By Richard Morey
August 4, 2023
New Holding Pattern +6%
For all of you closely following your accounts, July was obviously a difficult month for our Tactical Allocation Portfolio (TAP) funds, with a total drop of 1.5%. Decisive reallocations were needed. At the end of July we cut the risk by approximately one-third, and on August 3 by another 33%. We are now positioned for safety and reliable fixed returns, with a 12-month yield of 6.14%, where we will remain until markets finally begin their reversion to the mean.
Current TAP Allocations
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First, what are Bonds?
Bonds are simply loans that pay a certain interest rate over varying time periods. Individual bonds are priced at $100 upon inception. Upon maturity, each bond repays the purchaser with the principal ($100), plus interest. If the purchaser decides to sell the bond before maturity, there is a huge secondary market, in which the price rises and falls every day. But remember, if the bond is held until maturity, it will be redeemed for the original price plus interest.
Brief TAP Analysis
The Tactical Allocation Portfolio is now one of the safest 6%+ portfolios in existence. Half is in US government bonds or government-backed mortgages, which means no credit risk. In terms of length, all the bonds in this portfolio average only 2.53 years to maturity, which caps duration risk. In terms of volatility, this portfolio has a standard deviation of 2.80% – versus 6.09% for the entire US bond market, and 18.17% for the S&P 500. This is obviously considered exceedingly low, meaning very safe. But as mentioned, in terms of yield, we get a 6.14% 12-month yield – on the entire portfolio.
Why are these yields so high? The biggest reason is that prices fell so far last year. You can only get yields of 7-8% in premium, mostly government-backed bonds when their prices have fallen. When I listened to Alfred Murata, manager of the PIMCO (Pacific Investment Manager Company) Income & Mortgage fund, give a presentation
at PIMCO’s headquarters in Newport Beach a few months ago, it sounded like they’re “shooting fish in a barrel” these days. That’s how many ways there are to make extra yield in the bond market today, when you have some of the deepest pockets, and most of the other lenders have stopped lending.
At times like this, it is advantageous to have a long-standing relationship with PIMCO, the largest bondholder in the world. That size translates to a lot of leverage for our clients. We ourselves are fortunate to have such a reliable partner managing $2 trillion in assets across the globe. How did they get so large since 1971? Simply put, they are the best-run bond management firm I’ve ever seen.
For example, looking at their track record through the 2008 mortgage crisis, they made a fortune for their investors buying and selling mortgage bonds. It should be noted that last year was as bad for the entire bond market as the mortgage crisis was for mortgage loans. PIMCO made a fortune the last time parts of the bond market collapsed – in the very market that collapsed, and it appears they have just started to do so again – heavily weighted again towards short-term, government-backed mortgages. You could say that’s one of their “sweet spots” as an investment firm – they know opportunities in mortgages.
The risk of inflation is why we’re keeping TAP so short-term in our bonds. Avoiding inflation risk is key, and short-term bonds have half the inflation risk of intermediate bonds – much less if short enough. You can simply look at last year to see how much better short-term, high-quality bonds do when inflation hits. Last year the entire US bond market (US Aggregate Bond Index) lost 13.02%. Our new portfolio – which is 80% in bonds – would have gone down a tiny .34% last year (before making 3.33% in the first half of this year). Of course, the fact the Campbell Macro Strategy fund made 31% last year would have helped erase almost all the losses from our new bond funds. And this was during a devastating year for bonds.
To keep this in reference, the two bond funds we’ve purchased, PIMCO Mortgage Opportunities and PIMCO Income, are “safe” from almost every angle, and historically have rarely lost value. Inflation is bond market risk #1. Last year’s losses in these funds of 6.84% and 7.81% respectively were roughly half the rest of the entire bond market – and again, they would have been almost fully offset by the Campbell fund.
But in TAP we avoided all the bond market losses last year and are now “buying low” into high-yielding, safe bonds which we expect will become more valuable should investors become skittish. In fact, if a person understands how PIMCO is taking advantage of today’s prices, you see they are buying at rock-bottom prices in many cases today, or with remarkably “rich” terms. The sharp decrease they’re seeing in both bank and private lending leads to higher rates for PIMCO’s investors, and better terms. Even so, mostly they’re putting the bulk of their money in the highest-quality, short-term bonds – places you want your money if things go wrong.
You’ll notice we keep 15% in exactly one quantitative fund, which is Campbell. Their performance continues to speak for itself. In our case, we get the best hedge available – for the bond market’s biggest risk called inflation – from Campbell, and still receive 6+% in steady income on the entire portfolio while we wait for markets to have their long-delayed reversal (which we fully expect will be dramatic at this point).
Logistics
We sold five funds on August 3-4, though we haven’t yet completed the 1-Year Treasury purchases. In most accounts, the five funds sold recently and listed below consisted of several that rose this year and several which went down, for a wash or modest gain in 2023 (earlier in July we had already sold the two quantitative equity long/short funds which have accounted for all our losses this year).
- Catalyst/Lyons Tactical Allocation - replaced with PIMCO Income
- Wasatch-Hoisington Treasury - replaced with PIMCO Mortgage Opportunities
- Catalyst Systematic Alpha - replaced with PIMCO Mortgage Opportunities
- Sprott Physical Gold & Silver - replaced with 1-Year Treasury
- AQR Managed Futures - replaced with PIMCO Income
What does this say about our future?
For now, we’re going to opt out and essentially sit, making 6.14% while we wait for the eventual yet inevitable market downturn. By then we’ll all be able to see which of the funds we have just sold are starting to perform as advertised during a bear market for stocks, credit liquidation event and/or recession.
At that point, we will cautiously resume repositioning towards extra profits both during and after the massive downturn we see coming. Of course, our more conservative clients may want to keep most or all of their retirement in safe, high-yielding funds for an extended period of time – perhaps, for example, for as long as yields are so high.
But until some or all of the funds we just sold are firmly and consistently rising, we’ll be patient and satisfied to receive the 6.14% in steady, safe income (12-month yield).
Economic Summary
Understanding the economy and markets – especially during highly partisan elections – can be difficult. These days, each news station presents the views of the political party they represent, regardless of actual economic facts.
Here are some facts I haven’t heard mentioned once in recent days from the Productivity report put out by the Bureau of Labor Statistics. When computing productivity, they use different measures for employment – I would say near irrefutable numbers as they’re based on all the hours upon which employment taxes are paid. For the second quarter of 2023, employment growth came in at 0% – the lowest since the second quarter of 2020. Most concerning is that total hours worked contracted at a -1.3% annual rate in the second quarter. Other than the pandemic, we haven’t seen employment contract that much since the third quarter of 2009 as the mortgage crisis and recession raged.
Yet on television all I hear about is the great jobs market, and the numbers reported have been more than solid. All this means is that they will soon be revised hundreds of thousands of jobs lower. Always keep in mind the headline employment numbers they use include large numbers of jobs that are simply made-up. Unlike the commonly used Establishment Survey – or “employment” to almost everyone – that is constantly manipulated through questionable statistics and guesses, we greatly prefer to focus on economy-wide jobs numbers that are simply recorded, not revised or manipulated.
We’re also hearing a great deal about all the money being pumped into manufacturing, especially green energy manufacturing, here in the United States. From an economic perspective, putting money into cutting-edge manufacturing is a good investment. This doesn’t, however, change the fact that the main measure of manufacturing is called The Manufacturing Purchasing Managers’ Index (PMI), which measures the activity level of purchasing managers in the manufacturing sector. A reading above 50 indicates expansion in the sector; below 50 indicates contraction. The latest reading came in at a dismal 46, indicating manufacturing is continuing its recessionary contraction.
Retail sales is another area we hear proving economic resilience. Yet when you simply look at the US Census Bureau report of total retail sales, you notice they have dropped .5% in the last five months. If you dig into the details of the retail sales report, the subcategories show a clear trend away from spending extra money and towards “battening down the hatches” and surviving on the part of consumers.
Next an overview of corporate earnings. Here’s something you’ll be hard-pressed to find reported anywhere in the financial media. After dropping 7% in 2022, corporate profits have fallen another 7% so far in 2023. The second number is a moving target estimate, as we’re in the middle of 2nd quarter earnings season.
Gross Domestic Product came in at a surprising, positive 2.4% in the second quarter. Yet Gross Domestic Income – which is supposed to measure exactly the same overall economic expansion – has now been falling all year.
Finally, the key fact the economy can’t avoid is that bank lending continues to contract at a rate we’ve rarely seen. Lending is required for economic growth, and in an over-indebted economy it’s like grease without which the whole system comes to a screeching halt.
This is not to discount parts of the economy that continue to grow. The fact is we still see government stimulus money out there creating jobs and lifting up local economies. We also see the amount left is now a fraction of what it was two years ago. We’re running on fumes in stimulus money in an economy that is already sputtering on its own. And with Fitch having lowered the credit rating of the US from AAA to AA+ (more realistic) due in large part to our ongoing budget deficits, this time the markets shouldn’t expect the cavalry to show up in the form of more government money to bail us all out.