Since the end of January, Growth sectors have handily beaten Value sectors:
Technology (XLK ETF) +11%
Communications services (XLC) +8%
Financials (XLF) -13%
Energy (XLE) -13%
Our strategy performance is better than the sectors where most of the portfolio tends to be concentrated (Financials and Energy) but it has fallen far short of the Growth sectors.
There may, however, be light at the end of the tunnel. Last week, the OECD leading indicator turned up.
This is a signal we have been waiting for for the last 1.5 years. The indicator turned down in late 2021 and has been falling since.
It has historically been the case that stocks, and in particular the kinds of risky stocks we invest in, do better in periods when the OECD leading indicator is increasing than when it is decreasing.
Over the past decade, big losses in our strategy have tended to happen when the indicator was pointing down (in particular, 30% drawdowns in February 2016 and December 2018), while big gains have tended to happen when the indicator was pointing up.
We believe there is a good chance the same will happen this time around too.
Bank of America equity strategist Michael Hartnett last week compared the current market to that of 2008 after the collapse of Bear Stearns bank. In 2008, just like now, tech stocks rallied after the banking troubles started. What is different this time is that defensive stocks have outperformed riskier cyclical stocks, as investors have been aggressively positioning their portfolios for a recessionary environment, fearing a repeat of the 2008 crash. The cyclicals – banks, oil companies, REITs and small caps – have become cheap, with prices that already incorporate a recession. A confirmation of the start of the recession could then counter-intuitively provide a catalyst to buy cyclicals, as the bad news will then be out, the recession may not be as bad as feared, and uncertainty starts to reduce.
We would agree with Hartnett. The recession is a well-known problem and investors are prepared for it.
How do we act in this situation? By doing something different from the crowd. It is not possible to beat the market by always being defensive ahead of a recession and doing the same things as others – i.e., investing in cash, bonds or technology companies.
Thus, we have decided to dial risk in the portfolio back up again, this time with a more “tough it out” mindset. We were cautious for the past 1.5 years and reduced risk aggressively multiple times – in March 2022, June 2022, November 2022, March 2023 and May 2023. This is not usual for our strategy but it was done because we wanted to avoid the 30% drawdown the strategy previously experienced in February 2016, December 2018 and March 2020.
The OECD leading indicator a kind of lode star for us, and we are happier to take risk more aggressively when it is pointing up. Risks remain, to be sure, and we would not be surprised to see another drawdown over the coming months, due to the impending recession. We are mentally prepared for it and would use it as an opportunity to add funds to our account. For the first time since 2021, there is the possibility of some real money being made over the next 12 months, we believe.
2023 performance YTD
We bought US real estate companies (Equity Residential, Simon Property Group, Healthpeak Properties), oil companies (Eni, Suncor), auto companies (Stellantis, Volkswagen), Financials (Equitable Holdings, Santander), and tobacco (British American Tobacco). All these companies are cheap. Some have >50% upside to our fair value estimate. Most are, of course, also risky companies – if the economy deteriorates, their shares will fall fast. This allocation is in line with our approach of higher risks for higher returns.