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Q1 2020 Portfolio Management Summary

Q1 2020 Portfolio Management Summary

How will Aspetuck position portfolios in the next quarter amid extreme market swings and what will most likely be several weeks of more dark news surrounding Covid-19 in the U.S.?

I think the economy will experience a steep recession in the second quarter to be followed by a return to growth that will be above average. I am moving to an overweight allocation to equities over next few months given my view that the U.S. economy emerges from a recession in the third quarter. In April, I am reducing bonds from overweight to slightly neutral position, and cash-equivalents to slight underweight. Many investors now have an underweight in equities thanks to the bear market, and an overweight in bonds. This suggest a need to rebalance portfolios – effectively buying equities and selling bonds in April.

Stock market returns from bottoms are highest the first one to three months and the next twelve months. However, there is no free lunch. Volatility is also the highest. It will take a few months for the bottoming process to be confirmed. Buying stocks for the long term now makes sense to me. I’m not alone. Insider buying reached a one -year high which is one of the most reliable buy indicators. Market sentiment indicators are at panic levels. Also, the VIX Volatility indicator, a fear gauge, reached extreme panic level. Historically, buying at extreme VIX readings has produced high twelve month returns. However, as long as uncertainty exists surrounding the duration of the virus, the market will continue to be vulnerable to a re-testing of the lows. Moreover, dismal economic reports, and recession type earnings announcements will weigh on markets for months to come.

I see many early signs of the U.S. stock market in a bottoming process. In the past, just about every market bottom was characterized by the following: narrowing credit spreads, steeper yield curve, peak in US dollar, a bottoming in energy prices, decline in VIX Index off its high, and declining selling volume. Most of these indicators are off their peak and are starting to move in a favorable direction for equities. We will get further confirmation when Small-caps, and Semiconductor stocks outperform defensive stocks (Utilities, Consumer Staples) over the course of a couple of months.

With those thoughts and view, long term equities offer more growth, and higher income than bonds. I am buying only the highest quality stocks that pay dividends. For example:

• Microsoft (symbol MSFT). Microsoft is the world's largest software company. It is best known for Windows and Office and is rapidly expanding into cloud services such as Azure. Yields 1.7%
• BlackRock (symbol BLK). BlackRock is one of the leading investment management companies in the world and the largest asset manager in the U.S. Yields 3.4%.
• Lam Research (symbol LRCX). The company is the largest semiconductor equipment manufacturer of etch products, among other tools it produces. Yields 1.8%
• Taiwan Semiconductor (symbol TSM). Taiwan Semiconductor company is the world's largest pure-play semiconductor foundry by revenue. Yields 3.5%.

The names I’m buying have fortress balance sheets that will survive a “U” recovery. If I am adding equity risks it is in large-cap growth names, and not any deep value names found in energy, and travel sector. I would rather go with a financially strong company even if it means lower returns. These stocks can be found in either SPDR Large-Cap Growth ETF (symbol SPYG) and or Vanguard Dividend Growth ETF (symbol VIG).

In your accounts, I am favoring U.S. equities over foreign because of their quality bias and expect the unprecedented amount of monetary and fiscal stimulus to be successful in bridging the U.S. markets from recession to recovery. Incidentally, higher-quality US dividend paying equities tend to hold their value better in volatile markets.

Accounts are overweight in U.S. large-cap stocks, and very underweight in mid-to-small-cap stocks. Large-cap stocks are more defensive than small-cap stocks in a recession. The top three sectors held in the accounts are Technology, Healthcare, and Communication Services. Technology and healthcare sectors have more defensive earnings characteristics and technology sector sales have been very resilient. Many technology stocks act more like consumer staple stocks than traditional cyclical stocks because of their steadier revenue streams. Business and consumers must spend on technology to operate, and I think we will learn that Covid-19 necessitated the ramping up of technology spending for businesses of every size during the pandemic. The spread of the coronavirus should also increase demand for healthcare.

Energy, Financials, Utilities are underweight sectors compared to benchmark. Energy and financials require stronger economic growth to outperform. Utilities in particular are extremely expensive to buy and are not as good of an equity risk hedge as investment grade bonds.

Going into the quarter I am overweight in bonds because April is expected to remain volatile and the markets are likely to re-test. I intend to rebalance from bonds to equities on a successful re-test. I expect a successful retest based on progress being made with Covid-19 case growth rate, while monetary and fiscal stimulus should help consumers and businesses to bridge over from a short recession to recovery phase.

I own investment grade only bonds in the fixed income area of portfolios. I’m still concerned with credit markets. Default and bankruptcy risks are elevated in the energy and airline industries, as well as others, severely impacted by Covid-19. Although non-investment grade bonds are now offering a risk premium that will compensate for default risks, with current yield spreads that provide future higher returns, I prefer to add risks to portfolios through high quality dividend paying equities with balance sheets that can weather dangerous credit markets and a recession.

The fixed income component is skewed toward intermediate and short-term bonds. Long bonds will have greater interest rate risk as economy starts up again. I am waiting for long-term bond prices to fall before rebalancing into them.

Lastly, I am buying preferred stocks that offer triple the yield of long-term Treasury Bonds. Preferred stocks are mostly financial firms (i.e. major U.S. Banks). National U.S. banks are extremely well capitalized. Preferred stocks are over sold and are now selling at attractive prices.

One Caveat: An “L” scenario projects economy will not recover for a long time. There are quite a few investors who believe this recovery will be an “L” shaped one. While I don’t believe this will be the case, I am holding investment grade bonds, Treasuries, and Gold as a hedging strategy. Given the current uncertain environment. “L” shape is a Depression scenario like 1929 Depression with extreme credit market stress. Unemployment would have rise to at least 10%-32%.

What’s different this time? We are seeing the largest economic stimulus in history with potentially more on the way. Monetary and fiscal stimulus has been massive and swift. The Fed established numerous facilities that provide liquidity in credits market areas that need it. Furthermore, Banks are financially fit and are an asset not a liability, like in the 1929 Great Depression and 2008-09 Great Recession.
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