A Mid-Year Portfolio Strategy Discussion

Includes: DVY, EMB, EMCB, HDV, VIG
by: Michael Fabian

Over the last several days I have been exchanging emails with a dear friend of mine who also happens to be a very talented portfolio manager that I've known for the last 15 years. We rarely find the time to share our thoughts about the markets with each other, but in light of the recent market volatility, our topic of conversation has been squarely focused on interest rates, spreads, monetary policy and naturally the risks associated with managing money in this environment.

He initiated the exchange by sending over some links regarding the sad realities of the U.S. fiscal deficit, structural budgetary challenges and debt per citizen. After reading through everything, what really got me thinking is the balancing act of making long-term portfolio management decisions knowing that these challenges are going to be with us for the foreseeable future, and even continue to grow worse. The recent dose of economic data has not been inspiring either, with several important areas showing signs of slowing.

Fast forward a couple of emails later, we began debating the realities of another 2008, or a similar protracted downtrend as a result of the country's fiscal issues. We both settled on the conclusion that the Federal Reserve, Congress, institutional investors, etc. are paying way too close attention to let things get out of hand in the very short term. However, the-will-or-the-means will likely not exist in the future to prevent the pot from ultimately boiling over. That dilemma in itself may cause this theme to be a self fulfilling prophecy.

As the topic of conversation shifted to portfolio management practices, I filled him in on how our clients were conservatively positioned, and what was beginning to look attractive to me. We discussed the recent price action in high yield bonds where I made the case for the stabilization of treasury rates, and the additional widening in high yield spreads. We reminisced about the days when spreads would "comfortably" hover in the 7% range, then 2008 rolled around and spreads got old-school cheap when they blew out to 20+%. Then fast forward to today, where we find ourselves both hoping to reallocate with the 10-year treasury rate above 2% and spreads at 6%. Which probably isn't very realistic in the yield-hungry world we still reside in.

Another sector I found attractive before the recent selloff is emerging market bonds, and with the decline in prices, valuations have only gotten better. Timing will prove to be key, but an overweight position to this sector using a dollar cost average approach could prove to be a very valuable income and capital appreciation play during the second half of the year. Two ETFs to watch are the iShares Emerging Market Fixed Income ETF (NYSEARCA:EMB) and the WisdomTree Emerging Market Corporate Bond ETF (NASDAQ:EMCB).

In my opinion, investors will be faced with difficult decisions for raising the yield of their overall portfolio, and also managing their risk in equities. I liken it to playing chicken with the market to be able to muscle out any "real return" that is worth the risk. Our strategy has hinged on selling into strength, then holding a sizable portion in cash or low duration bonds until price levels once again reach an attractive level. The areas we continue to focus on are defensive stocks with ample free cash flow, and stable if not growing dividends. A few good ETF examples are the iShares Dividend Select ETF (NYSEARCA:DVY), the iShares High Dividend Equity ETF (HDV) or the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG).

The final nugget gleaned from our dialogue was that heightened volatility will likely continue to be with us for at least the next several months and that investors will need to take a more active role to preserve capital or protect gains. In addition, carrying a good slug of cash on hand so that you have the ability to take advantage of opportunities. That way you are not forced to make unfavorable sales at inopportune times.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Fabian Capital Management and/or its clients may hold positions in the ETFs or mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.