- The S&P 500 has not only fully recovered from the lows of the 2020 pandemic but has added on nearly 45% compared to the beginning of 2020.
- Will the current bull run continue in 2022, or are we heading towards a cliff? Should you invest now or wait for lower prices?
- We provide a strategy to invest now to capture most of the future gains while preserving the capital in the event of a correction.
- Looking for a portfolio of ideas like this one? Members of High Income DIY Portfolios get exclusive access to our model portfolio. Learn More »
The last two years or so have turned out to be quite impressive for most stock investors, especially so for passive investors. If you were fully invested simply in the S&P 500 on January 1st, 2020, you have gained roughly 45% (110% from the March 2020 lows), and the market rally may not be over yet. Moreover, that's just the S&P 500. The tech-heavy NASDAQ's gains are even more impressive.
This is especially important knowing where we have been. It has been a roller coaster ride, with a once-in-a-century pandemic and unprecedented economic lockdowns. Folks who do not try to time the market and patiently ride out the market's ups and downs have been rewarded. However, many of them are now getting nervous about overstretched valuations that resemble a bubble about to pop.
Then there are a lot of people who may have missed out on the gains for various reasons. Many believed early in 2020 that the valuations were too high. Others felt that the bull market was already in the 11th year and could not go on much longer. Many others were scared out of the market when the pandemic set in, and the market started crashing in early March. Sure, there are others who just like to keep a lot of cash reserve as a way of their investment style.
In addition, let's not forget about recent retirees who, in fact, retired during the year 2020 or 2021, and for them, it's just coincidental. Let's say besides the regular 401K, you have a significant amount in the company-provided pension fund, and you want to roll over the pension money into an IRA to self-manage.
Now, after a nearly 45% rise in the stock market in 2020 and 2021 (and more than 110% from the bottom in March 2020), everything looks pretty expensive. In fact, not only stocks, almost every asset class looks expensive these days. What if you were to invest now only to see a big correction in the near future.
Almost on a daily basis, we read or hear from market experts that another crash is imminent. In fact, South Africa has just identified a new Covid variant (named Omicron) and is causing some panic in the markets. Some have declared that this is the start of another crash. There is no shortage of other worries that have been lingering on for some time, for example, excessive government spending, rising energy prices, persistent inflation, the political showdown related to the debt ceiling, and the Fed's tapering and raising of interest rates.
However, there's no guarantee that a crash will happen and a bear market will set in. Instead, the current bull market may just continue for another full year or more. If you were to wait, it's quite possible that you might just lose another year of 10-20% gains.
So, the question is if today's scenario is more like the year 1998 or like 2000. Just to provide a perspective, the S&P500 had gained over 131% from January 1995 until the end of 1998, but then continued the bull run in 1999 and the early part of 2000 to add another 25% of gains before peaking in August 2000. It then began a three-year-long correction losing nearly 45%. There are valid reasons to believe either side of the story, which appear to be fully rational. You are in a dilemma that you can't seem to overcome.
Obviously, there's no perfect answer or solution to the above situation, as no one knows where the market will be next month or six months down the line. Nonetheless, we will try to attempt something that could make the best of any situation.
Note: All the tables and charts included in this article are sourced from Author's work unless specified otherwise underneath the image. The stock market data, wherever used, is sourced from public websites like Yahoo Finance, Google Finance, Morningstar.com, etc.
Portfolio Construction for 2022
Let's assume you have a cash reserve of $300,000 waiting to be invested. Divide your capital into three parts or buckets as detailed below. If you are a retiree or otherwise a conservative investor, a fourth bucket with cash-like investments would be desirable. For younger investors, the fourth bucket with some high-growth stocks will certainly be beneficial.
Bucket 1: Value-Oriented DGI Bucket (40%, $120,000)
We should choose at least 15-20 stocks for this bucket.
The first half of the list of stocks would be the ones that tend to have a natural resistance to correction or recessionary periods. This list is based on our prior research and published work on SA.
We will choose the other half of stocks that have lagged the market somewhat in 2021 and have not fully participated in the recent bull rally. This will ensure that we do not overpay and the yields are high enough. It does not mean that we would select companies that have something wrong with them. It just means that somehow markets were not excited about them due to one reason or another, or they have not recovered fully. Otherwise, these should be large and stable companies with a solid dividend-paying history. You could run a stock screener to filter out such stocks with the following criteria:
- Market cap larger than $10B
- Total return in 2021 (YTD) less than 10%
- Dividend yield > 2.5%.
- Five-year dividend growth rate to be positive.
We ran our screener and also checked them for dividend safety, and selected the top 10 names (three of them, JNJ, CLX, and VZ, were duplicated with the first half of the list, so they were eliminated).
So, we now have a total of 20 companies based on the above criteria. We will divide the bucket capital equally into these 20 stocks.
Table-1 (DGI Bucket):
Bucket 2: CEF Bucket (20%, $60,000)
If you are an income investor, CEFs could be a good choice for a small portion of your overall portfolio. They could offer certain advantages over typical stocks, and they will add to diversification while providing high income. However, you should stick to quality names based on their long-term NAV preservation and growth.
- They can offer different types of assets, such as equity, bonds/credit securities, utility, infrastructure, real estate, energy MLPs, preferred income, floating-rate income, etc., thus providing broad asset diversification.
- Most of them pay high distributions, making the majority of the total returns. Even if there is a correction of, say, 10% in 2022, we can keep collecting the distributions, and eventually, the prices should come back. Please note that CEFs' prices can be more volatile than the broader market, but the regular income should provide the necessary cushion. Also, we should only invest a small portion of the overall portfolio in CEFs. We recommend no more than 20%-25%.
We will select a set of 10 CEFs from different asset classes that have sound management, good history of maintaining their NAV, and yields/distributions in the range of 6%-8%. These are 10 CEF funds (one of them being an individual company stock), and we will invest equal amounts in each of them.
- PIMCO Dynamic Credit and Mortgage Income (PCI)
- Calamos Convertible Opp & Income Fund (CHI)
- Eaton Vance Enhanced Equity Income Fund II (EOS)
- Reaves Utility Income Fund (UTG)
- Nuveen Taxable Municipal Income (NBB)
- Nuveen Pref & Income Opps Fund (JPC)
- Tekla Healthcare Investors (HQH)
- BlackRock Science and Technology Trust (BST)
- Cohen & Steers Infrastructure (UTF)
- Enterprise Products Partners (EPD)
Table-2 (CEF Bucket):
Note: All of the above funds are CEFs except EPD. EPD is an MLP (Master Limited Partnership).
Alternate Bucket 2: Options Income Bucket (20%, $60,000)
Folks who do not like to invest in CEFs could use an Options bucket to generate income. We are assuming that the investor has some prior experience with stock options. If you do not have prior experience, we recommend having a trial account (without real money) with your broker and gaining some experience before committing to real money.
We could use this bucket to sell some (cash covered) PUTs and covered-CALL options that have an expiration date of approximately one to two months. This means you will need to do some homework on a monthly basis to be able to manage this bucket. You can buy or sell options as one contract or more, each contract representing 100 shares of the underlying security. Our $60,000 in this bucket will not go far, and we will probably have to be content with only about five to ten different contracts. A suggestive and sample list of trades is presented below:
* Premium and prices as of 12/01/2021.
If we were to write cash-covered PUT options on all eight trades (as above), we would need to reserve roughly $61,000. However, we will immediately earn a total premium of $1,121 and provide an annualized return of 13%, excluding any dividends.
Bucket 3: Rotational Risk-Hedged Bucket - (40%, $120,000)
So, what's a Rotation strategy, and why invest in it? This bucket can act as an insurance bucket (or hedging bucket), which should preserve our capital in times of crisis or panic. In addition, it would reduce volatility, provide a decent return, and some of them could provide a good income. The strategy outlined below rotates among a set of six securities and uses the "relative momentum" of each security to determine which one to invest in for the next holding period, usually a month.
A Rotation Strategy for the Bull as well as Bear markets (Bull-N-Bear Rotation Model)
This portfolio is designed in such a way that it aims to preserve capital with minimal drawdowns during corrections and panic situations while providing excellent returns during the bull periods. Due to much lower volatility, this portfolio is likely to outperform the S&P 500 over long periods of time. However, it may underperform to some extent during the bull runs.
The strategy is based on six diverse securities but will hold any two of them at any given time, based on relative positive momentum over the previous three months. Basically, we will select the two top-performing funds. The rotation will be on a monthly basis. The six securities are:
- Vanguard High Dividend Yield ETF (VYM)
- Vanguard Dividend Appreciation ETF (VIG)
- iShares MSCI EAFE Value ETF (EFV)
- Cohen & Steers Quality Income Realty Fund (RQI)
- iShares 20+ Year Treasury Bond ETF (TLT)
- iShares 1-3 Year Treasury Bond ETF (SHY)
Please note that the last two are long-term and short-term Treasury funds, which are used as hedging securities.
The back-testing results going back to the year 2008 are presented below:
Chart-1: Growth Chart with No Income Withdrawals:
Growth Chart with 6% Income (Inflation-Adjusted) Withdrawals:
The below chart demonstrates the dangers of sequential risk with index investing and how devastating a deep correction can be at the onset of retirement (if you were to draw a significant amount of income). So, yes, drawdowns matter a lot, especially if you're a retiree who needs to withdraw income and a correction happens early in your retirement years. Due to a deep drawdown and 6% income withdrawals, the S&P 500 really got crushed and never got a chance to make a comeback in spite of the extraordinary growth of the S&P 500 in the last 12 years.
Chart-1B: Growth Chart with 6% Income Withdrawal
Future Expectations and Likely Scenarios:
Since we have completed the portfolio construction, let's try to analyze how the combined portfolio would perform under different situations.
Scenario-1: What happens if there's a 10% market correction in 2022
In this scenario, we would assume that bucket-1 will fall less than normal since they are all high-quality dividend stocks. We will assume a 7% loss (70% of the broader market).
The CEF portfolio will lose more, let's assume 1.5 times at 15%. If you are using the Options portfolio for bucket-2, the strike price is on average 10-12% lower than the current prices. Also, if we were to include option-premiums, we would be covered for about 18-20% loss. For simplicity's sake, we will consider only the CEF bucket.
There would not be much change to bucket-3. The Rotational portfolio should provide the necessary hedge and is likely to preserve capital. So, for simplicity's sake, we are assuming zero downdrafts for 10% correction and 5% downside in case of a 20% correction.
Scenario-2: If there is a 20% market correction in 2022
Just like the first scenario, we would assume our bucket-1 will fall less than normal since they are all high-quality dividend stocks. We will assume a 15% loss for bucket-1. The CEF portfolio will lose more, assuming 1.5 times at 30%. We are assuming a 5% capital loss to bucket-3.
Scenario-3: What happens if there's a 10% market gain in 2022
In this scenario, we would assume that bucket-1 will gain in line with the broader market. The CEF portfolio will gain less at, say, 5%. There would be a 5% upside to bucket-3.
Scenario-4: If there is a 20% market gain in 2022
This is how we can summarize for 2022:
S&P500 loses 10%
Bucket-Portfolio loses 3.90%
S&P500 loses 20%
Bucket-Portfolio loses 9.50%
S&P500 gains 10%
Bucket-Portfolio gains 9.70%
S&P500 gains 20%
Bucket-Portfolio gains 18.7%
As you can see, the goal is to capture market equivalent gains during bull runs and lose less than half of the market during big corrections. Over time, this results in far superior performance compared to the broader market.
It must be kept in mind that all of the above calculations are based on certain assumptions. The reliability of the results would be dependent upon the accuracy of assumptions. One should try to modify the assumptions according to one's risk tolerance. Also, there's no certainty about the future, so our calculations are simply our estimates. However, the main purpose here was to demonstrate that we can remove the fear (and greed) out of investing when we invest with a well-planned strategy. The systematic investing approach helps overcome excessive greed, fear, or impatience. This approach will not only preserve capital but provide roughly 5% income and reasonable growth, making it an ideal choice for retirees and conservative investors.
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This article was written by
Financially Free Investor is a financial writer with 25 years investment experience. He focuses on investing in dividend-growing stocks with a long-term horizon. He applies a unique 3-basket investment approach that aims for 30% lower drawdowns, 6% current income, and market-beating growth on a long-term basis and he focuses on dividend-growing stocks with a long-term horizon.He runs the investing group High Income DIY Portfolios which provides vital strategies for portfolio management and asset allocation to help create stable, long-term passive income with sustainable yields. The service includes a total of 10 model portfolios with a range of income targets for varying levels of risk, buy and sell alerts, and live chat. Learn more.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, RQI, STAG, STK, TLT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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