Tactical Asset Allocation in Uncertain Times

Mar 10, 2020 | Irene So and Richard So


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How we have actively managed through this volatility.

It seems almost routine to see news headlines announcing “record point drops” in the stock market lately. March 9th 2020 marked the 11-year anniversary of the financial crisis stock market lows of 2009. To commemorate this day, the market had to digest news of an oil price crisis, driven by a dispute between Russia and Saudi Arabia. With a 2000+ point drop in the Dow Jones Industrial Average and a triggered circuit breaker that halted trading on the S&P500 for 15 minutes, markets are now roughly down 19% from the all-time highs that were made as recently as February 19, 2020. Some investors have asked us whether today’s price action could have represented the “big swoosh” or “last wave of selling” that is occasionally seen near a bottom. We are hesitant to call a short-term bottom in this market, as we have not heard much in terms of a catalyst to spur a turnaround. Although there is no single indicator that would be the ultimate signal of a bottom, we are awaiting the following developments:

  • The drop in Treasury Yields stabilizing
  • Fiscal stimulus coming from the US and other G7 nations
  • Fed boosting liquidity in the lending markets and looking toward further rate cuts
  • Global Covid19 cases declining and containment in sight
  • Saudi Arabia and Russia coming to the negotiating table to resolve oil production dispute

As portfolio managers who oversee a discretionary PIM model (Private Investment Management), we have been focused on managing risk while making rotations into holdings that we feel comfortable owning, even after the volatility has subdued.

The PIM model is dedicated towards risk management, with the goal of limiting the downside amongst market uncertainty. As many of our clients have seen, it is often what you don’t own rather than what you do own that enables you to avoid a portfolio disaster. Individual equity selections do matter, however, even the best company in the wrong sector adds little value. Below we seek to provide an illustration of our actions taken in the PIM model.

Asset Mix

For the balanced PIM model, the target mix is typically 65% equity and 35% fixed income and cash. Due to the uncertainty building from coronavirus developments, and the most recent oil price shock, we have gradually reduced equities to 50%. The cash balance has been increased, which represents an ample amount of “dry powder” that enables us to gradually add back into our equity weighting over time.

Fixed Income

Bonds and fixed income have provided the ballast that our portfolio needed during this equity market downturn. Even prior to recent health and oil concerns, we had decided to avoid chasing and holding “high yield bonds”. These types of bonds pay greater income, but they can come at the cost of greater credit risk, which traditionally makes them highly correlated to stock markets. Hence, these bonds can provide high income and even significant price gains while the economy and markets rise, but they can exhibit the same downside volatility should the narrative change for the worse. We have instead focused our fixed income holdings on government treasuries and investment-grade corporate bonds. The recent unprecedented drop in yield and interest rates has led to immense price gains for our treasuries, some of which we have taken some profit on. We have also added to some products that are currently positioned in low duration and short-term bonds, which have limited volatility since they mature quickly. Overall, although the yields on this type of fixed income holdings are not high, they have provided price gains and negative correlation to stock markets, which has greatly helped the portfolio.

Equities

Fundamentally, we do believe equities will recover, but recognize that the market is currently facing a three-front attack from coronavirus, oil price shock and the potential of a presidency led by the Democratic party. In previous blogs, we have written about gold as a good hedge during times of uncertainty. Hence, some gold exposure was added, which has greatly outperformed the equity markets.

What to Avoid

As early as January, the PIM portfolio sold off most of the already few holdings of energy-related stocks. Currently, the portfolio holds only 1% in integrated oil companies. Moreover, the most hard-hit sector of “travel and leisure” had always been too cyclical in nature for our liking and therefore was never included in the portfolio. Finally, as we have written in previous blogs, we had taken an underweight in the Canadian banks due to the potential of higher credit losses. This positioning has served the portfolio well, as the shock to oil prices has also hurt the bank stocks, since they all conduct business in the oil-dependent western provinces.

Taking Some Profits

During times of volatility, it can be difficult to watch past gains be lost. Although we are confident in the future of our individual holdings, the need to raise cash in the short term and smooth out volatility supersedes our long-term outlook. Therefore, position sizes were reduced in many names, notably in banking, payments, industrials, and even technology.

What to Rotate in

Using the proceeds from sales and existing cash balances, we separate our buying into three categories: 1) Stocks that should perform well in the short term, as coronavirus may actually lead to a boost in sales or gain in market share. This can include companies in the retail sector that consumers flock to for necessities. 2) Stocks that have fallen in sympathy with the market but fundamentally have little direct exposure to coronavirus fears. These include companies in aerospace & defense, fleet management and diversified REITs. 3) Stocks that we have always wanted to own in the past, but were unable to buy at what we deemed a fair price. This watch list can be quite long, but includes companies that seek to benefit from the secular wave of growth in Cloud, e-commerce and 5G.

Overall, the PIM portfolio is a constantly monitored and tactical portfolio that seeks to practice risk management. Limiting one’s downside exposure can prevent one from having to climb out of too deep of a hole. Although all investors need time to allow for a sustainable recovery to take hold, a portfolio that effectively rebalances both asset mix and holdings to better match the current investment environment can equip the investor with the patience that is so integral to investing.