Be Selective Here, Because The Worst Is Not Over

Main Thesis and Background

The purpose of this article is to evaluate the current state of the equity and debt markets in the U.S. to decide what investments are appropriate for new positions now. Towards the end of last year, I began reducing my equity exposure, but recommended getting back in slowly when the market began to drop. At the beginning of last month, I reviewed the general state of the market and cautioned investors that buying in was a bit risky, but to use large down days as chances to build on core positions. In hindsight, this outlook made sense, although it was perhaps a bit too optimistic. For example, we have seen some gains after large drops, but the general trend over the past month has still been very negative, as shown below (through 4/2):

Source: CNBC

As you can see, the broad indices have seen large losses, and the resulting volatility has not been easy for many investors to handle.

With this in mind, I want to update my outlook on the broader market. While stocks are indeed way down, a point to emphasize that is consistent from my last review is that stocks are still not “cheap”. The market’s multi-year rise was simply too far, and stocks coming down to current levels does not automatically warrant buying in. However, it is also true that all stocks and sectors have been hammered hard in 2020. To me, this opens up an opportunity for selective buying. Simply, while I see some of the large losses as very justifiable, I see other areas that have been disproportionately impacted relative to the actual financial position or outlook. Therefore, I am going to touch on a few areas, in both the equity and fixed-income markets, that I feel offer some relative value. Primarily, I am focusing on less cyclical areas, because I see the COVID-19 pandemic carrying on for quite a while. This means avoiding certain areas is just as important as buying the right ones.

Buy Sectors The Fed Is Supporting

To begin, I want to focus on the primary areas in the fixed-income world I would recommend buying now. While I do believe there are some intriguing opportunities out there in riskier assets, taking those positions now is something I would recommend only for an investor who can withstand losses and a great deal of volatility. While I do point out specific buy opportunities in riskier products from time to time, for the purpose of this review, I am gearing this towards my mainstream reader audience. As such, I believe a more conservative slant is paramount, as many retail investors are not going to be able to withstand further losses of the magnitude we have seen of late.

With this in mind, I believe managing risk is critical right now. However, staying out of the market all together has risks of its own. Investors could miss out on substantial upside, or they could lose a critical income stream. Therefore, I believe the most prudent course of action right now is to “follow the Fed”. What I mean by this is the Federal Reserve has announced sweeping stimulus measures to support the stock market and the economy. In doing so, they have committed to buying multiple different types of asset classes on the open market. The objective here is to stabilize markets and provide liquidity. Based on the most recent announcement in late March, we know what assets they are targeting for purchase:

  • The Federal Open Market Committee will purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.
  • Facilitating the flow of credit to municipalities by expanding the Commercial Paper Funding Facility to include high-quality, tax-exempt commercial paper as eligible securities.
  • The Secondary Market Corporate Credit Facility will purchase in the secondary market corporate bonds issued by investment grade U.S. companies and U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds

Source: Federal Reserve

Simply, the Federal Reserve has launched a massive stimulus program aimed directly at stemming losses in treasuries, agency MBS, investment grade corporate bonds, and investment grade municipal bonds.

The result has opened up some opportunities for investors. They can attempt to “front-run” the Fed, by getting in to specific funds or bonds they anticipate the Fed is going to buy. Further, investors can hang on to these sectors if they already own them because the Fed has made clear their support for these areas. Finally, and just as importantly, it highlights investors may want to avoid the most risky sectors, such as high yield corporate or municipal bonds, because the Fed has not declared support for these areas.

While this may sound like a strategy that is too easy to be effective, consider that the Fed has already put this announcement in to practice. In fact, the Fed’s buying began immediately in the agency MBS market, and hit historic volumes in a matter of days, as shown below:

Source: Bloomberg

Clearly, the Federal Reserve has taken strong action that is supporting this sector, and a similar story holds true for corporate and municipal bonds. This is greatly helping to support these sectors, which had seen large outflows in the weeks leading up to this announcement. In fact, with respect to municipal bonds in particular, investor outflows were quite severe, especially considering the uninterrupted weeks of investors inflows we had seen, illustrated below:

Source: Charles Schwab

My overall takeaway here is investors would be wise to “follow the Fed”. As evidenced by the heavy buying, the Fed’s directive has teeth to it, and that could set investors up for some sizable gains in sectors that probably should not have sold off as far as they have. However, I would caution investors to be selective even among these sectors, in terms of what products they buy. Because of this Fed buying activity, the prices on some ETFs that hold these bonds have been bid up beyond their NAV, which can be uncommon for many passive products. This is a point I touched on in a review of the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) recently, when the fund began trading at a premium. While I still see merit to owning it, be aware of the risks of buying these funds at premiums, and consider the myriad of options out there for these sectors. Given how volatile the market has been, the market prices to NAVs are changing, sometimes substantially, on a daily basis, so what may be cheap one day could suddenly be expensive the next.

Now Seems Like A Time For Consumer Staples

The second area I would consider right now is Consumer Staples, whether through a product like the Consumer Staples Select Sector SPDR ETF (XLP), or through some individual names. I would specifically look at big box chains, pharmacies, and grocers. My favorite picks in this arena would be Walmart (WMT), and The Kroger Co. (NYSE:KR), but I imagine investors would do well with multiple other companies that cater to consumers’ direct needs right now. While discretionary spending is down sharply, Americans still need the essentials. These would include the most obvious products we use every day, such as food, prescription drugs, and toiletries. The demand of these products is almost always constant, but it is the relative demand now that is so especially attractive. What I mean by that is a greater portion of consumer spend is going to go towards staples right now, which makes investing in discretionary sectors more risky. Further, companies like WMT are seeing a short-term bump in demand for essential staple products, as consumers are prone to hoarding in these types of environments.

Another key reason why I like established players, such as WMT and KR, is because these are the companies consumers are turning to for their online purchases. While being stuck at home undoubtedly gives consumers a lot of options when it comes ordering online, a survey shows they are turning to the familiar names, as shown below:

Source: Bloomberg

My point here is consumers are shut out from malls right now, and weak consumer sentiment is not likely to encourage much discretionary online spending. Therefore, I see the companies catering to the most basic consumer needs, who also have an established internet presence, as the best consumer plays in the market right now.

What To Avoid – Leverage

I noted at the beginning of this piece I was going to highlight some areas where I see value. However, I also want to touch on areas to avoid. I believe this is critical because almost every stock or fund is trading near their annual lows, and perhaps even multi-year lows. This makes almost every play look like a “value” play, and could lead to indiscriminate buying. I would discourage this practice at the moment, especially for the average retail investor. Of course, volatility creates plenty of short-term opportunities, and beaten down stocks have been rallying at times over the past month. But for those without an appetite (or the ability/luck) to correctly time these moves, it may mean a doubling down on risk at a time when investors likely want to limit it.

To put it simply, I use myself as a classic example. I have a substantial equity position in my portfolio, as I am a professional in my mid-30s. As such, I am holding on to my equity positions, and continuing to add incrementally. However, the bulk of my new purchases are going to safer plays. While I can stomach seeing my equity positions move lower in the short term, I do not want to compound losses if the indices do move lower. Simply, I am staying within my risk tolerance in terms of how much I am willing to lose.

On this note, I believe investors would be wise to avoid leveraged plays in this environment. This may come as a surprise because I often recommend leveraged CEFs, in many different sectors. In fact, when the market hit the lows we saw over the past few weeks, I reviewed a couple high yield options that I thought had some value, such as the BlackRock Corporate High Yield Fund Inc. (HYT). In fairness, that play would have resulted in a fair bit of alpha in the short term. However, the markets have rebounded a bit since that time, and I believe taking risk off the table and locking in those gains is prudent.

A key reason for this sentiment is the cost of leverage, which has spiked in the short term. This has caused many fund managers to liquidate assets, due to client redemptions and margin calls, at prices below what the assets were worth. The result has been disastrous for many leveraged funds, including many of the popular PIMCO CEFs that I regularly cover. What is happening is the cost of the borrowing is going up for these firms. This is coupled with client redemptions, forcing some managers to sell at an inopportune time. Finally, the sharp drops in value of these assets (due to being sold on the open market for less than the NAVs suggested they were worth) was soliciting margin calls from lenders in order to protect themselves in the event of further declines in the value of the assets. Add this all up, and it is not hard to contemplate why many leveraged CEFs saw sharp losses over the past few weeks.

To put the cost of leverage in context, consider the graph below. It shows the prices of options and spreads, compiled by the Bank for International Settlements, and plainly illustrates the rise in cost in a short time period:

Source: Bank for International Settlements

My takeaway here is not to suggest these are “bad” products, because they aren’t. I have bought leveraged funds in the past and will continue to do so in the future. It is an important part of CEF investing and can compound returns during good times. The issue is it can compound losses in bad times as well, and that is what we are seeing play out. While the sharp drops in prices in many leveraged CEFs are likely generating some investor interest, the recent price action suggests investors would be wise to back off this exposure for now. The sharp rise of the cost to borrow, coupled with the enormous declines in a manner of days, tells me only investors who can withstand a fair amount of risk should be using these products for the time being. We don’t know if and when liquidity issues will flare up again, and avoiding this risk appears to be the prudent course. After all, the broad market is giving investors more than enough volatility on its own, without compounding it with leverage.

Self-Storage An Interesting Option

A final area that interests me is the self-storage space. This is a sector dominated by a few key players, including Public Storage (PSA), Extra Space Storage Inc. (EXR), CubeSmart (CUBE), among others. I find this space especially interesting for a few reasons. One, this is a sector that pays relatively high and reliable dividends. Two, all these stocks have reached levels I view as oversold in the past few months. They have gone down with the market, which I feel is not justifiable given the stable nature of the space. To illustrate, consider the chart below, which lists the year-to-date losses of each of the big three I mentioned, as well as their current yields:

Company YTD Loss (does not include dividends) Current Yield
PSA 10% 4.03%
EXR 12% 3.76%
CUBE 19% 4.93%

Source: Seeking Alpha

I view this as a potential buying opportunity for what I see as a fairly recession proof sector. People need storage in good times and bad. However, I did note that just buying in to stocks that have dropped is not a good enough differentiator right now, as most stocks are down in 2020.

To understand why I like this space, aside from the dividend play, is that demand has actually been increasing in some key areas over the past few weeks. For instance, as colleges and universities around the country have shut down, students have been kicked out of their dormitories. This has occurred without much advance warning and, with the exceptions of those in their final year, the majority of these students will be returning to the same location next semester. Rather than bringing all their belongings home, many are turning to self-storage units. In fact, if we look at the number of interest searches for self storage units in college towns, we see a dramatic increase, as shown below:

Source: Spare Foot

My takeaway here is this seems to be a sector that is unique in that it is seeing a surge in interest, similar to the rise in demand for consumer staples. People are taking steps to position themselves for a protracted COVID-19 world, and I see investing in storage as a way for investors to profit on this reality.

Bottom Line

This is a very challenging market, and I expect more pain ahead. The virus situation in the U.S. is getting worse by the day, and employment figures have shown millions are now out of work. However, I see pockets of value in the market, which investors can turn to for some peace of mind as this crisis drags on. While volatility is all but a certainty, I believe the above strategies could limit downside risk from here.

Disclosure: I am/we are long PSA, NEA, MUB, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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