Heard from Clients: Can I take advantage of falling investment markets?

In general, we feel it’s pretty rare for investors to have opportunities to make outsized returns. Doing so typically requires you to “walk into a burning building and write a check.” We use that phrase with clients all the time because we think it captures the feeling of buying into a falling market quite well. When the market is crashing and people around you are panicking, it can feel like the craziest thing in the world to talk about pulling money from safe investments and investing in the very thing that is falling, but in many cases, that is exactly what you should do.

Warren Buffett once said that as an investor it is wise to be “fearful when others are greedy and greedy when others are fearful.”

HOUSTON, 1987: A CASE STUDY

In 1987, the country was in the midst of the savings and loan crisis, and the Houston economy had plummeted. The apartment complex down the street from where I was living had been converted into condos and was more than half empty. Still, the owners of the complex were asking $80,000 for a 2-bedroom unit on the second floor with a view of the parking lot, and rumor had it that the developer had gone bust.

About a year later, a young woman moving to the area let me know she had bought one of the condos for $14,000 at a foreclosure sale. She laughed and added that she probably could have paid for it using her credit cards. Several thousand “credit-card condos” were sold at auction over the next few years. In fact, over the next five years, thousands of foreclosure sales were held all across the country.

Before all those auctions got rolling, however, a California real estate developer cobbled together funds from friends and bought as many half-empty apartment complexes and foreclosed condos in Houston as he could. His average purchase price was approximately two years of rental income. Other wealthy families and eventually larger institutions quickly caught wind of this opportunity and prices rebounded, but not before the developer had purchased some 40,000 units. He is a great example of someone who benefitted by walking into a burning building and writing a check.

When we think about Warren Buffett, the take-away from his famous statement is that valuation matters, and it matters more than you might think. This is true for most asset classes. Even though many investors are generally hard-wired to stay with the herd, we know that if valuations are high when compared to history, investors shouldn’t expect relatively high returns in the future. Many investors rely on the good returns of the most recent few years to justify the prices they are willing to pay. And, many investors capitulate when valuations are lowest because they can’t stomach the losses. But often, the best opportunities exist when valuations are lowest.

We teach our clients that you cannot successfully time the markets. That said, investors can often take advantage of mispriced assets.

So how do you know when to walk into the building? Start by adjusting your thinking, viewing market corrections as potential buying opportunities. As an example, we typically use March 2009. If you listened to any major news network around that time, you may have heard that the financial system was on the verge of collapse and that we all might be going back to the barter system at any moment. Although it wasn’t clear that the worst days of the liquidity crisis were behind us, investors who had the confidence to remain in the market through the crisis fared well, and those who chose to invest at this point did very well.

We believe that there are two key ways to conquer fear of investing in times of a downturn. First, you need to look beyond the moment. Remember that we all still need food and places to live and that those key facts can provide excellent indicators of where to find returns. Second, invest the time to learn about the valuation drivers for each asset sub-class. There is nothing that dilutes fear as much as knowledge. Having the facts and data to make an informed decision gives you the confidence and conviction you need to enter into a distressed market.

Finally, remember that the next market crisis (or opportunity) will likely look very different from the previous ones. For example, if you’re looking for an opportunity in high-yield credit because it performed well after the last downturn, you might miss an opportunity in bank loans or master limited partnerships (“MLPs”). Allow yourself the freedom to search for opportunities and react to what the market has to offer.

CASE IN POINT: EXAMPLES OF MISPRICED ASSETS

Master Limited Partnerships

From their lows in January 2009 through May 2014, oil prices had been rising, but in May 2014 they started to fall, and they fell quickly. As oil prices dropped, the price of midstream natural gas MLPs also began to fall. What does the price of oil have to do with the prices of pipelines that transport natural gas? Answer: not as much as the market seemed to think. Yet, prices for midstream MLPs continued to fall until January 2016, when the price of oil finally bottomed. This wasn’t the first time that this mispricing had occurred. In June 2008, oil prices peaked at over $150 per barrel. As the price of oil fell to the mid-$50s per barrel by January 2009, the price of midstream MLPs dropped by more than 50%, despite the fact that most of the midstream MLPs were forecasting increased distributions in the coming year. In both of these instances, and in four other cases dating back to the mid-1990s when oil prices dropped significantly, the price of midstream MLPs followed. Yet, in each case, the prices of midstream MLPs recovered quickly because their earnings and distributions had less to do with the price of oil than many investors realized. Investors who understood that this was a case where MLPs were mispriced were able to reap the rewards by buying midstream MLPs in early 2009 and again in January of 2016.

High Yield Bonds

The option-adjusted spread on high-yield bonds reached 250 basis points (“bps”) in June 2007, and by December 2008 it widened to almost 2,200 bps. In the dark days of the Great Recession, almost all forms of credit instruments were deeply discounted. Investors were spooked, and the Federal Reserve and U.S. Treasury were taking unprecedented steps to add liquidity to the banking system. Investors who were willing to take the risk of buying lower grade bonds were well rewarded for doing so. Spreads tightened by over 1,500 bps within the year. For a portfolio with an average duration of seven years, a 1,500 bps spread tightening equated to a gain of almost 100%. This phenomenon had occurred previously. In fact, when high yield spreads exceeded their U.S. Treasury equivalent by more than 650 bps, investors were generally well paid for the risk of this type of asset.

The bottom line is that there is plenty of opportunity to make outsized returns if you are aware that such opportunities exist and are on the lookout for them. Of course, we recommend you work with an independent advisor who can help guide you through these kinds of investments.

Andy Hart
Managing Partner, Delegate Advisors

 

A PDF of this column is available for download here.

Andy Hart Discusses MLPs in U.S. News & World Report

As interest rates rise, many investors are re-considering if MLPs, master limited partnerships which invest in American energy infrastructure, still belong in their portfolios. Delegate Advisors President Andy Hart shared his views on the role of MLPs in a portfolio in a recent articlein U.S. News & World Report. 

“MLPs were popular holdings for income-starved investors when interest rates were at rock bottom and equity markets delivered higher yields than much of the investment grade fixed income universe. Depending on the investment, MLPs could kick off yields of 6 or 8 percent or even more, making them good alternatives when U.S. Treasury notes yielded 1 percent or less. But with the Federal Reserve raising interest rates, yields on U.S. Treasury notes are starting to rise too,” U.S. News & World report explains. “Because of rising rates, many market strategists say it’s time to get rid of investments like MLPs. Other experts, however, tell investors not to overreact.”

Hart is on the side of not overreacting. He tells U.S. News & World Report that he’s less concerned about the Fed raising rates because short-term interest rates don't affect MLPs as much as long-term rates. The difference in yields between 10-year U.S. Treasury notes and MLPs, known as the spread, is attractive, Hart says. Historically, the spread between the two instruments has ranged between 280 and 300 basis points. The MLPs he likes yield 8 percent versus the nearly 3 percent yield from Treasurys. That 500-basis-point difference “is a very nice spread and has a lot of cushion.”

Rising interest rates aren’t the only reason some investors are losing interest in MLPs – there is also confusion among investors about how they are taxed. The Federal Energy Regulatory Commission recently said that certain interstate MLP pipelines are ineligible for some tax breaks, Hart explains. But investors misunderstood the situation as the MLP's most important feature, its tax status as a pass-through instrument, remains intact. Pass-through investments don't pay corporate taxes. Instead they "pass through" profits and losses to the owners and investors, who are responsible for paying taxes on their individual portion of the MLP.

To read more about MLPs see the full U.S. News & World Report article here.

 

Canaries in the Coal Mine

In our last update, we noted that the theme of 2018 was to be coordinated global growth. In the past quarter, however, three indicators have caused us to become more cautious more quickly due to the increased likelihood of a correction or worse: increased volatility, a flattening yield curve and the ballooning federal deficit.

Increased Volatility

Volatility has historically risen near the end of a protracted expansionary cycle and often serves as a warning sign of a bear market. The S&P 500 Index has already experienced daily moves of more than 1% (either positive or negative) than it experienced in all of 2017. At the current pace, 2018 would experience 92 days of these 1% moves. This figure is elevated compared to recent averages and would be the most 1% days in the last several years, as illustrated below.

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As we explained in our 2018 Global Economic Outlook and Asset Class Assumptions presentation (available upon request), market volatility tends to be low during extended expansionary periods of an economic cycle. In the current cycle, January of 2018 marked the 107thmonth of expansion since the 2009 market bottom, which is almost three times as long as the average duration of 41 months. The recent uptick in volatility may be temporary, but it may also be a warning sign that post-crisis bull market is coming to an end. 

Flattening Yield Curve

In an expansionary period, the yield curve is usually upward sloping, meaning that yields on the “long end” of the curve (longer maturities) are greater than on the “short end” (shorter maturities). This environment indicates that interest rates are expected to rise as a result of normal inflationary pressures resulting from a growing economy. Recessions, however, are often preceded by a flattening yield curve, when the yield for all maturities is roughly the same, or an inverted yield curve, when yields on the short end are greater than yields on the long end. An inverted yield curve usually indicates that interest rates will likely fall in the future as a result of an economy in contraction or recession, lacking inflationary pressure.

A flattening yield curve can be measured by the difference in yields between 2-year and 10-year US Treasury bond yields (the 2/10 spread). When the difference in the 2/10 spread nears zero, the yield curve is flattening. A negative 2/10 spread is a strong indicator that the yield curve is inverting. 

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As illustrated above, the 2/10 spread has been declining for some time now and is approaching levels reached in or shortly prior to the bursting of the “dot com” bubble in 2000 and the global financial crisis of 2008. The possibility of an inverted yield curve, which has historically portended a recession or contraction, is yet another reason to be cautious in the current environment.

Ballooning Federal Deficit

On April 9, the Congressional Budget Office (“CBO”) reported that the federal deficit is projected to be $804 billion in 2018 (a 21% increase from 2017) and that it will top $1 trillion per year by 2020. The CBO noted that a primary reason for the increased deficit is the recent tax cut package pursued and passed by President Trump, which the CBO has calculated will add $1.3 trillion to the deficit through 2028. Supporters of the tax cuts stressed that the simulative effect of the new law on the economy would outweigh the growing deficit. The CBO, however, projected that the bill would not boost domestic GDP as quickly as the deficit will increase. In 2017, the deficit as a percentage of GDP was 3.5%. This number is projected to grow to 5.1% from 2022-2025 and to remain near 5% thereafter.  

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While a large and growing deficit might not have an immediate impact on financial markets, the long-term effects could be substantially negative for domestic economic growth. Deficits can metastasize, as larger deficits require larger interest payments, especially in periods of rising interest rates. A larger deficit will eventually have a dampening effect on economic growth as government spending shifts more towards debt service from programs and services that are accretive to domestic GDP.

Trade Wars Brewing

On March 1, 2018, President Trump announced via Twitter that “trade wars are good, and easy to win.” Soon thereafter, the White House floated the idea of a 25% tariff on all imported steel and 10% on all imported aluminum to disadvantage imports and support the domestic industry. The rationale had three main components, all of which align closely with President Trump’s campaign platform:

  • Creating leverage for the US in renegotiating NAFTA; 
  • Protecting national security; and 
  • Protecting US metal production jobs. 

Economists, government officials and corporate leaders generally disagreed with the President’s position and proposal with little hesitation. Their basis was that tariffs would likely be met with retaliation from other nations, which would add more barriers to global free trade (a net negative on the local and global economy). This would likely cause ripple effects throughout the economy, including rising input prices for a variety of goods eventually affecting individual consumers by way of higher prices (i.e., inflation).

President Trump’s announcement induced substantial backlash across the globe. Domestically, many US companies, industry associations and trade associations opined that tariffs would negatively affect business. Even some congressional Republicans, usually free market/business friendly advocates, urged Trump to reconsider. The announcement was also at odds with views expressed by the Federal Reserve Chair Jerome Powell, who testified to Congress that free trade is a net positive to the economy. Even Gary Cohn, Trump’s top economic advisor, announced his resignation on March 6, allegedly due to his disagreement with the policy. Internationally, the EU, Canada, Mexico and China all quickly responded to the rumors with announcements that they were actively evaluating retaliatory tariffs on US goods.

President Trump ultimately signed a 25% tariff on imported steel and 10% tariff on imported aluminum on March 8, keeping a campaign promise to be more aggressive on trade policy. These tariffs took effect on March 23, 2018. He did walk back the initial announcement somewhat, as Canada and Mexico were exempted. Trump explained that the tariffs were an early step in renegotiating many of the US’s trade deals, including NAFTA. Then, on March 22, 2018, President Trump signed an executive memo placing tariffs on goods from China in aggregate of $50B on over 1,300 products. This was done as part of a string of actions against China on the basis that China is stealing American intellectual property. China retaliated by matching the US dollar for dollar by placing $50B in tariffs on 128 products. An end to this dispute, which has already affected hundreds of companies and will likely affect more, does not appear imminent.

While it is difficult to predict the potential effects of what appears to be, at the least, increased protectionist policy and, at most, a global trade war, the momentum towards global free trade over the past several decades is subsiding and potentially reversing.Many prominent market strategists believe that this may have negative consequences for the coordinated global growth that the world has recently experienced. Ray Dalio, founder and co-chairman of Bridgewater Associates, recently noted that, due to China’s extensive holdings in US government bonds, a trade war could become an “uglier” capital war. Additionally, Jeffrey Gundlach, founder and CEO of DoubleLine, reminded investors in a recent interview that tariffs were one of the primary causes of the Great Depression. While Delegate does not believe that a depression is in the cards, we are advising our clients to be underweight versus policy targets in most public risk assets, as we believe the downside potential is currently greater than the upside.

Delegate Advisors Wins Multi-Family Office Award from Family Wealth Report

We are pleased to share that Delegate Advisors has won the Family Wealth Report Award in the category of Multi-Family Office (up to and including $2.5 billion AuM/AuA) as part of the 2018 Family Wealth Awards presentation.

“Delegate Advisors is a special team of truly dedicated individuals who genuinely care about the families with whom they work,” comments Managing Partner Andrew Hart. “We’ve really come a long way since the inception of our firm, and we are so honored to be recognized for this dedication to our clients. We put clients first. Plain and simple.”

Since the inception of the firm in 2012, Delegate Advisors has created a reputation in the industry for the innovative, outside-the-box solutions it provides for client families. Delegate embraces a culture of “work smarter” than other, larger firms, and focuses on core values and goals. Most importantly, the team genuinely cares for clients.

ClearView Financial Media’s CEO, and Publisher of Family Wealth Report, Stephen Harris, was first to extend his congratulations to Delegate. He comments, “The firms who triumphed in these awards are all worthy winners, and I would like to extend my heartiest congratulations. These awards were judged solely on the basis of entrants’ submissions and their response to a number of specific questions, which had to be answered focusing on the client experience, not quantitative performance metrics. That is a unique, and I believe, compelling feature. These awards recognize the very best operators in the private client industry, with ‘independence’, ‘integrity’ and ‘genuine insight’ the watchwords of the judging process - such that the awards truly reflect excellence in wealth management.”

The Family Wealth Report Awards judging process is focused around three main areas: experts (individuals and teams), products and services (for wealth managers and clients/institutions of all sizes and types). To avoid any conflict of interest there are three judging panels. One panel of bankers/MFOs who judge the trusted advisor categories. A second panel of trusted advisors who judge the MFO and banking categories and a third panel dedicated to judging the technology section.

Delegate President Andy Hart Discusses Fixed Income ETFs' Move Into ESG

Impact investing, which seeks both financial returns and philanthropic impact, is on the rise, and as a result, there is an increasing number of ways to align your personal values with your portfolio. Andy Hart, president and chief advisor of Delegate Advisors, recently spoke to ETF.com about the increasing prevalence of fixed-income exchange-traded funds that include environmental, social or governance criteria.

ETF.com reports that in the past several months, several fund issuers such as Nuveen, iShares and Sage Advisory have launched fixed-income ESG ETFs, finally offering financial advisors and their clients a way to apply ESG criteria to their whole portfolio.

What has held issuers back until now was a lack of robust data to create debt-focused ESG indexes and ETFs, says Martin Kremenstein, head of ETFs at Nuveen Investments.

Hart comments that he is pleased to see these funds launched and that he’s had at least one client express interest. “Before we invest,” he says, “we are in a “wait-and-see mode” to ensure the other core elements of underlying liquidity, quality and duration are a right fit for clients.”