“The First Cut Is the Deepest”
In 1967, a little-known English singer of Greek origin, Steven Demetre Georgiou, released his second album, “New Masters,” under the pseudonym Cat Stevens. This album included 12 songs, among which the most famous is “The First Cut Is the Deepest.”
In the case of the S&P 500’s decennial bull market, the first cut also was the deepest as the market experienced the largest plunge in its history, even as it was at its historical maximum. That first and deepest plunge lasted for nine days, from Feb. 19 to Feb. 28. The first week of March offered just barely enough time to catch a breath, then came the terrifying two weeks of sell-offs in mid-March.
The following chart shows the S&P 500’s rollercoaster ride over the past three months (since Jan. 27). The ride began with the steep and severe initial plunge on Feb. 19. What followed was one month of free fall, with five long dips, each followed by a subsequent short rebound, until the market hit bottom on March 23. Since then there has been a gradual, but mostly continuous recovery, interrupted just twice during April.
(All data as of April 29).
Bracing for the Ride
The following chart shows the actions I took during the sell-off. Looking back, perhaps I moved too much and too soon at the end of February, but I wanted to create a strong foundation that could withstand further shocks and at the same time open a path to new growth. The steps I took bore fruit through the entire month of March, especially during the above mentioned dips.
In the meantime, as shown in the following chart, the CBOE Volatility Index (VIX) reached a maximum of 83.56 on March 16, with a same-day close not so far from there, at 82.69. I really acted in the middle of the storm!
As April drew to a close, the markets, drugged by massive injections of liquidity into economies by the central banks, seem to have found an equilibrium point. The VIX is currently swinging around 30-35.
Will This Time Be Different?
The financial past doesn’t repeat itself exactly, but it rhymes. Human nature never changes, no matter how vociferously someone tries to tell you that this time is different. (…) On Wall Street, everything has been tried before. Whatever it is, it will almost certainly turn out the same this time as last time.”
(Jason Zweig, introduction to “The Devil’s Financial Dictionary”, 1st edition, 2015)
Of course nobody knows if this time will be different. In the first half of March, the S&P 500 officially entered in a bear market. Almost anywhere you looked, you read that “the worst is yet to come.” So far the worst hasn’t shown up. Maybe the fire is still smoldering under the rug, but in this moment we are looking at a long (and to some extent unexpected) market rebound. Some sources even say that a new bull market is starting.
Markets normally anticipate the economic cycle. In fact, the world’s central banks are taking action to prevent a severe recession, marked by a significant decline in general economic activity in Europe and the US. “Recession is a normal, albeit unpleasant, part of the business cycle (…) characterized by a rash of business failures and often bank failures, slow or negative growth in production, and elevated unemployment.” (Investopedia)
By this definition, we’re already experiencing a recession. The crucial point is, how long will this recession last?
My Diamond Collection
The answer, for now, is blowing in the wind. Meanwhile, as we all wait for that answer, I put the finishing touches on my Cupolone Income Portfolio. Today, the projected overall yield for my new portfolio is 9.72%, assuming there will be no dividend cuts.
These are the funds that make up my completed Cupolone Income Portfolio:
- BlackRock Health Sciences Trust (BME)
- DoubleLine Income Solutions (DSL)
- Eaton Vance Tax-Adv. Global Dividend Opps (ETO)
- Eaton Vance Tax-Adv. Dividend Income (EVT)
- Guggenheim Credit Allocation (GGM)
- John Hancock Tax-Adv. Dividend Income (HTD)
- Pimco Corporate & Income Strategy (PCN)
- Pimco Dynamic Income (PDI)
- John Hancock Premium Dividend (PDT)
- Pimco Income Opportunity (PKO)
- Pimco Corporate & Income Opportunities (PTY)
- Cohen & Steers REIT & Preferred Income (RNP)
- Cohen & Steers Quality Income Realty (RQI)
- Cohen & Steers Infrastructure (UTF)
- Reaves Utility Income Trust (UTG)
Currently, the following funds are less stellar than they were one month ago:
- DSL has recently been “painfully” downgraded from a four-star Morningstar rating to one.
- EVT went from three stars to two.
- HTD went from four stars to three.
- PDI, RNP and RQI have all been downgraded from five stars to four.
The only good news is that during the same time period, GGM was upgraded from a three-star Morningstar rating to four.
Despite the declines for some of the funds in my portfolio, I remain confident in their efficacy based on the analysis I described in my November, 2019 article “Comparing Morningstar Ratings and Total Returns.”
The following table shows the final composition of my Cupolone Income Portfolio following the adjustments I made in first week of April. Given the current load prices of the funds in my portfolio, today I’m breaking even.
As always, when I planned my Cupolone Income Portfolio I based my initial decisions on the Morningstar star ratings and RiskGrades reported at the beginning of February. I didn’t make decisions for rebalancing my portfolio on the fly, especially because values of the RiskGrades were particularly fluid. I remained determined to stick to my original plan and stayed the course during the storm.
From that starting point, I shaped my portfolio to take into account the current circumstances (for example the possible consequences of a recession in real estate). I decided to place more emphasis on the PIMCO funds for three reasons: Quality, yield, and the rare occasion when they sold at discount. I underweighted both BME and UTG because of their lower yield and the fact that they rebounded first, forcing me to chase their prices.
A Mathematical Approach to RiskGrades
One of my readers, Tom InvestStudy — whom I thank for sharing, made the following comment on my last article (“Buying the Dips”): “A common way to balance risk and get more bang for your buck overall is to take the inverse risk score of each holding, sum them up, then divide the inverse risk score of each holding by the total of the inverse scores and multiply the result by the total value of the portfolio.” This means allocating capital in an inverse proportion to the risk score. Higher score => less capital allocation: lower score => higher capital allocation. (The inverse of a number is the multiplicative inverse, or reciprocal. When a reciprocal is multiplied by the original number, the product is always 1.)
As Greek philosopher Socrates used to say, “I know that I know nothing," so I welcomed the suggestion and applied it “retrospectively” to my portfolio. The following table shows the result of this mathematical approach to RiskGrades. I’ve called the portfolio built based on the method Tom suggested “Risk Scored Portfolio.” The comparison is based on RiskGrade values as of February 2020, which is when I planned my portfolio.
The Risk Scored Portfolio would result in a 9.60% yield.
The percentages from the two methods of structuring the portfolio diverge from one another, primarily because in structuring my Cupolone Income Portfolio I didn’t use the exact (mathematical) proportions for each CEF.
Indeed, I based my portfolio on RiskGrades but I decided to proactively adjust some of the proportions in my Cupolone Income Portfolio by “customizing” the plain data of RiskGrades. Anyway, the result is a mathematically non-risk scored portfolio whose yield is not so far from the one predicted for the Risk Scored Portfolio.
At the end of the day, even though not all of the funds I’ve chosen should turn out not to be the diamonds I had hoped for, I plan to stay true to the portfolio I’ve designed for “all eternity”… Or at least, as we say in Italy, my love will be “eterno finché dura” (eternal as long as it lasts).
I don’t think we are entering a new bull market yet. We are approaching an easing of the lockdowns, that’s true, and markets are showing small signs of resuming something that resembles normalcy. Such a moderately-optimistic environment is probably not the best moment to short stocks, unless the end of the lockdowns in May should prove to be premature. Let’s hope it won’t. Then we’ll see if this resumption will turn into a bull market.
Some comments to my previous article prophesied an inevitable wave of dividend cuts or suspensions on the horizon. My answer was, and still is, “we’ll see.” If we really do begin to come out of the woods, I don’t personally believe there will be massive dividend cuts. There may be some sporadic, but not systemic, cuts since almost all of the CEFs in my portfolio follow a more or less declared regime of managed distributions. In other words, the CEFs managers plan their distributions well in advance - none of them lives month by month. Let’s wait for the June and July distribution announcements before we worry about this.
And, as a final thought, it’s in the funds’ interest to avoid cutting dividends if it’s not necessary and/or compulsory. We must trust our fund managers. I continue to believe they have enough skill and experience to get us to safety. It’s their job.