construed as BTS general assessment, complete analysis, research report or updated outlook with respect to the topics discussed herein. This commentary contains views and opinions which may not come to pass. To the extent this material constitutes an opinion or assumption recipients should not construe it as a substitute for the exercise of independent judgment. This material has been prepared from information believed to be reliable, but BTS makes no representations as to its accuracy or reliability. The views and opinions expressed herein are subject to change without notice. Returns for specific BTS portfolios are available upon request.

It should not be assumed that investment decisions made in the future will be profitable or guard against losses, as no particular strategy can guarantee future results or entirely protect against loss of principal. There is no guarantee that the strategies discussed herein will succeed in all market conditions or are appropriate for every investor. Investing in BTS portfolios involves risk, including complete loss of principal. General portfolio risks are outlined in BTS' Form ADV Part 2A and specific strategy brochures, which are available upon request. You should review these risks before deciding to invest in BTS portfolios.

BTS Asset Management is affiliated with BTS Securities Corporation, member FINRA/SIPC. Securities are offered through BTS Securities Corporation and other FINRA member firms. Advisory services are offered through BTS Asset Management, Inc.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

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