CRWD - The 'Nothing Is Working' Market; A New Bond Strategy - 'Enhanced Bond Portfolio'

Summary

• "What's working" is natural gas and not much else; "What's Not Working" is dominated by digital assets and other "risk on" indicators.
• The "Nothing is Working" Market.
• A New Bond Strategy - "Enhanced Bond Portfolio".

Brian Dress, CFA - Director of Research, Investment Advisor

After markets put in a temporary bottom on June 16 of this year, we had a fairly constructive summer across markets. We had a strong earnings season not only with impressive earnings results, but also with positive stock price reactions, to match.

However, all the improving sentiment and market momentum has been erased almost instantaneously over the past two weeks. A brew of higher interest rates and hawkish talk from the Federal Reserve has come together to create yet another market correction.

Throughout 2022, there has been an urge for investors to keep moving funds from one sector to the next, looking for an industry where investments could be relatively safe from the sell-off. We know, because we’ve felt and acted on that urge here at Left Brain during different times of this difficult year. Unfortunately, in a bear market, virtually no place is safe from selling. We saw yet another example of that this week in what has been this year’s strongest sector: energy. This leads us to the conclusion that the best course for investors now is to forget about trying to find short-term areas of strength in this market. Instead, we would rather focus our efforts on filling our portfolios with businesses that look poised to perform well over the next 3-5 years. We think investors should zoom out and focus squarely on business fundamentals and not the macroeconomic picture, which is in a constant state of flux in 2022.

Interest rates are driving everything in recent weeks. As market participants react to the hawkish tone of the Federal Reserve, they have pushed US Treasury rates back to 2022 highs. The US 10-year Treasury flirts again with 3.25% and the 2-year Treasury has recently pushed above 3.5%. We have seen 30-year fixed mortgage rates eclipse the 6% level in the last month, up from as low as 2.6% in early 2021. The Fed appears to be getting its wish for the economy to cool down, as markets from housing to stocks to labor to rentals all cool down.

Holders of both stocks and bonds are feeling the brunt of these higher interest rates. The last two weeks have been absolutely brutal, both for those with income needs and for growth-oriented investors. But as we look to find a way to take advantage of lower prices almost across the board, we are seeing the chance to implement a new bond strategy. In today’s letter, we will describe this novel strategy to you and give you an example of one bond that fits the bill.

With that all being said, let’s get into it!

Below is the performance data of key indices, ETFs for the five trading days between 8/25/22 and 9/2/22:

What is/is not Working?

With the S&P 500 down nearly 5% over the last five trading days, it should come as no surprise that the market sell-off was broad-based. All 11 S&P 500 sectors lost ground on the week, led to the downside by Materials, Information Technology, Energy, and Industrials, all of which fell between 6-8% for the week.

Defensive sectors like Utilities, Health Care, and Consumer Staples fared relatively better, but no place was safe, as these three segments of the market all lost between 2-3.5% in value.

Out of our more than 300 sector and industry ETFs that we follow in our database, just 13 were in positive territory for the week. And among those, most were funds that focus on betting against the market, like AdvisorShares Ranger Equity Bear ETF ( HDGE ), Direxion Daily 20+ Year Treasury Bear 3X Shares ( TMV ), ProShares Short High Yield ( SJB ), and ProShares UltraShort 20+ Year Treasury ( TBT ).

The Invesco DB US Dollar Index Bullish Fund ( UUP ) advanced by 1% this week. Continued Dollar strength had some persistent negative impact on the price of commodities like oil, copper, and the like. The US Dollar has been in a remarkable uptrend throughout 2022 and is one reason why inflation hasn’t been worse in the US (outside the US, inflation is even more severe due to currency impacts). We also saw United States Natural Gas Fund, LP ( UNG ) move slightly higher over the past week, which is remarkable considering that crude oil fell by more than 6%. Supply worries for natural gas continue to become more real as Europe creeps toward a dark winter, presumably without a source of natural gas from Russia.

Digital assets continue to dominate our “What’s Not Working” list, as they have seemingly for the entire year. Note that Bitcoin has lost more than 56% of its value just since the beginning of 2022. Our worst performing ETF this week was the Grayscale Ethereum Trust (ETHE), which lost nearly 16% of value over the last five days’ trading. The Bitwise Crypto Industry Innovators ETF ( BITQ ), First Trust SkyBridge Crypto Industry and Digital Economy ETF ( CRPT ), and Invesco Alerian Galaxy Crypto Economy ETF ( SATO ) were all among the worst 6 performing ETFs and all lost double digits for the week. It is becoming increasingly clear that cryptos are a high beta play on growth, as well as extremely interest rate sensitive. On both accounts, these are the wrong assets to hold in the current environment.

There was significant damage in a number of ETFs that had previously experienced a resurgence over the last few weeks. The classic “risk on” indicators were under extreme pressure this week. We saw double digit drops in SPDR S&P Semiconductor ETF ( XSD ) , First Trust Cloud Computing ETF ( SKYY ), ARK Innovation ETF ( ARKK ) , and just under a 10% pullback in the Renaissance IPO ETF ( IPO ) .

Commodities also felt the sting of the market’s sell-off this week. The Federal Reserve is hell-bent on reducing inflation and that is having a direct impact on this corner of the market. Among the weakest sector ETFs in commodities were VanEck Gold Miners ETF ( GDX ), SPDR S&P Oil & Gas Equipment & Services ETF ( XES ), and VanEck Steel ETF ( SLX ). Despite this heavy share price pullback, we remain convinced that the oil industry will deliver strong returns in the medium-term, due to secular supply/demand dynamics. We also continue to favor some of the materials names due to strong cash flow characteristics and return of capital stories there, as well. However, investors in commodities must be vigilant and may experience some difficult times over the next few months, as the Federal Reserve moves toward the end of its rate hiking cycle.

The “Nothing is Working” Market

Ordinarily in the financial markets, bonds and stocks move with reverse correlation to one another. That is as stocks rise, bonds tend to fall and vice versa. Usually investors can build portfolios that are a collection of stocks and bonds and expect to have some mitigation against volatility. Since 1928, there have only been 4 years in which we have observed an annual negative return in both the stock and US treasury markets (off of which other bonds are priced). This year represents just the 5 ^th such year in the last 100! This is the biggest reason why we are calling this the “nothing is working” market, as there is no safe haven in which to hide, not even in US Government bonds!

The “nothing is working” theme extends far beyond just the stock and bond dichotomy, though that itself is remarkable. As we mentioned above, we are seeing recent weakness in energy stocks, mostly related to movements in the US dollar and interest rates. In the short-term, markets can often decouple underlying business fundamentals from daily stock movements. Throughout 2022, we have made the case that supply and demand characteristics are well in the favor of oil/gas producing businesses. Since these companies have made conscious decisions to limit capital expenditures for new petroleum discoveries, there has been a persistent cap on supply, exacerbated by OPEC supply cuts , announced just this week. Moreover, oil companies are returning capital to shareholders through stock buybacks and dividends. Despite that, the Energy Select Sector SPDR Fund ( XLE ) fell by more than 6% this week. The sector that had been relatively “safe” throughout 2022 (energy) was anything but, this week.

We saw a similar dynamic in cybersecurity this week, another industry that has massive tailwinds. Cybersecurity was already a priority for businesses of all sizes, but Covid and Work-From-Home accelerated the threat for on-premise networks everywhere, as well as in the cloud. We recently received stellar earnings reports from industry leaders Palo Alto Networks, Inc. ( PANW ) and CrowdStrike Holdings, Inc. ( CRWD ) . Management for these two businesses reported accelerated revenue trajectories, amid the backdrop of an ever-evolving cybersecurity threat landscape. Again, we see (presumably) temporary decoupling of stock prices and fundamentals.

How should investors respond to the “nothing is working” market? As with any other matter of investing strategy, it really depends on individual circumstances. If you happen to be an investor in the relatively early stage of life and career, still in the accumulation phase of wealth building, you should view the market’s weakness as a glorious opportunity. If you are saving/investing on a monthly or periodic basis, lower stock prices just mean that you can purchase more shares for the same money. While it may hurt as you look at your statements each month, you will benefit in the long-term and five years from now, 2022’s market action will be a mere blip in your wealth graph. The only caveat to this -- we would caution investors in this situation to think in a maniacally long-term way: use this time to purchase shares in high quality businesses at low prices and hold them for the long haul, so long as business continues on a positive trajectory. Energy and cybersecurity stocks are great examples of this concept.

If you are in or near retirement, the situation is a bit more complicated. In the later phases of life, you may not have the wherewithal to absorb even a temporary drawdown in financial markets. Now is the time to consider whether, in fact, you do have the proper asset allocation to fit your needs and your risk tolerance. After a decade long bull run in the stock market, you may have a higher percentage of your net worth in stocks than you intended.

We do see a ray of hope for you investors in the preservation/income-replacement phase. As interest rates continue to rise, we are seeing bond prices fall precipitously. We complained for nearly 15 years that suitable high-quality, income-producing assets were in short supply. That reality is changing rapidly and for the better, if you are in need of income. We are starting to see investment-grade corporate bonds trading at prices which imply annual yields between 5-6%, virtually unheard-of in the last decade. Now is the time to take advantage of lower bond prices to build bond ladders that can sustain your retirement for the next decade and beyond.

A New Bond Strategy: “Enhanced” Bond Portfolio

As stated above, we are starting to see very compelling opportunities in the bond market, not only in high yield bonds, but in higher quality issues that may connect better with the investment objectives of more conservative-minded investors. In the post-Covid era, due to unprecedented bond buying from the Federal Reserve, many corporate issuers were able to access the debt markets and sell bonds at historically low interest rates. As we dig through our bond database, we see bonds with coupons between 2-4%, again almost at unseen-before levels.

Why is this relevant? Again, bond prices and interest rates move according to an inverse relationship. When rates rise, bond prices fall. Bonds like the ones we are describing here are, in many cases, now trading between 80 and 90 cents on the dollar. From our point of view, this represents an interesting opportunity for a novel strategy.

Consider a bond from airplane manufacturer, Boeing ( BA ) . The company has fallen on some hard times in recent years, due to mismanagement and some safety issues. But the company is one half of a world duopoly (along with Airbus) and orders are beginning to pour in again as travel resumes in earnest around the world. The basic point is we are confident in this company’s ability to service its debts well into the future. Take a look below at a bond in the Boeing debt stack, the 3.6% bond of 2034:

Investors can purchase the above bond for roughly 80 cents on the dollar, locking in a yield of 3.6% annually until the year 2034. As we divide 3.6% by the price of the bond, a bondholder receives what we call a current yield of 4.5%, taxable at ordinary income rates (if purchased in a taxable brokerage account). When the bond pays back at maturity, you will receive a roughly 25% capital gain on your initial investment, which is taxable at the lower long-term capital gains rate. Already we hope you can see that there is a tax advantage to purchasing a discount bond like this one.

However, we see a possibility even more interesting here, using a bit of creativity. Let’s say you have $10,000 to invest in a bond. What if instead of buying $10,000 worth of BA bonds in current value, you purchase $10,000 of face value for $8,054 (using the quoted price of the bond). In 2034, you will receive back $10,000 plus all the contracted interest payments. The rest is left over to invest elsewhere.

$10,000 bond face value - $8,054 bond price = $1,946 residual to invest in stock

On the other hand, you could put that residual money to work in a security with more upside than the bond purchased. You could use that $1,946 to buy a growth stock, a dividend stock, or even a long-dated stock option, all of which offer more upside than does the Boeing bond we have described. And consider this: even if the stock you purchase goes to 0, you will still get back your initial $10,000 investment (plus the interest payments), provided that Boeing never declares bankruptcy. And with investment-grade bonds, the odds of default are, by definition, quite low. If the stock you purchase with the excess capital performs better than the 6% yield to maturity currently implied by the bond’s price, you have a relatively low-risk opportunity to deliver a higher than bond return with a bond-like risk profile.

As I write this section of text, I recognize that this strategy may seem a bit complicated, but I hope I am getting the idea across somewhat effectively. We can use the opportunity of discounts in investment grade bonds to create a portfolio of (mostly) bonds, with a bit of the upside of stocks, that carries the risk profile of the bonds you buy. There are a number of bonds that fit the description of the Boeing bond we list above, so it is certainly possible to build a portfolio of similar opportunities, that can provide you with both income and some upside.

With the complexity involved here, you will want to work with a financial professional with the experience and the tools to identify suitable bonds (and stocks) for the strategy.

Takeaways from this Week

The market’s winning streak from the summer has been quickly erased, causing losses in both strong and weak businesses alike. Bonds and stocks are both falling in 2022, which is a very rare, but painful, occurrence for investors. But in the difficulty, we are finding opportunity.

For investors with long time horizons, we are seeing a wonderful chance for you to buy stocks at discounted prices that will benefit you years and decades down the line. For investors needing income, we see selected investment grade bonds offering yields of 5% or more. While this alone is attractive, we think there is an even more exciting possibility for investors to pair a portfolio of discount bonds with a handful of stocks to offer additional upside.

Enjoy the long Labor Day Weekend!

For further details see: