In our flagship Tactical Fixed-Income strategy, BTS is currently invested defensively in money markets.
Our exit from high yield bonds in the latter part of September was not due to the emergence of new market or economic risks—or even the intensification of existing ones.
What changed, rather, was investors’ comfort with those risks. Right now, investors are like the tightrope walker who looks down while far out on the wire.
In this letter, we’ll touch on what investors are seeing as they “look down”—and what we think many people may be missing. First, though, we’ll briefly sketch out our positioning over the course of the quarter.
BTS Positioning
For most of the third quarter, we were invested in the high-yield market in a “risk-on” positioning consistent with a medium-term positive price trend. During parts of July and August, we also employed a partial hedge consisting of Treasury bonds.
As we have said several times this year, it’s important to seek to participate in what may be bear-market rallies—because you never know which rally will turn into the next bull market.
We were happy to participate in part of the apparent upward trend in risk asset prices until early September, so long as investors were relatively sanguine. Initially, even early September’s downturn did not lead us out of the market. After all, we have seen investors respond dramatically to positive news about fiscal and monetary stimulus. The same could have occurred, which is why we seek trend confirmation.
But no snap-back came. After a couple of weeks, our momentum indicators had deteriorated sharply, prompting us to exit the high yield market.
Technically speaking, high-yield bond prices broke downward through a “double bottom,” which could reasonably be taken as an indicator of coming trouble for the stock market as well, given the greater wariness among bond market investors this year.
Another sign of trouble for stocks has been the VIX Index. Despite the S&P 500 Index advancing off its early September lows, the VIX has been “stuck” at a high level.
A third related signal is the recent new lows in the dollar index in combination with higher yields at the long end of the Treasury curve. These factors could limit upside potential in stocks.
The tightrope walker has his blindfold off, the wind is blowing, and it’s a long way down.
Three Looming Risks
Of course, the potential for a “long way down” has been with us throughout the COVID crisis. As we noted at the outset of this letter, our focus as tactical, momentum-oriented investors has been to closely monitor sentiment while staying keenly aware of fundamental risks. Three stand out for special mention.
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The election: There may come a time, whether before or after the election when corporate CEOs and boards of directors start taking specific action in anticipation of tax and regulatory changes should Biden be the winner. Markets could also price in a Biden victory and subsequent sell-off if it becomes clear that Biden will be the winner before or after the election in November. Also, it’s impossible to ignore the potential for continued social strife and revolt, which could increase in intensity should the election be legally contested by either party. High unemployment also has the potential to fuel increased social unrest.
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Lack of fiscal support for continuing COVID-related economic fallout: Prior to the pandemic, the consensus was that new weekly unemployment claims of around 200,000 to 300,000 was a reasonably tolerable and to be expected level. Markets cheered when new jobless claims fell below a million new claims each week, down to a level of around 900,000. It’s obvious but worth saying that level is three to four times the pre-pandemic level. And there are many indications that shifting consumer and work patterns mean that many of the lost jobs won’t be returning any time soon. Limited support for unemployed people—the reduction of the $600 weekly supplement, for example—is, of course, making life harder for those unemployed. But it’s also affecting the broader economy, as those people are more reluctant to spend on consumer goods. Among the companies hit hardest may be those with poor cash flow to debt ratios—such as many high yield issuers in retail, real estate, and energy.
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The virus itself: A clear move back to economic growth will not occur until a vaccine is widely available, and people feel comfortable participating in social events and consumption as much as they did before the pandemic. We don’t doubt that an experimental vaccine may be developed in the near future; however, we expect it to only be available to healthcare professions and front-line workers, with access to ordinary citizens becoming available sometime in 2021. The longer this process of mass access to a vaccine takes, the longer we should expect weak real economic growth.
As of this writing in early October, it’s fair to say that markets are simply “taking a breather.” We are not seeing, for example, a dramatic flight to quality and commensurate upward pressure on U.S. Treasury bond prices. (Nor did we expect that, as we went “straight to cash” in the recent trade.)
From here, we could see risk assets snap back upward in response, say, to resolution on fiscal stimulus and good news on the vaccine front. In that case, we would—as always—monitor price action for a solid trend before looking to participate again in an upswing.
Or, we could see the bottom fall out.
High Yield Market Factors
This quarter, we’ll focus on comments on market dynamics around three differences between high yield bonds and stocks that matter right now:
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High yield concentration in the energy sector: Oil prices remain stubbornly below the level many U.S. producers need to achieve profitability. Because energy firms are an outsized portion of the high yield market, persistently low oil prices are a major risk factor. To a somewhat lesser degree, similar concerns apply to the real estate sector, given high yield concentration there and the highly uncertain—tilting toward highly negative—outlook for commercial and possibly multi-family residential real estate.
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High yield new issuance: During the summer, after bond markets stabilized thanks to Federal Reserve action, many high yield issuers (along with investment-grade issuers) issued additional debt. This may have been wise from a business perspective—giving them extra cash available to help navigate uncertain times. This cash came at an unusually low cost, given low U.S. Treasury yields and no dramatic increase in credit spreads above that yield. But, of course, this money needs to be paid back. There are many unprofitable companies out there—unprofitable, that is, even before the pandemic—that are now loaded up with additional debt.
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High yields never recovered to the degree stocks did: More than in stocks, bond investors seemed to apply a “wait and see” attitude to economic recovery as the COVID situation improved. This has led high yields to more quickly test their lows. This tendency could heighten the high yield market’s predictive power.
Strategy Snapshot
Last quarter we initiated a new section in our quarterly letter, taking a look at an aspect of our work in practice. This quarter, we’d like to offer a few thoughts on the typical scale of hedging positions when active.
Through practical experience and backtesting, we have seen how a partial hedge—say, 30% Treasuries complementing 70% high-yield bonds—may permit us to stay invested in high yields while maintaining our commitment to capital preservation.
We’ve found in both modeling and active trading that a 30-40% hedge may be sufficient, over time, to potentially mitigate major downside losses. (Assuming, we typically expect, that prices of Treasuries rise as prices of high-yield bonds fall.)
Closing Thoughts
We have said since the economic impacts of the pandemic started appearing that it’s not what markets are doing mid-year that matters. It’s whether they can reach December 31st in solid shape.
The end of this year will continue to test the strength of the markets as we begin to see the fallout of the damages to the economy and labor market from the pandemic.
Although the Fed has been extraordinarily accommodating with its policy, a lack of support from the fiscal side would derail the current positive trends in personal income and consumption. Even a lackluster second fiscal stimulus plan could have markets pause their current advances.
Until a vaccine is developed, many investors will continue to hold their bearish views and remain on the sidelines. Prolonged savings rates and higher cash balances for investment will negatively affect the real economy and may put a cap on how far the markets can move higher.
Stock market returns were flat in the decade of the 2000s. The decade from 2010 to 2019 saw the longest bull market and expansion in history. Moving into the 2020s, we suggest that the stock market is setting up to potentially mimic the decade of the 2000s wherein valuations had to form a base to usher in the returns of the last decade.
We believe in tactical and defensive position capabilities during periods of volatility. Although “playing defense” may mean giving up some gains, we always remain willing to step aside when we believe it’s necessary. That was the case in February of this year, where certain of our portfolios were positioned to avoid much of the March crash in risk asset prices.
Thank you for the opportunity to manage your assets.
Sincerely,
Vilis Pasts
Matthew Pasts, CMT
Isaac Braley
Co-Portfolio Managers
S&P 500 includes 500 leading companies in leading industries of the U.S. economy and is a proxy for the total stock market.
VIX is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments.
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.
© 2020 BTS Asset Management
© BTS Asset Management
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