Weighing the Week Ahead: Building a Transition Portfolio
We have a moderate week for data, featuring housing, sentiment, and unemployment claims. Most important will be the report on personal income and spending.
Attention will remain focused on vaccine progress and the pandemic, as well as the progress through Congress of a stimulus package.
With markets near record highs, many investors are wondering about the safety of their portfolios. With growing hope for a full economic recovery, it is wise to ask:
Is it time to build a “transition” portfolio?
Last Week Summary
In my last installment of WTWA, I described a special letter I received from Mr. Market. It was brimful of optimism, an explanation of what to expect if everything goes right. It was fun for me to write and I hope readers found it useful.
Since we are about to get the annual letter from Mr. Buffett it will be interesting to contrast his thoughts about the market.
I always start my personal review of the week by looking at some great charts. This provides a foundation for considering news and events. Whether or not we agree with Mr. Market, it is wise to know his current mood.
I am featuring Jill Mislinski’s chart of the market week. Her approach combines several key variables in a simple readable format.
Sector movement is another important clue to market trends.
Juan Luque from Incline’s trading desk provides a helpful interpretation of the sector moves.
The S&P 500 finished the week down for the first time in three weeks. The Energy sector was up 4.5% followed by the Financials sector at 3.78%. Both sectors continue moving along the leading quadrant. Materials and industrials were also up 1.92% and 1.42% respectively. The remaining sectors posted losses for the week. The Utilities sector was the worst performer this week posting -2.76% weekly loss and remains in the lagging quadrant. The second and final sector in the lagging quadrant is the Consumer Staples which was down almost 1% for the week.
The market lost 0.7% on the week with a trading range of only 1.7%. You can monitor the actual volatility versus the VIX over several time periods in my Indicator Snapshot, featured in the Quant Corner below.
The News Overview
Each week I break down events into good and bad. For our purposes, “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!
I carefully sift through many articles, so that you can see the most relevant information for individual investors. Most of these have links to specific posts, but that is difficult for one very prolific writer. If you like the several charts a include from https://thedailyshot.com/ you should check out the massive full slate.
With 83% of the S&P 500 reports in, 79% have beaten estimates. The size of the beats, at 14.6%, is the fourth highest level in more than a decade. (John Butters, FactSet). Surprisingly, the companies with positive surprises have not been rewarded with a higher stock price.
Coronavirus and Vaccine Distribution
I am delighted to include this topic in the “good news” section.
- Many of my regular data sources reflect the reduction in new cases. This chart from STAT shows the decline in the rate of new cases, back to the November levels.
- My own favorite indicator is the percentage of positive tests. I calculate this from other sources and maintained my data since June. The rate for the last month was 5.9%, the best level since November. The target for this metric is <3%.
- State-by-state analysis shows the wide disparity in the testing results. States seem to have given up on a tracing program. If you go to the site and mouse over the map, you can see the results for each state. My state is still over 15%. Here is a static version of the map.
- Vaccine progress is very encouraging.
- Industrial production for January increased 0.9%, beating expectations of a 0.6% gain, but below December’s downwardly revised 1.3% increase.
- Housing starts for January increased 1580K (SAAR) missing expectations of 1607K and lower than December’s 1680K — but….
- Building permits, a leading indicator for housing starts, increased registered a SAAR rate of 1881K, much higher than expectations of 1670K and December’s 1704K.
- Best of all, retail sales for January increased 5.3%, crushing the expectations of a 0.8% gain and December’s -1.0% change.
We know that part of the spending is fueled by government stimulus and assistance payments. Home refinancing including a “cash-out” has increased dramatically since the start of the epidemic.
- Initial jobless claims increased to 861K missing expectations of 775K and up from the prior week’s 848K (revised up from 793K). Here is a chart to help with perspective.
- In contrast, the “high-propensity” business applications show improving prospects for business formation. (This classification requires, among other things, a stated date for the beginning of wage payments). The Census Bureau no longer does a seasonal adjustment, resulting in this chart.
The Daily Shot version provides a more helpful chart design, comparing the early-year seasonally strong period with those of prior years.
The Texas winter storm emergency leaving more than 4.5 million customers without power and a death toll which officials say is probably larger than the 70 known cases. The Texas Tribune.
We have a normal economic calendar with several housing reports, the weekly unemployment update, and sentiment data from both the Conference Board and the University of Michigan. Most important is the report on personal income and spending for January, both expected to show a large rebound from the December data. This report also includes PCE prices, the Fed’s favorite inflation gauge.
Pandemic updates and progress of the stimulus bill in Congress will capture most financial headlines.
Briefing.com has an excellent weekly calendar and many other useful features for subscribers.
Theme and comment
With the continuing focus on new market records and expected tailwinds, there is little attention to most of the economic data. It is a good time for investors to do a critical examination of the source of the market highs and their personal portfolio allocations. Think about the post-recession environment and view today as a way-station. Investors should be asking about:
Building a transition portfolio.
Readers often ask how I can remain so cautious about committing new money to long-term equity investments. While I have been providing updates about how I have been positioned, some have asked for more detail. As an investment manager, I obviously cannot just list my holdings. Instead, I will do the following:
- Describe an approach to building your portfolio in uncertain times.
- Provide some specific examples.
- Include some background information from useful sources.
Each investor must make a personal decision about goals, immediate needs, and risk. This is an important process, and the right answer varies a great deal. I classify stocks as solid post-pandemic holdings, stodgy names with limited downside (and upside), aggressive speculations, and ultra-risky holdings. I also work to earn a reasonable return on cash. I currently hold over fifty positions in individual equities and nothing in bonds.
Eric Savitz notes the transition in the company, reinventing itself for the cloud-computing era.
If Oracle is a cloud play, it is certainly not being valued as one. The stock trades for 14 times consensus estimates for the May 2021 fiscal year, or 13 times if you use the fiscal 2022 consensus. That compares with the S&P 500 index at 23 times this year and 20 times next year. Were investors to use the cloud-based data warehousing company Snowflake (SNOW) as a benchmark, Oracle would be valued at more than $3 trillion, up from its current $183 billion.
I am always delighted when Barron’s is on board when I already own the stock! In my Yield Boosting Corner we have a very active chat room with many excellent investors. They constantly recommend ideas which I screen, discuss in our weekly Zoom session, and add to our watch list with a specific rating. One of the rating categories is “too good.” This means that the stock has so much upside and potential for gap-style moves that I do not want to write calls against it. We always start our screening with a look at the FASTGraph analysis. Here is what we saw:
I am suspicious of the earnings forecasts for some stocks, especially those threatened by the pandemic or the economic cycle. The Oracle business model is reassuring on this point. I love the earnings growth rate of over 11%, the high credit rating, and attractive valuation.
Pfizer (PFE) is an example of a typical holding. Blue Harbinger writes:
Sometimes it can be better to avoid the highest dividend yields, and instead invest in a steady growing blue chip dividend payer. For example, the 4.5% dividend yield of mega-cap pharmaceutical company Pfizer is worth considering because its return on capital is above its cost of capital (a good thing), its margins should increase as a result of the Upjohn spinoff, its covid vaccine is in addition to an already strong core business, it’s paid 328 consecutive quarterly dividend (and has increased the dividend 11 years straight), and the share price just dipped.
My basic approach to high-yield income investing is illustrated in my Yield Boosting Corner. No one will be excited by the individual stocks. Stodgy and safe is the name of our game. We seek a safe platform for selling calls. This constitutes 80% of our return with dividends making up the other 20. Breaking even on the underlying asset trades is just fine.
We are currently taking a monthly payday, representing 10% of the cash returns. So far this leaves us an equal amount to reinvest at attractive prices.
The key to the success is in the overall portfolio, not obsessing over individual trades, and being very fussy about stock selection.
Stocks with Post-Pandemic Risk
Airlines provide a great example. Airlines Still Don’t Know When Passengers Will Return
The four largest U.S. airlines — American, Delta, United and Southwest Airlines — lost more than $31 billion last year, and the industry over all is still shedding more than $150 million each day, according to an estimate from Airlines for America.
My Wisdom of Crowd surveys from the Great Reset project did well to identify the danger in this sector. Despite the government help, the rebound is far away. Can these companies expect more assistance?
The High Risk in Bonds
Rida Morwa gets it right when he explains why Treasuries Are Losing Their Safe-Haven Luster.
…Treasury bills have outperformed during times of turbulence for capital preservation. They also have acted very well during periods of declining interest rates. However today Treasuries are losing their safe-haven luster. With the 10-year yield around 1.2%, you are not getting much income. Add to this that with rising interest rates (which I expect to slowly creep higher), bond investors are set to see capital losses, especially for the longer term treasuries. One reason to worry is that the Fed has pledged to let inflation run above its 2% target to get the economy going. Higher inflation erodes the value of long-dated bonds. As long-term interest rates rise, Treasury prices decline. This is because future coupon payments on Treasuries are worth less in real terms. This is an asymmetric risk working against you, and you are not getting paid much for this risk.
He argues that some REITs have more potential, but more volatility.
My own approach to creating a bond proxy also involves REITs. The key to my method is identifying the sectors for which the expected economic conditions are most friendly. Then I look for the safest names within that sector. I buy a basket of the best based upon safety, with an expected range of =/- 5%. I do not select based upon yield. Whatever I get is better than bonds and (arguably) safer. The current yield of this portfolio is 4.2%. Two of my own holdings are on the Morwa list, WPC and O.
This approach is something that investors can imitate if they focus their research on finding the safest REITs. Take, for example, this excellent article by Brad Thomas, Nothing Scary About W.P. Carey. His logic for a “safe” rating includes this analysis:
But its three- and five-year dividend growth rates are both below the typical 2% inflation rate to just 1.2% and 1.7%, respectively.
To some, this may be an issue. However, it remains much better than dividend freezes or, even worse, dividend cuts. Instead of doing either, it increased its dividend more than once last year – giving it a consecutive 24-year streak in this regard.
Moreover, its dividend sustainability and safety remains impressive. WPC paid $4.17 per share in dividends in 2020 and generated $4.74 per share in adjusted funds from operations (AFFO).
We all love to own some stocks with exciting potential. Your asset allocation should include a bucket – probably a small one – for these ideas. Here is an example from Barron’s. Author Daren Fonda believes that Flour (FLR) has 80% upside based upon a restructuring, better progress on a big Canadian project, reduced reliance on the energy sector, and more consistent cash flows via new contracting procedures.
The key to a good speculation is finding something not reflected in the traditional metrics. Here is what to expect on the FASTGraph.
My most recent choices are much more sedate. Ford (F) is a good example.
My colleague Juan Luque is a contributor to Incline’s Investing with the Trends blog. His most recent post includes and interesting argument in favor of holding some commodities. This is a challenge for most investors to do properly. They really need an expertly guided investment product to add diversity and increase overall return expectations. Juan writes:
Looking at commodities, chatter is picking up that the next commodity bull run may have begun. We are starting to see major moves in some of the agricultural commodities, metals, and oil. The last peak in the commodity cycle was in 2008. Demand is being driven by China (China recovered quickly from the pandemic) in addition to monetary stimulus and a weak U.S. dollar. As a reminder, commodities have served in the past as a hedge against inflation. There are several commodities reaching six year price highs and the Bloomberg Commodity Index keeps trending higher.
Even the best sources say stupid things. This week one of my favorites, who will go unnamed, explained that the spike in jobless claims was OK because it increased the chances that Congress would pass the stimulus bill.
Employment is certainly important, but the battle lines on stimulus relate more to overall cost, the inclusion of a minimum wage, the size of payments, and aid to state governments. None of the swing voters is looking at weekly updates of unemployment claims.
The most important investment advice this week comes from Chuck Carnevale in How To Know When To Sell A Tech Stock.
This article is packed with wisdom, including this gem about efficient markets:
Legendary investor Peter Lynch in his best-selling book “One Up On Wall Street” said it like this: “Just because you buy a stock and it goes up does not mean you are right. Just because you buy a stock, and it goes down does not mean you are wrong.” The point is that a rising stock may be dangerously overvalued, while the falling stock price may indicate that the company is becoming a rare opportunity on sale. Understanding this comes down to realizing, without questioning, that the market is not always right nor is it always efficient. On the other hand, it would be more correct and accurate to say that the market, although not always efficient, is always seeking efficiency.
That last statement is why I rely on valuation so much. Over the years I have learned that the price of the stock will inevitably align itself with the intrinsic value of the business. Unfortunately, the timing of that occurrence is unpredictable. Sometimes, the movement back to intrinsic value (up or down) can be very swift, at other times the valuation anomaly can continue for a tortuously long time. Therefore, you simply cannot predict how high is up or how low is down. On the other hand, you can recognize too high and too low when you see it. Once that is accomplished, you can make a rational long-term decision. And more importantly, if you give that decision time to work itself out, it will also be a profitable decision.
As always, he provides some solid examples. He looks at Microchip Technology (MCHP) and describes his feelings about his five-bagger. He sold half of his position, locking in a profit more than double his original cost. What next?
I still am letting some of my winner run. But most importantly, I continue to monitor this remaining position closely to not give away as much of my excess profit as possible. In other words, if the stock price takes a drastic turn for the worse, I am poised to finish harvesting the entire position. Unrealized gains can quickly turn into unrealized losses if you are not diligent. Once again, I do not expect to execute my sell perfectly, but I take solace in the fact that I am already well rewarded regardless.
Finally, he looks at replacements that are more attractively valued. This is an excellent process, which I endorse and use. I have several big winners that I monitor in this way. Here is one example from my “Aggressive Stock Program.”
My basis in this position is 28.72, so there will be tax consequences to selling. One of the toughest challenges for the investor is letting winners run. The market obviously places a value on this technology that is much higher than traditional measures show. So far, my patience has been rewarded, but it seems like a good time to use Chuck’s advice.
I have a rule for my investment clients. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update, featuring the Indicator Snapshot.
For a description of these sources, check here.
Technical measures have improved in the short and long-term time frames.
My continued bearish posture for long-term investors is based upon both valuation and fears about the continuing recession. My own earnings analysis suggests that the recession is not reflected in current, bottoms-up estimates. As always, I expect good times – but not yet. This is going to take a lot longer than people expect.
One of our featured sources, Georg Vrba covers this nicely in his recent unemployment update,
His chart summarizes the indicators and the full article describes what it would take to get a signal for the end of the recession.
With the addition of important data, it is time for a review of Jill Mislinski’s Big Four Indicators.
It is comforting to see the January uptick. The January Real Income data will be out in the coming week.
The Atlanta Fed has updated its GDPNow forecast. This responds to several economic data reports in something close to real time. I am going to show the update and then the recent factor changes.
I have not comprehensively reviewed the underlying methodology, but this does not feel right. The GDP forecast moved from 5.2% to 9.5% in three weeks? Few of the listed factors would be viewed by most economists as among the most important reports.
For contrast, here is the most recent update from MarketDesk Investment Research, which provides comprehensive analysis on the economy, emerging trends, and relevant data. They also follow a number of strategic and tactical approaches. I find their work very useful.
There is a lot of information packed into this table, which I regard as right on target.
The leading business cycle source, Dr. Robert F. Dieli, just provided his regular update on where we stand. A key point, which most others ignore, is the importance of not “forecasting the forecast.” Build a great approach and then use it. Here is his current take.
Final Thought for Investors
I hope readers enjoyed my excursion into portfolio construction. I appreciate those who have been worried about me being “out of the market.” As I have written several times, all of my programs are doing fine. I currently hold about fifty individual positions in stocks and nothing in bonds.
The biggest worry for investors should be the risk in the traditional 60/40, stock to bond, portfolio. Both sides have major risk right now. It is time to be much more selective and careful in building your portfolio.
Those who would like some help in their research should check out my collection of White Papers (covering risk, market highs, and investor pitfalls) as well as our Great Reset project findings. (Coming soon) I am introducing a new forum there to facilitate discussion. There is no charge and no obligation for either my collection of White Papers or the Great Reset Group reports. Just make your request at my resource page.
My portfolio fits my own situation and comes approved by Mrs. OldProf, although she has a few of her own choices where valuation is no concern. She definitely lets her winners run and I am not allowed to meddle!
For readers, my key suggestion is as follows:
It is time to check for hidden risk in your holdings. Be ready to trim winners and look for value.