In this video Webinar, CMG Capital Management Group Head of Distribution Mike Sciortino hosts Steve Blumenthal to discuss the CMG Managed High Yield Bond Program. The Webinar was an interactive follow-up to Steve’s Forbes piece titled, Junk Bonds Are The Investment Opportunity Of A Lifetime, Just Not Yet.
Access the 45 minute video Webinar here: CMG May 20, 2015 High Yield Webinar. Transcript below.
May 20, 2015
Mike: Good afternoon, and welcome from our offices here in Philadelphia. This is Mike Sciortino, Head of Distribution here at CMG.
Today I have with me Steve Blumenthal, CEO and founder of CMG. Steve will talk a little bit about a recent article that was published in Forbes magazine entitled High Yield – An Opportunity of a Lifetime, Just Not Yet.
The way we’re going to format the webinar today is Steve’s going to present for about 20 minutes, and then we’ll follow it with some Q&A, if you will.
Very few have traded high yield trends and high yield cycles as Steve has. Steve has run our flagship strategy, the CMG High Yield Bond strategy, since 1992. Today we have an extraordinary circumstance that exists in high yield, and I think what you’ll find is that Steve’s going to present some very interesting insights that you can use with your clients to present the high yield opportunity.
I will tell you that Steve believes that there is an opportunity, an opportunity that’s greater than in 1991, 2002, and even in 2008. What he’ll show you today is why he believes that now is the time to start positioning your clients in the high yield bond arena.
Our goal today is really very simple. By the end of the day, what we would like to leave you with is a good understanding of how to participate, how to protect, and how to position your clients for this upcoming opportunity.
Now, before I turn it over to Steve, I’d like to take a quick poll. I’d just like to get a feel of how you are utilizing high yield today with your clients in their portfolios.
If you look on the bottom of your screen, you’ll see there’s a question that we pose, and the question is simply, “What percentage of your clients’ portfolios is allocated to high yield today?”
Take a moment, give us your response, and later on in the webinar, I’ll share the results.
So, with that, Steve, I’d like to welcome you. I know Steve’s really excited about the opportunity that we have to visit with you this afternoon. I’d like to turn it over to Steve so that he can share this opportunity.
Steve: Well, thank you, Mike. Thank you very much, and thank you for being with us today.
I thought this was a great little statement of the opportunity that I see ahead, and we’re going to talk about that today. It’s very good, it’s soon; it’s just not yet. The idea behind the article that I wrote for Forbes, Junk Bonds are the Opportunity of a Lifetime, Just Not Yet, let’s dive into that a little bit deeper and talk about what that looks like, and how you can help prepare your clients.
The Situation in High Yield
In 2006 and 2007, corporations issued $700 billion in debt. 28% of that was B rated. In 2013 and 2014, corporations issued $1.1 trillion in debt, 50% more. 71% of that was B rated. Less than 20% of the debt in 2006 and 2007 was covenant light – and we’ll talk about covenant light in a second – now, it’s 60%.
Over the last five years, because of the 0% interest rate policy, assets have been in – and investors have chased into – higher, riskier asset classes. The total amount of money into high yield in five years has been an additional $1 trillion. We’ve gone from $1 trillion to a $2 trillion sized market.
When I started trading high yield back in the early 1990s, perhaps it was around $200 billion. When the high yield market was created back in the 1970s, we’ve gone from zero to $1 trillion by 2010, and within five years, it’s doubled. That’s alarming. And when you look at the statistics above that quote, 71% B rated, 60% covenant light, all of this is a backdrop of what will set an opportunity, and I’m going to talk a little bit more about that.
In 1987 when Greenspan took office, debt to GDP was 150%. Now, it’s 390%. When we borrow today and spend that money, it lifts the economy, but at some point, that money needs to be paid back or something happens in the form of defaults or restructures or those sorts of things.
The developed countries around the globe are in the same debt mess, and some of them far worse than we are. So this is an issue. It’s a drag on growth. We do have business cycles and recessions; we’re going to look at that and how to think about that in terms of positioning.
So the situation here when you look at 2006 and 2007, the issuance of covenant light bonds, and then particularly, take a look at 2011, 2012, 2013 and 2014. What does this mean?
To an individual investor, think of it this way. Your brother comes to you for a loan. You want some promises as to how you’re going to get paid back. You want some promises as to when you’re going to be paid back.
You might say, “Hey, you can’t go over to our sister and borrow from her as well. We’re going to put some kind of restrictions on all of this borrowing so that I know if I’m making a loan, I’m going to be paid back.”
The same happens with corporations. When all this money, the trillion dollars, floods into the high yield market, if I’m a portfolio manager, I need to find a place to put that to work. I’ve got to buy bonds. All that extra liquidity in the system has enabled companies to be able to borrow at favorable rates and extend their runway.
But we do ultimately develop into, as we’ve been saying, more and more debt, lower quality debt, less restrictions.
Here’s a slide I thought was very cute and very representative of what’s happening today. On the left-hand side, we’ve got this fellow diving into a trash can looking for junk, and on the right-hand side, we’ve got another person peering into it saying, “Hey, this is looking pretty attractive.” All this trillion dollars that’s flooded into the high yield space, I think it’s represented pretty well with the smile on that face there.
The problem is what they’re buying today is riskier and riskier than pretty much at any point since I’ve been doing this in my 23-plus years.
Moody’s rates the covenant quality. 1 is best, meaning if I loan money to a corporation, I put more restrictions in those covenants, I have a better likelihood if there is an event, a default, a problem, of getting paid back a more sizeable percentage of my assets. If it’s 5, then that’s least restrictive. That favors the borrower, it doesn’t favor me as the investor or lender into buying that bond.
At 4.51, we are at a very, very high rating; least restrictive. Keep in mind that when default happens, there’s little behind it that helps to pay us back, so prices will decline greater.
“What a wonderful day to declare bankruptcy.” I think if we look forward into what the future might look like, this is going to be a more prevalent situation.
The maturity calendar; when might this happen? With high yield, it is default cycles, recessions, up interest rates, and certainly when you call your brother to get paid back on that loan that you issued and you want paid back in 2015 and 2016, the question is whether or not he’s in a position to pay you back. The same with bonds.
Within the next five years, $791 billion of this $2 trillion-plus that’s in high yield and in leveraged loans is coming due. So this maturity calendar is something that’s growing closer, the timing of which could be near another recession, and we’ll look at the schedule of recessions and what those expectations might look like.
High yield is a great asset class. This chart shows the performance of high yield from 1983 through the present, the blue line. The dotted black line is the performance of the S&P over that period of time. High yield has done a great job as an asset class to be in a portfolio.
But like all this money that’s flooded into the space, the riskier companies being able to borrow with less protection to us, the investor, in the equity markets, we can measure how much leverage is in the equity market by, number one, the percentage of household assets that are invested in stocks. It’s near where it was in 2007 and 2000.
We can also see how leveraged the system is by looking at New York Stock Exchange margin debt. The red line shows March of 2000, July of 2007, and where we are currently, or most recently, in March. We are more leveraged, more on margin, than we were in 2007 and we were in March of 2000. Of course, post those periods of time led to recession, led to 40%, 50%, 60% sell-offs. In the case of 2000, techs went down 75%, the S&P 50%. In the case of 2007, roughly a minus 54% for the S&P.
The System is Fully Leveraged
When you’re this leveraged, it may be that some of that money has gone to buy more stock, leverage in an account, and it’s also because, similar to 2007, where investors borrowed lines of credits against their house to use it as spending machines, I think that a lot of investor accounts have had that same crisis, or taken that same opportunity with low interest rates and borrowing from their investment accounts, leveraging their stock positions.
What do you do when the selling pressure starts? Margin calls kick in, and it begets more selling. Leverage is a good thing when it’s working for you, but when it unwinds, that’s where the difficulties are.
So the system is loaded, fully leveraged, higher risks in the quality of bonds that extend out there. And ultimately, this is what will set up, I believe, the greatest opportunity that I’ve seen since trading high yield for many years.
Liquidity will be challenged. A race to the exit doors, I think, is ahead. There’s different dynamics in place today than in 2008. Dodd-Frank, for example, this regulation to secure up and firm up and make us more comfortable in our banks, one of those consequences is banks have decided to leave the market-making business. They no longer buy and hold inventory of various bonds. They’re more transactional today. That level of support in a period of sell-off is absent.
So when the selling pressure hits, when default cycles pick up, whether it’s an interest rate increase and the investors run to the exit door at the same time, I think we’re going to have a quicker, harder, more attractive sell-off , a more attractive opportunity, than we had before.
The Dynamics of ETFs
The dynamics of ETFs and how they trade, when investors start selling out, who’s going to be on the buying side of that? Would-be buyers tend to back away. When you have that much margin, that much leverage in a system, the selling is quicker, harder, faster, and we want to be positioned to both avoid that and also take advantage of the opportunity when that goes away.
I found this interesting. El-Erian was on CNBC the other day; they were talking about Greece, of course, and Greece could be a snowflake that trips the next avalanche within the global credit system. Maybe it’s not. Certainly, European QE is alive and now active, and maybe that prevents it, maybe it doesn’t. I don’t know.
But his comment was that – forget about Greece for a second, or Spain or Portuguese debt and the massive level of debt that exists within the system. The issue that we need to focus on, the biggest risk is that investors in markets are underestimating liquidity. That liquidity, that rush to the exit door, that lack of support beneath the system, the buyers to help hold those prices in check, is the opportunity we want to prepare for, and I think he’s right on the money, and I agree with his position on that.
What happens? Business cycles happen. We do have recessions. We’ve one to two recessions a decade since the 1980s. We had two in the 1980s, we had one in the 1990s, we had two in the 2000s; one in 2001, one in 2008-2009.
Recessions are healthy. They help clean out some of the excesses within the system. We correct, we move forward.
The Fed, Keynesians, may have a belief that we can prevent and smooth the business cycle. I think that that is a stretch of a hope. I think it’s an impossibility. I think the business economy, the business cycle, is far too big for any one central bank to be able to prevent, and we will have recessions again. It’s been six years, seven years since the last recession. Whether it’s within the next six months or whether it’s within the next two years to three years, I don’t know. But recessions do happen, and we want to be aware of that, because when the economy turns down, these borrowers on the fringes are the ones that will declare bankruptcy. So let’s look at what happens when that happens.
But until then, here’s my view. We’re in a period that requires patience, like a surfer waiting to jump out and catch a good wave. We know out there is another wave coming. We’re not sure exactly when that’s going to come to shore, but in the meantime, it requires patience so that we are in a position to be able to ride the favorable wave and not get crashed into the wave. So at this point, patience is required.
When recessions happen – this chart shows the default rate cycle for both high yield bonds and leveraged bonds. If you look to the far right, you’ll see a percentage range that goes from 0% to 16%. The two red arrows point to the recessions in 2001 and 2008. Look what happened to the spike in defaults. They went in 2008 from 10% to 14%.
I think we’re going to see a cycle, just because of the pure size of the number of companies that have been B rated that have gotten funding with poor covenant qualities, in the next recession, we’re going to see a significantly bigger spike than that, bigger than I’ve seen since my 23 years of trading high yield. And that’s the opportunity that we want to prepare and be positioned for.
What happens to yields? Look at the top two circles here in this next chart. They’re in yellow. We went in 2007 from a yield of, let’s say 6%, 7%, similar to where we are today, up to over 20% in a short period of time. When markets disconnect, they disconnect hard.
So that’s the opportunity. We want to avoid the price decline that happens on the way to that, and we want to be in a healthy position to be able to take advantage and re-enter. We’re going to look at some ideas of how to do this.
A technician looks at price momentum, and there’s different ways that a technician might smooth that price momentum.
One way is to look at a 13-week smooth moving average line over a 34-week.So here, if you can see in the light blue, that’s the 13-week smooth trend line. Here, the black line represents the price performance, total return, of HYG, iShares High Yield Corporate Bond fund ETF, and the red line below is the slower 34-week.
So the idea, if you look at the red vertical line on the far left, and then the blue vertical line, your exit is when the short-term trend drops below the longer-term trend. And it did a very good job of keeping you away from danger and positioning you to be able to come back in and take advantage of that opportunity. We want to avoid the default waves, avoid the price declines, and be in a position to take advantage of lower prices and higher yields.
It doesn’t always work. There are some trades that were better than others, but you can see here that you caught the majority of the trend. We’re currently in an uptrend by this measure. It’s a strategy that requires discipline and stay-to-it-ness and patience, but it’s a strategy that can do a good job of protecting you and keeping you from a lot of the downside danger.
Another technician might say, “Hey, I want to do things a little bit quicker.” Here is a 21-week moving average line in red, and the blue line is JNK, that ETF. The red arrows represent periods where the price of JNK dropped below its 21-week trend line. So that would be an exit point. The green line represents a point where it went back above it. So you want to be in when it’s in an uptrend, and you want to be out when it’s a down trend.
Again, you’re going to have some false trades. You’ve got to find a way to have conviction in a process so that you can make the next trade, and then the following trade.
I’ve been trading high yield since 1992. It’s a trend-based strategy. It’s different than the two processes I just showed you, but it’s based on price momentum. My triggers are tighter. I get in a little bit sooner; I get out a little bit sooner.
This is our real-life performance from 2000 to present. We compare it, net of fees, to PIMCO’s High Yield fund, a great proxy for how we could get exposure to the high yield space, we compare it to the Barclays Agg. Bond Index, and we compare it to the S&P 500 Index.
I’m proud of this. There is no guarantee that we can replicate this performance. Past performance in our business guarantees nothing. But I have conviction that I’ve got a process that I believe in that can help me risk manage, participate when trends are going higher, and protect when they’re going lower.
The performance here – $100,000 in our strategy turned into roughly $320,000, net of fees. The same $100,000 invested in the S&P turned into $190,000.
Remember that chart that showed high yield and its performance over time compared to the S&P? My point that I hope I can make is that it’s a great asset class, it trends predictably, there’s ways to participate, and I believe it’s a healthy portion in a portfolio.
Mike: Thank you, Steve. Some tremendous points, and we’re going to highlight them a little bit further as we go forward.
As I promised you at the beginning, I’d like to share the results of the poll. If you recall, the question was, “What percentage of your clients’ portfolio is allocated to high yield today?”
We have an interesting distribution in terms of answers. We’ve got about a sixth of the audience currently allocated at zero. That was before the webinar; now that they’ve heard Steve’s story, I know that’s going to increase. Five percent was about a third, 10% was about another sixth, and 15%-plus was a third. So, a very interesting wide distribution of the answers.
Steve: Well, if I could interrupt for a quick second.
Steve: I think a point here to take – the reason that we wanted to ask the poll was to just get a feel for how a typical portfolio may be allocated to high yield right now. Investors have put a trillion dollars into high yield in the last five years, so your client, while they’re allocated to high yield with you to some degree, probably have a discount account somewhere where they own high yield; another brokerage account with another adviser.
I think that there is an opportunity to tell this story to your client, with you being that resource to be able to help them protect, and most importantly, position for the opportunity. We know there’s a lot of money allocated to high yield, and I think that most individual investors have little understanding, like that fellow peering into the trash can, “Looks good,” and he has no idea the risk he’s taking on.
Mike: That’s a tremendous point. The overall theme that we really want to get across today is the idea of how do you participate, how do you protect, and how do you position?
I’m looking at the questions. The first one we’ve got, Steve, I think is excellent. What convinced you that high yield bonds were the vehicle to use in this strategy that you have?
Steve: In 1985, I was on an options arbitrage desk with Merrill Lynch Institutional in downtown Philadelphia. Now, that’s a mouthful. What option arbitrage is is that there are options on stocks, and those options would have pricing, and they correlate with what’s happening with the stock. And oftentimes, either the price of the stock or the price of the option got disconnected from what’s fair value. So an option arb person would come in and make a risk-free trade, squeeze the difference, and make a profit.
It’s a great strategy. It’s largely gone within the space now, just because of how systems work and the number of traders doing these sorts of things and how electronic the world has become.
But what caught my eye is I played on a softball team – Drexel Burnham was big back then – and a couple of the guys that I had become friendly with had left Drexel and they started doing this with high yield. So to me, what caught my eye was, like, what are they doing? How does this work?
This was before a lot of the academic research papers on trend, price momentum, and that sort of thing. I called the Merrill Lynch mutual fund department. Back then, you didn’t have computers and Excel spreadsheets, you had reams of dot matrix paper that would be mailed to me, so I’d have to wait. It’d come about 10 days later, and I’d have a stack of pricing history for the Merrill Lynch High Yield fund, for the Kemper High Yield fund, which was a popular fund way back then, and I just started looking at the price movement. Is it predictable? How does that trend? And what was happening back then is once in motion, it tended to stay in motion.
So that’s how I came about it. It really was stumbling across it, and my eye towards driving returns and being able to manage downside risk.
Mike: You may have stumbled across it, but now that you’ve been managing it since 1992, as you showed in the chart earlier, you’ve been through several recessions, so you know what the indicators are, you know what to look for, and most importantly, you know how to position in those upcoming times.
Share a little bit about maybe what the triggers might be today that you’re really focused on.
Steve: I think an investor could do a pretty good job following a trend process like 13-week over 34-week, that crossover, or a 21-week moving average, or something shorter.
I think the biggest lesson for me over that period of time – our system is different. We trade – it’s inside of 1%. So in high yields – when I look at a basket of very large high yield funds, I want to see what their price is doing, and when the majority of them are going up in price by somewhere that’s less than a percent, I want to be in. When the majority of them are starting to roll over and go down, I want to risk protect and move to short-term cash or Treasury bills.
So that’s the process. But what happens is that over the years, you get knocked on the head a few times in a healthy way. I can tell you, several times I thought I was a lot smarter than my process, and I made those trades. What do you do if you’re right? That’s probably a big mistake, because are you going to do that again the next time? I have an emotional belief, like 25 Wall Street analysts, that interest rates were going to go up in 2014 from then 3% to 3.25%? They went down to 2.40%, and then they went less than 2% most recently. They were all wrong. They had a fundamental view.
So I have learned that while I have a fundamental view, what’s my process to be able to exit or enter or risk manage or reduce positions without that process or that discipline? Price tells us everything we need to know about supply and demand, and so by looking at that, I think that gives us edge as to how to position.
So I developed a process that I have a great deal of conviction in. I wasn’t perfect. I tried to override some of that process. I got stung. Not big, but I got stung enough to know, just follow and stick to the process. That was a big part of my learning development.
Now, with recessions; you mentioned that. The first several, I was scared to death. What do you do with that buy signal when the world’s looking very, very ugly? What do you do with a sell signal when the world’s looking like Goldilocks and happy and nothing ever – there’s no housing crisis, there’s never been a decline in housing prices, and then, of course, it was a near collapse of the entire financial system; subprime, CDOs, all those sorts of things.
So having a process takes the noise out of it. I might win seven or eight out of every 10 trades. That’s okay. But I might lose three in a row, and if I lose four in a row, do I have the conviction to be able to trade back in?
When those recessions hit, I had been so nervous. I have emotional feelings, like everybody else. And when we got a buy signal in December of 2008, I can tell you, I was scared. But that feeling gave me confidence and conviction. I followed the buy signal. When I’ve been most afraid, most fearful, that emotion, those have always been our buy signals. And I’m going to look for that in the next opportunity also.
Mike: It’s interesting, I’m looking at the questions that have come in, and this question reminds me of the picture of the surfer that you had waiting for the wave. The question is, “You say there’s an opportunity maybe six months to 12 months away. Does that mean I should be building up a cash position, when I know what your position is right now; you’re invested in the high yield market.” Talk a little bit about that.
Steve: Hey, we’re collecting a 6% yield right now, and while prices might at some point collapse, I have conviction that our process will help us limit the downside, move us on the sidelines towards safety, shorten our maturity of high-quality Treasury bills, that sort of thing, and then be in a position to take advantage of the opportunity that comes.
I don’t know what triggers this. Nobody knows when. Or what the Fed response may be if we start to dip into recession again. Maybe more goodies passed out in the form of a QE5, I don’t know, or what the market’s behavior and reaction to that at that time might be. But at some point, the Fed is going to have to lift. They want to normalize and get off this. They want to lead themselves in. They’re not in a healthy position like they were coming out of 2008. Their balance sheet is $4.5 trillion. They don’t have the same leverage that they had before. So I think the next crisis is going to be harder, faster, bigger, and the best opportunity of a lifetime.
Mike: So, to clarify, we’re not suggesting that the money stays in cash right now, we’re suggesting that we put it in the process and let you manage it in the process.
Which kind of ties into the poll, going back to that for a second. So the average allocation for our audience, about a third of our audience had 5% allocated to high yield, and yet another third had 15%. What are your thoughts on that? That’s quite a range.
Steve: I think it really is client-specific. It depends on the risk, the needs, the time frame, objectives of the client.
If I am just buying and holding high yield, I’m expecting there’s going to be a 40%, 50%, 60% decline. I don’t want to get hit by that crisis. So the opportunity is to put in place a process that lets you continue to participate. If you outsource to managers, look at us to do that. If you’ve got conviction and can run that yourself and have that discipline, then put a process in place. Otherwise, outsource it to somebody like us that does it.
But the opportunity is by having a process that enables you to continue to participate, if we’re going to click forward at just 6% yields for another 12 months, I don’t know. At least you’re participating with a process to protect, and importantly, preparing the client for the opportunity so that when it presents, there isn’t that sense of panic, they see that opportunity, I think that will help you in your relationship with your client. I think that will help you with prospects and new assets. I think it’s a great story to tell.
And then, beyond that, it’s like that surfer waiting. The wave is coming out there. We want to be prepared to be able to get on the board and ride it.
Mike: Absolutely. One of the questions, Steve, that we get very often is, “Has the strategy, à la the process, changed over the last 20 years, or have you stuck to the discipline and the conviction of that one process?”
Steve: I stick to the same one process. I follow the exact same process, largely because I have tremendous conviction in it. If I flip and change that around, then I’ve got to question the next trade and the following trade.
I have conviction that my process is sound, so emotionally, as a trader, that helps me stay on sides with each trade.
Mike: It’s interesting, I know you and I have attended a couple of conferences in the last couple of weeks, the iShares conference up in New York and then the Investment conference in Chicago, and at the iShares conference in particular, they came up with an interesting statistic about how the Baby Boomers are aging. Do you want to share that with us? I think that’s very applicable to the situation.
Steve: I wrote about this briefly in one of the On My Radars, and it was – what an opportunity as an adviser, really, is what hit me.
BlackRock did a study, and they said that by 2020, 70% of the assets are going to be in the hands of pre-retirees and retirees. So we’re in this Baby Boom generation, and there are 11,000 of us retiring pretty much every day. In the past, our parents had pensions and defined benefit plans and things like that. This is the first generation that’s retiring with control of that money.
If you’re 65, you’re thinking, “How do I provide income generation? How do I beat inflation so that my money continues to grow and provide me a comfortable living next year, the following year, and down the road?”
If you’re 45, you’re thinking a lot differently. “What’s my return relative to the S&P?” When you’re 65, “How do I provide income? How do I preserve my principal? How do I protect against inflation?”
Mike: Sure. Which, I recall, brought up an interesting point, and the point was that of benchmarks. The question became, “Hey, did your strategy beat the S&P last year?” And the point that was made – and I thought it was a great point – was that is it really important how you as that Baby Boomer who is relying on that pot to provide you monthly income, is it important how you do relative to the S&P, or is it important that you get the income that you’re required?” Right?
Steve: Well, that’s phenomenal, and I have some interesting thoughts around there, because I think that as an adviser, when you’re sitting with your client, that is the single toughest question to answer within our business.
I’m thrilled that we’ve been able to achieve the type of performance history that we have. I like this. When I redid the math recently and compared against the S&P, what a gap in performance. Yet, it’s an asset that’s done since 1983, equivalent to it.
The hard part along that way is how many times a client – like, in 1999, I remember a client named Roberta calling up. “Hey, I’m moving my money to a Merrill Lynch account. I’m investing in safe stocks.” She was unhappy that she did 14.5% per year for two years in a more conservative approach than investing in stocks. And so, what do you look as safe stocks? Intel, GE, those sorts of things.
Her husband remained a client. I got a call a couple years later at the bottom of the market in October of 2002, and he wanted to come in because Roberta was panicking. She hadn’t, for more than a year, opened up her statement, and her million dollars was worth $500,000.
It’s very difficult. Emotionally, investors don’t spend a lot of time being educated on how money compounds, how important risk protection is in the compounding process, and that we want to chase this return or that return. We’ve also done a very poor job in the industry of telling everybody to benchmark anything they have against the S&P, so that becomes what is believed.
Well, that’s just wrong. How do you benchmark your bonds against the S&P? If you want to compare a correlation to see if they complement each other and add value, great. So I’m sensitive to how difficult it is.
We’re getting more and more calls, and I got a call recently from one of my favorite people in the world, [Arom 36:32], and his neighbor is buying dividend stocks and making a fortune, and he’s got a couple hundred thousand dollars to play with. Well, that to me is a closer to the top of the market than the bottom. This return envy, this chase in. Highly leveraged, lots of margin, valuations very expensive, interest rates low, probably moving higher, all of this sets up for what I believe is a great opportunity.
So it requires patience, it requires coaching, and being able to answer that question with a client.
Mike: And the consistency of the system. Which leads me to a common question that we get often: do we ever short in this strategy, or have we ever shorted in this strategy?
Steve: Yeah, it’s a great question. I don’t favor it. We’ve never shorted in this strategy, and the reason is that when you short and the yield is 6%, you have to pay that yield away to somebody. You have to be precisely accurate in your timing of your short.
Now, with that being said, I think that there’s a great opportunity for all the reasons I’ve laid out where – no guarantees, but I think that there’s a coming default wave, a crisis cycle, a liquidity issue, that’s going to drive prices down significantly.
So for those that are stronger in their risk posture, there are ways to short high yield, and I actually think it could be a great trade. But I don’t do it within this strategy.
Mike: Getting back to that income, being that that is probably the number-one concern of the Baby Boomers, how do they provide the income, since they don’t have pensions to depend on? I know in the past, many in our field have advocated the idea of taking a distribution, a monthly set distribution, maybe 4%. How might one use that with a strategy like the high yield strategy?
Steve: A lot depends on how much you size into a particular strategy, right? Is an investor comfortable putting 100% in this strategy? I have conviction. I could do that. I don’t, but I could do that. But is that prudent for an investor?
I think a better solution is combining multiple sets of risks. I write often about a 30/30/40 allocation, as opposed to 60/40. 60/40 today is going to get 3% before inflation over the next 10 years. I can’t guarantee that, again, but if you look at the history of where valuations are and where equity ownership is, you can very accurately project forward what 10-year returns will be. And for the stock market, that’s 2% to 4%.
If you’re Jeremy Grantham from GMO, for the next seven years, they see negative returns for equities and they see negative returns for fixed income. So if 60% is getting you 2% to 4%, if 40% is getting you 2% in a Treasury – that’s what bonds are yielding – how are you going to get a 4% yield and then also beat inflation?
I think a better idea is to look at the forward potential return landscape and have equity exposure and have fixed income exposure.
Now, within that fixed income bucket, what I like to think about is having perhaps 10% of the 30% – if you break the fixed income allocation of 30% into three separate allocations, one high yield, one tactical fixed income – I post weekly on Trade Signals, I link to it each Friday in On My Radar Trade Signals. We have – went back to 1985, the great Marty Zweig and Ned Davis put together a bond process to short exposure, longer exposure. We can do this today with Treasury bills. You have a long TLT or something along those lines, or some sort of bond fund when it’s in a favorable trend, and you move it shorter term.
So I like mixing, because rates are so low, mixing tactical into the fixed income. And let’s call that for maybe a moderate investor, a 30% allocation to that, 30% to equity with protection, and then 40% to what I call alternatives, as defined as anything that is not buy and hold into that bucket.
So I think that by combining these different set of diverse risks that aren’t dependent on the market just going up, that aren’t dependent on interest rates just going down, that – managed futures, for example. Mixing different sets of strategies that can drive return absent of the market just going straight up that can make money when the market’s going down, or choppy.
So by combining those sets of risks, I think that what we can do is define a return objective and we can define a risk objective by combining these non-correlating strategies.
We just finished white paper, if you’re interested, on correlation and diversification. The next paper is almost done on the total portfolio solution.
So, it’s tough for somebody to put 100% of their money into a high yield strategy, and…
Mike: Sure. Absolutely. Well, let me ask you this. This is one final question. It kind of wraps things up. And I’ll ask you to share within the context of this any final thoughts you might have on it, but reflecting on the 20 years that you’ve run this strategy, what couple of indicators can really trigger and have become very helpful to you in staying with the discipline, using the patience and the consistency that it takes to run the strategy?
Steve: We look at seven very large mutual funds. Those money managers are buying and creating a broadly diversified portfolio to a lot of different high yield risks. Now, what they’re buying is a universe of less protection than their bonds, right? So they’re buying riskier bonds. But when that money floods in, they have to buy.
Watching those price streams gives me a really good feel for where the trend is going. And so what we look at is when the majority of these funds that I follow roll over and start declining in price, think of it like a stop-loss. Declines by a half of a percent or a percent, we look to get out, and we move short-term to safety, Treasury bills, those sorts of things.
When it starts moving up from a bottom price, we trade back in, much like the 21-week, much like that 13-week over 34-week. Those are slower measures than what we use, but it is a process that I’ve always used that helps me.
The interesting thing about high yield is that it’s an asset class that I think is a leading indicator for the equity markets. So I would keep an eye – when it starts turning, keep an eye on future potential recession, equity market corrections, as well.
Mike: That’s good. As you know, when we started today, I told you our goal was to help you to be able to participate, protect, and position your clients. This particular strategy is available in three formats. It’s available in a managed account, it’s available in a variable annuity, and it’s also available in a 1940 Act fund.
I’d like to tell you that I know everyone here at CMG stands ready to help you position, help you consult. You can reach us, as you see up on the screen, at 610-989-9090. We’d love to work with you, run comparisons, hypotheticals, or whatever they may be. You can also reach us at our website, which is www.cmgwealth.com.
Steve mentioned white papers. Last year, we kicked off a blog portal called Advisor Central, http://advisorcentral.cmgwealth.com/. You’re able to go to this particular site, you’re able to register and download and order these various papers that we have found have been extremely helpful with our adviser in explaining either what tactical is all about, or Steve said his last edition is on correlation.
What we want to be at CMG is we want to be your partners in building your business and your partners in success. Not only your success, but obviously the flow-through success of your clients.
I very much appreciate the time that you’ve taken, Steve, to be with us today. Thank you, and have a wonderful afternoon. Thank you.
Steve: Thank you.
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