SPY - OEF: The S&P's Absolute Return Drought Continues Time To Get Creative

2023-04-13 18:51:03 ET

Summary

• The broad stock market has flopped around, but there has been no sustained positive returns for some time. Not even in OEF, a more mega-cap version of the S&P 500.
• This has to be frustrating for equity investors used to consistent double-digit annual returns. I know its frustrating to me!
• Looking forward, I see more risk of major loss than sustained positive returns. So here are some strategy ideas to consider.

You couldn't blame equity investors from saying "enough already!" 2022 was a frenetic year when very little worked in the stock market. And 2023 seems to have broken out to a nice start. But, in reality, most of the gains are coming from the same small number of stocks that kept the market looking deceivingly strong during 2021. In other words, the current lack of breadth in the S&P 500 Index is reminiscent of the stock market's behavior leading up to last year's 25% intra-year decline, and the Nasdaq's 33% drop. This, on the heels of 2020's flash crash (S&P 500 decline of 33% in just five weeks) may make long-term equity investors feel like that old Elvis song: "We're caught in a trap, we can't walk out." So, it's time to start making room in portfolios for some other strategies that don't rely on the stock market consistently going up.

Depending on how long you have been an equity investor, and how long your memory is, we've been in situations like this many times this century. There have been flat periods in between recessions, and there was even a 13-year period (1999-2012) where the S&P 500 produced a total return of about zero. First, let's review the recent history, and then quickly move on to what to do about it, with a focus on the role those top 100 stocks that make up the iShares S&P 100 ETF ( OEF ) can play, without making it a classic buy and hold situation. Because that's not been working, and an era of inflation, a possible severe corporate earnings recession, frenetic bond market activity and that annoying debt ceiling issue all conspire to make me believe that risk is high. That doesn't for a second mean that the S&P 500 and particularly the S&P 100 ( OEF ) can't rally strongly during the rest of 2023. But for how long? Sustainability of rallies is the big issue.

And, with dividend yields not particularly high, and bond rates acting like a moving target, I think this is a time for some out of the box, creative thinking in allocating assets.

The absolute return drought of 2022-2023

Rather than throw a ton of charts to paint a picture this current malaise, here's one that summarizes the main issue I see. This shows both the S&P 500 ETF and OEF. My takeaways from this chart:

1. If an investor bought either vehicle at nearly any point in the past two years, they have not made a positive return, even including dividends. This is a chart of 12-month rolling returns, so every point on the chart is saying if you bought and held a year ago, as of the date on the chart, this is your return. So, if you had bought SPY or OEF at this time last year, your total return was around -5% to-6%. This streak has been going on for a while, as the chart shows. The last time a one-year holding period produced a return even higher than the current three-month T-Bill rate was from early April 2021 to early April 2022.

Bottom-line: In a market increasingly characterized by investors wanting returns "right now," this is turning into a situation that demands action. Because again, for the "it all works out over time" crowd, we're still not far removed from a decade-plus period of nothing for the stock market.

2. When we analyze the S&P 500 or 100, we're talking about many of the best-performing stocks in the world for the past decade. These have been the leaders. And while it seems like they lead for moments at a time, the sustained advances have not been there. Rather than count on that resuming, let's introduce some other approaches. Because this drought is here until it's not.

OEF: part of the solution?

I focused on OEF in part because I follow its components closely. As an ETF-centric investor, it has become quite apparent over the years that if you don't have a sense of how the 100 biggest US stocks are doing, and which sub-segments are fundamentally, quantitatively and technically attractive, you are a step behind. I have written over and over how I think the S&P 500 is an overvalued, over-loved and oversimplified index. That makes the biggest 100 stocks even more so. Because so much money has flooded into S&P 500 index funds over the past several years, it has required us to de-value some traditional analysis of the broad stock market and focus instead on things like inflows to SPY and what a handful of big tech stocks are doing. The rest of the "market" is important, but not to the masses. They're addicted to that index fund. That spells opportunity to me, both near term and long term.

A few things to keep in mind about OEF: 40% of its assets are in 10 stocks, vs. 27% of the S&P 500 in the same stocks. It has outperformed SPY by about 1% a year over the past five years, but has "only" $7.5B in assets. That makes it just 2% as big as SPY. And, with so much in the S&P 500 through non-SPY vehicles, I consider OEF to be akin to the market's dirty little secret. It has all that SPY does, but less, so to speak.

That makes OEF more of a research list. You can try to screen and filter 500 stocks, but in my experience, the top 100 have most of the performance-driving potential of the 500. The biggest negative I see with OEF is that it is even more focused on a handful of sectors than SPY (see below).

How to get a little creative

So, here's what I'm focusing on right now, as I believe that the mega-cap stock market, and the market in general, is more likely a continued quagmire than a pending new bull market.

1. Use equities as a base for cash flow.

The dividends are nothing special, but for the first time in a long time, I'm seeing the benefit of covered call writing. However, the search for a worthy one has been elusive for me. Partly because I'm in the early stages of researching that sub-sector of the equity market. In the past, my covered call writing work was done at the individual stock level. But many of the most popular ETFs in this space write options on an index, rather than on the stocks themselves. To me, that's a bit of a mismatch since the underlying stocks have higher volatility than the index they're a part of. That means that the earnings from the index call writing will likely be less than doing so on many of the underlying stocks. Why leave so much meat on the bone?

2. Account for massive downside risk scenario

In the case of covered call writing, I have seen many investors just count on that income and not care that they were giving all back in principal loss. This is not last decade, where things always worked out for the stock market. Thus, covered call income has to have a sidekick in the form of tail risk protection. There are many to cover, but I recently wrote on ProShares VIX Mid-Term Futures ETF ( VIXM ) and Cambria Tail Risk ETF ( TAIL ), among others. Remember all of those potential market spoilers I noted above. Take them seriously.

3. Don't forget about the top 100 stocks

One of the first things I was taught as an investor (albeit, way back in the 1980s) was that stocks can stay overvalued for a very, very long time. As the expression goes for short sellers, the market can stay up longer than you can stay solvent. And this period of leadership, despite the absence of positive returns for a while, could still be the last of the soldiers to fall or the ones to lead us out. I spent years trying to ignore the market's love affair with the mega caps at any valuation. Now I nearly always have some exposure to them, no matter how bearish I might be at the time. I just make sure, as noted in #2 above, that my position size is not big enough to hurt me, and/or that I'm hedged against huge air pockets of loss.

4. Get up to speed quickly on Treasury Bonds, but don't trust them "forever." I'm on record as saying that I don't intend to have much non-Treasury exposure in my bond allocation for some time. I still believe there's a credit crisis looming. But with rates up, it makes sense to embrace having some bond exposure, even if it's at the short-term end of things. In addition, as a tactical investor, I'm approaching bonds along the yield curve in the same way I approach the equity market: With the idea that I'm renting them, not owning them. In other words, I don't trust the market to move rates in one direction for long, without changing its mind. So, I think there's total return there, but not buy and hold style.

Summing up

The equity market is in a funk, and I don't assume that will change. If it does, I'm ready, willing and able to transition some of my hoard of T-Bill holdings to capturing sustained equity returns once I believe they're possible. In the meantime, this is when investor should expand their playbook, including in the ways I noted above. And OEF, the ETF that represents the top 100 stocks, is a Hold rating for me, only because I see it more as a tactical tool amid this very sloppy environment for equities. But within those 100 stocks are the key to understanding where and when the market is going to make a truly investable move, in one direction or the other.

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