Four Horseman Funds: Portfolio Management In Volatile Times

Man makes notes about portfolio management in the notepad.

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My followers know I advise investors to construct and maintain a well-diversified portfolio built for the long run and to stay invested in the market during good times and bad in order to achieve the long-term returns the market is willing to give them. My previous Seeking Alpha articles on top-down portfolio management have discussed how to allocate capital among the various “buckets”. These buckets can include broad market funds, technology, dividend stocks, energy companies, sector-specific ETFs, speculative growth opportunities, and precious metals – just to name a few. Each investor designs his own buckets to match his or her specific life situation (age, income, retirement, goals, risk tolerance, etc.).

One oft-overlooked bucket is “cash”. Cash has a number of important purposes – including meeting day-to-day and big-ticket expenses, emotional security, emergency backup, to keep from having to sell other assets at lows, and to take advantage of market opportunities as they arise. It is the latter that I will discuss today.

As you all know, the market has been going through a pretty brutal sell-off: some of the broad market averages are down significantly since the start of this year:

Vanguard S&P 500 ETF price % change
Data by YCharts

As can be seen in the graphic above, the technology sector as represented by the Nasdaq-100 (QQQ) ETF has been hit particularly hard because many of the tech growth stocks have been re-valued by the market as interest rates have risen and investors are no longer willing to pay significant premiums for future cash-flow: they want free-cash -flow and dividends (or “value”) now.

Given the current macro-environment, it is not surprising that the Schwab Dividend ETF is the best performing fund of the selected group as investors put a priority on dividend-paying income (see Seeking Alpha’s post Investors Flood To Dividend ETFs For Safety† Out of the group, the DJIA ETF is in a solid second place and has been led by Chevron (CVX), the DJIA’s best performer YTD (+34%).

Of course, despite the severe sell-off, stocks could certainly go lower still. There are lots of macro-environment threats to the market and uncertainty abounds: inflation is high, oil & gas prices are high, the Fed is hawkish and will likely be raising the Fed funds rate by 0.50% at the next two meetings, Covid- 19 lock-downs in China threaten global growth and supply chains, and Putin’s horrific war-of-choice in Ukraine has broken both the global energy & food supply chains.

That said, the S&P500 is ~16% cheaper today than it was at the beginning of the year, so how much of these headwinds have already been baked into the market? honestly? I have no idea. However, on Monday of this week, I started putting a little more cash to work in what I call the “4 Horseman” funds that make up the bulk of my broad market portfolio allocation. These include:

  • The Vanguard S&P 500 ETF (VOO)
  • The DJIA SPDR ETF (SLIDE)
  • The Schwab US Dividend Equity Trust ETF (SCHD)
  • The Invesco Nasdaq-100 ETF (QQQ)

Now, of the four funds above, I have a significantly larger allocation to VOO as compared to the others and that percentage drops as you work through the list from top-to-bottom. On Monday, I put ~5% of the cash I plan to put to work into the market into these four funds – and in line with my current allocation percentage (ie, considerably more into VOO as compared to the triple Q’s).

However, don’t get the impression that I am not bullish on the potential of the technology sector – I certainly am a long-term bull on technology. It’s just that I have several other direct tech holdings – google (GOOG), Amazon (AMZN), and broadcom (AVGO) and significant exposure to semiconductors & software through the VanEck Semiconductor ETF (SMH) and the iShares Expanded Tech & Software ETF (IGV), respectively, both of which have taken a real beating of late. And while the tech sector is down the most, and one could argue I should have been adding more to tech as compared to the S&P500, sentiment is currently so awfully bad in the tech sector that I am biding my time before adding to my existing positions . However, you can be sure that I will be adding more to my tech holdings too.

Dead Cat Bounces

Of course, I could be early – and I probably am. But as the bullets at the top of the article said: “timing is everything, but you can’t time the market.” That certainly applies to me. As a case study, note that in the chart below of the “2000 meltdown” there were two significant dead-cat bounces (wicked-sharp market rallies in a bear market) before the much lower bottom was finally reached in early 2003 and whereupon the market went on to hit a new high prior to the 2008 financial crisis:

S&P500 - 2000 Sell-Off/Recovery

YCharts

I have a couple of friends who misread those two dead-cat bounce head fakes, went heavily back into the market, and – naturally – subsequently got badly burned and, exasperated, sold out of the market completely near the 2002 bottom. It took both of them many years before they got back into the market after getting stung so badly. In fact, one of them completely sat out the biggest bull market of his life.

And that is why I only put 5% of my cash position to work Monday. I am not in a hurry… and I am bidding my time. I don’t want to go “all-in” with my cash too early. But I also want to keep my overall portfolio allocation percentages where I set them – or at least to gradually move in that direction.

Meantime, I am quite pleased with how my portfolio has held-up during the sell-off. Significant exposure to energy companies and sector-specific ETFs like consumer staples (and cash) has helped me stay ahead of the overall market during the downturn. Part of that is due to some iBonds I bought many years ago that are now returning 9%+. There is beauty in simplicity – and it doesn’t get much better than the beauty of compound interest.

energy

However, energy – the largest source of my dividend income – has once again grown to be my second largest position after the S&P500. That makes me nervous. Remember, prior to covid-19, the energy sector was the worst-performing sector (by far) over the previous decade. Today, the energy sector is flush with free cash flow and the dividends are flowing. That’s great… but note many of these companies, now that their stocks have doubled and tripled off their lows, are now cranking up their share buyback programs again. Considering how much shareholder capital was destroyed over the previous decade with energy company stock buybacks, that too has me concerned.

Note that energy companies have a long history of suspending stock buybacks during the down-cycle (when their stocks are really cheap and should be bought) and over-emphasizing buybacks on the up-cycle, when their stocks are expensive and arguably should not be bought. For years I haven’t figured out why energy company CEOs don’t simply pay-off their debt so that, during the low-cycles, they can afford to spend what otherwise would have been wasted on interest expense to service their considerable debt loads to buying back shares when they actually represent awesome value. But what do I know… I am no energy company CEO. So, I watch as companies like ConocoPhillips (COP) and Exxon (XOM) crank-up their stock buybacks now that their stock prices have more than doubled off their lows.

Summary & Conclusion

For the typical ordinary investor, constructing and maintaining a well-diversified portfolio built for the long-term, and staying in the market thru thick-n-thin, is still the best way to go. Indeed, research shows that most ordinary investors are awful market timers and would do much better simply to invest only in the S&P500 and forget about it. Indeed, a solid S&P500 fund (like VOO) not only outperforms most ordinary investors but 80% of active professional fund managers as well. This is the main reason VOO is my biggest overall position.

That being the case, I am taking advantage of the recent market sell-off to, very slowly, add to my broad market funds in order to maintain my portfolio’s overall targeted allocation levels. While some investors get frustrated during market sell-offs and stop doing due diligence, I suggest they do just the opposite: take time this weekend to review your portfolio, your allocation targets, and your goals. Put together a “buy list” (or a “sell list”) and plan your moves should market volatility present you with opportunities that are too good to pass up.

I’ll end with a long-term chart of the S&P500. This graphic indicates two seemingly opposite things at the same time:

  1. The need for investors to stay in the S&P500 for the long-term and
  2. The fact that there could be (significantly) further to go on the downside

S&P 500 level
Data by YCharts

Thanks for reading and I wish you success!

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