Seeking Income in a Market When ‘Winter Is Coming’

I recently celebrated the end of two journeys I’ve thoroughly enjoyed: the Golden State Warriors’ march to the NBA title and the completion of the latest season of the popular television show, Game of Thrones. I see lessons to be gained from both journeys as I think about the markets. 

Investors are at an interesting juncture in their own journey: witnessing the aging of the American baby boomer, the “long in the tooth” bull market in equities and the aftermath of a 30-year bull market for bonds.   

Aging baby boomers require income that’s hard to find in a low interest rate environment, fueling demand for a wide variety of income-generating assets. In many cases, we see investors seeking yield in products that didn’t exist or were outside of the mainstream until relatively recently.

Equity markets are at an equally interesting point in time, reaching the third longest equity rally without a 10% correction since the 1930s. Completing the picture is the aftermath of the historic bull market for bonds, punctuated with the expected end to the Fed’s zero interest rate policy by the end of 2015.

Winter

“Winter is coming” is a motto frequently heard on Game of Thrones, providing a warning of challenges to come while urging constant vigilance. Winter in the Game of Thrones mythology lasts for years, presenting challenges including extreme cold weather, famine and threats from both human and mythical creatures. It combines economic, geopolitical and existential threats, providing a mile-high wall of worry and potentially the ultimate in bear markets!

The very real threats faced by today’s investors have their roots in the journeys described above. The reach for yield driven by aging boomers created a rush into higher-yielding instruments including REITs, MLPs, and high-yield and emerging markets debt. Intrepid investors have also embraced unregistered vehicles such as business development companies (BDCs) and peer-lending structures created by online credit providers such as Lending Club and Prosper.  

Investor commitment to riskier sources of income may be fickle, as last year’s oil price bust triggered a steep selloff in high-yield energy debt which in turn created selling pressures in the broader high-yield market. 

Many observers have called this the least popular, least believed bull market in history. As equity markets reach new heights and extend their rallies without a meaningful correction, many investors are worried that winter for equity markets may be just around the corner.

Fed policy contributes to the wall of worry, with the clear signal from the Yellen Fed that they would like to raise rates at some point before the end of 2015. The market responded positively to the latest signal, which guided to a current consensus view that rate increases will be more protracted than previously thought and may end at a terminal rate lower than indicated in past Fed communications.

However, considerable uncertainty remains about how income-oriented instruments such as REITs and MLPs will respond to the first rate increase.

Steve Kerr or Jim Harbaugh: Whose Style Should Investors Emulate?

At this stage of the investment journey, we think about how differences in investing temperament influence investment outcomes.  We have a point of view, which we’ll illustrate by comparing public figures outside of the investment profession. Returning to the journey of the Golden State Warriors to the NBA title, we’ll compare the approach of Steve Kerr, coach of the NBA’s Golden State Warriors, to that of Jim Harbaugh, former coach of the San Francisco 49ers and current coach of the Michigan Wolverines. We could provide an investment-oriented comparison (Warren Buffett to Jim Cramer?) but that wouldn’t be nearly as much fun!

Kerr and Harbaugh have a lot in common. Both were highly accomplished athletes and are now successful coaches. Kerr is fresh from his first season as an NBA coach, leading his team to the NBA title after a distinguished playing career in which he was a respected “role player” on five championship teams. Harbaugh has a distinguished resume in football, winning major college bowl games as a star player and as a coach, playing in the NFL for many years and coaching the San Francisco 49ers to three consecutive NFC championship games and one Super Bowl, narrowly losing the Super Bowl to a team coached by his brother. 

For all the success that Kerr and Harbaugh share, they couldn’t be more different in sideline demeanor. Kerr is the epitome of Southern California cool, looking unruffled and relaxed on the sideline regardless of what’s going on around him. Whether the team is playing well or poorly, Kerr looks the same on the sidelines. But few insiders mistake Kerr’s composure for complacency. The Warriors constantly adapt under his leadership amid changing circumstances -- adjusting lineups and offensive and defensive strategies as necessary. 

Kerr’s mellow approach appears designed to calm his young and excitable team while creating an environment that promotes clear-headed decision making for the staff.

Harbaugh is well regarded as a coach, both as a strategist and as a motivator. But his sideline and locker-room demeanor represent the polar opposite of Kerr’s. Harbaugh is the prototype of a frenetic coach -- arguing with referees, cajoling his team and running up and down the sidelines, looking poised to take action at the drop of a hat or at the drop of a penalty flag. 

A former player recently described him as “crazy,” though the description was intended as a compliment. Harbaugh’s style works for him, and has worked for his teams, but is vastly different than Kerr’s style. Football, with shorter and more intense seasons, is more sprint than marathon, and arguably lends itself more to the Harbaugh approach than to the marathon of an 82-game basketball regular season followed by playoffs that can add 20 or more games to the season total. 

Why Do These Styles Matter?

We expect the coming months to offer continued uncertainty about the path for the markets and interest rates, coupled with a constant stream of headlines that seemingly call for “action.”

Against that backdrop we think that investors should take a measured approach to reacting to the latest news, rather than the “shoot first, ask questions later” approach favored by many market commentators.

Although most investors seem more like Harbaugh than Kerr, our experience argues that Kerr’s placid, less reactive approach will lead to better investment decisions in the ultra-marathon of investing. With that perspective in mind, we offer tangible guidance to those who wish to emulate Kerr:

  • Have a “playbook” for your investments:  For example, our base case for high yield bonds over the next 12 to 18 months is that they will continue to outperform Treasuries if the economy continues to grow at a moderate level and if interest rates rise at a gradual pace.  There are longer-term clouds on the horizon, but with the exception of high-yield debt issued by the oil sector, we don’t see a likely near-term catalyst for high yield to suffer a significant decline. We’d revisit our base case if recession risks increase or if the Fed appears poised to raise rates by more than indicated in our base case estimates.  
     
    Part of our playbook also ties to diversification as, unlike a few years ago, we consider most income investments to be either fairly valued or in some cases over-valued. 
    We’ve diversified our portfolio, taking advantage of an interesting variety of opportunities while spreading our risks.
  • Look at what history will tell you about your investments:  REITs are among the more controversial holdings in many income-oriented portfolios. REITs have been outstanding performers in recent years, but have elevated valuations and are feared to be among the first casualties when the Fed raises rates. 

    Looking at historical data, rising interest rates haven’t always been a bad thing for REITs, and as with high yield, REITs are arguably more vulnerable to a rapid rise in rates than to a gradual rise in rates. In addition, understand which of your investments will react in concert with your other investments.  For example, high yield has historically moved in tandem with equity markets, so a big bet in high yield may magnify a big bet you may already have in stocks.

  • Understand what history won’t tell you about your investments:  Many of today’s “hot” income investments have limited history to draw from, and it’s tempting to extrapolate too much from a limited historical context. MLPs have been popular for a short period of time, with little empirical evidence to provide insight into how the asset class will perform if interest rates rise rapidly or if capital market liquidity dries up. 
    Peer lending structures are also untested, and only in a crisis will we truly understand whether peer loans have been underwritten with a proper margin of safety.
      
  • Examine the news for data points that contradict or disrupt your base case:  The best investors I know spend much of their time looking for data points that contradict their base case, rather than data points that confirm it. Understanding the bull and bear case for your investments is critical.

  • When in doubt, take a breath: When the latest headlines are too much to take, step away, take a breath, and clear your head to distinguish between the news that is merely headline drama and the news that truly changes your point of view about your portfolio.  

    Unless you’re a day trader, the more deliberate approach will probably save you money and reduce your stress!
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