What investors should do when risk rises
Despite some progress, we’re still a long way from recovery, says this U.S. analyst, and we must know how to manage risk in a bear market.
A recovery is under way.
It’s just not moving very briskly these days. Especially in the United States.
Here’s how one conservative U.S. analyst puts it: “The easy part of the return from the brink is over. Progress will be much tougher from here.”
Bob Carlson’s Retirement Watch speaks to those who want income. And after three frustrating years of crisis punctuated with rallies and promises of recovery, things aren’t getting any easier.
Mr. Carlson has always insisted on the importance of managing risk, and risk is rearing its head once again. As if it ever really went away.
In his own portfolios, this editor is taking steps to cut down on volatility without sacrificing yield. The funds he chooses are American, of course, and so are not liable to show up in Canadian portfolios.
But the nature of those investments is of considerable interest to those who are trying to find the right balance on today’s financial tightrope.
We’ll look at a few of his solutions and then get Mr. Carlson’s take on the economy and just how much risk we are facing.
A high-yield ride
Mr. Carlson’s Retirement Paycheck Portfolio actually welcomes a little volatility. It is set up for a high yield. As the editor puts it, “If you can stand the ride, I believe you’ll receive the higher payout and a solid total return.”
It is designed to deliver “an above market yield of over 6% with about the volatility of a typical balanced portfolio of about 60% stock and 40% bonds,” says the editor.
The portfolio holds no individual stocks (though it did have Verizon Communications (NYSE-VZ) for a time). Its largest single investment, at 20 per cent of the total value, is an exchange-traded fund (ETF) of investment grade corporate bonds.
iBoxx Investment Grade Bond (NYSE-LQD) is up about 4 per cent this year and yields over 5 per cent. It trades at $107.
The fixed income portion of the portfolio is doing very well, says the editor. It is centred around two funds that hold mortgage securities, Doubleline Total Return Bond (DBLTX) and TCW Strategic Income (NYSE-TSI). The latter fund purchases mortgages at a fraction of their face values and generates high returns when the mortgages are re-financed.
The yield for TCW should be close to 7 per cent for the year, while that of Doubleline is expected to be between 5 and 7 per cent.
Another fund, Nicholas-Applegate Equity and Convertible Income (NYSE-NIE), tracks the S&P 500 Index while paying a yield of over 7 per cent. With 60 per cent stocks and 40 per cent convertible securities, it has the ability to “reduce losses in a major stock downturn.” It also writes call options on the stocks it owns to pre-empt potential losses.
The portfolio also has a corporation that buys shares of master limited partnerships in the energy field, a closed-end fund that owns 150 different funds, one gold ETF — iShares COMEX Gold Trust (AMEX-IAU) — and another fund that holds gold mining and other natural resource stocks.
In short, this portfolio is not simply set up to preserve capital and eek out modest returns. It’s not a matter of avoiding risk, in Mr. Carlson’s view, but of managing it with as much dexterity as possible.
Not there yet
We’re not back to where we started three years ago when the subprime mortgage crisis first hit. We have had a strong recovery in the stock markets and the economy, says Mr. Carlson.
We’re just not there yet. And we won’t be there for a while.
Both the markets and the economy are well below their peaks, the editor points out, whether you measure those peaks by GDP, retail sales, income or just about any other benchmark you’d care to try.
The biggest concern of all continues to be the one we began with — de-leveraging. Paying down debt. The enormous load of debt that imploded with the crisis was built up over almost a quarter of a century.
From 1982 to 2007, credit and leverage went up and up and up, while inflation cooled down. We are still paying for that spending binge.
Look very carefully at employment, adds this editor. The massive firings of 2008 and 2009 are over in the U.S., he says, but the typical hiring boom that comes after a recession has not occurred (as last week’s figures unhappily confirm).
What’s more, we are now losing the government stimulus that prodded the recovery and the rally.
A vicious circle
But there is one bright spot. U.S. companies have lots of cash and most of their debt doesn’t mature for years. They have the capacity to increase dividends and share buybacks, or make capital investments.
Thus far, they have largely held onto that cash, says Mr. Carlson. And they might keep doing so until demand picks up. That will happen when spending picks up, which in turn will happen when there is less debt to be paid and brighter employment prospects.
If you think that sounds like a vicious circle, this editor would not disagree with you.
Earlier, he had predicted that the markets would fall off later on this year. “I may have been too optimistic,” he now says.
Markets peaked in April and employment data has been disappointing ever since. What we saw after March 2009, Mr. Carlson insists, “was a short-term rally in a long-term bear market.”
Today’s market has none of the hallmarks of a new bull market, he states. “The opportunities now are in select income and margin-of-safety investments,” he concludes.
In the end, Mr. Carlson’s is a simple one. If we don’t manage risk, it will manage us — right into some very tight corners.
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