Record high after record high....what to do?

I’m being asked a lot these days about what investors should do in this rather frothy market, one in which risk-on assets (like stocks) and risk-off assets (like gold) are both running.  It’s a difficult question, and I hardly know how to answer it anymore.  Perhaps the better question might be "aside from moaning about it, what am I doing in my portfolio to reflect my own concerns about the one-directional increase in the prices of risk assets combined with frothy valuations"?   The simple answer is "not that much". The reason is that asset prices – particularly stocks – are unpredictable and volatile, although I recognise that stock prices do generally trend higher over time. Although I have no particular insights that would allow me to answer this difficult question, I do try to stick to certain principals in managing my own portfolio in good times and bad.

• I am always long stocks and am comfortable being concentrated in this asset class, which enables me to reap the benefits of upwards runs (like now) although granted, I am equally exposed to sudden sharp declines.  For relatively new investors, I realise it is hard to imagine stocks declining for anything other than a matter of a few days or weeks.  The reality is that for several years now (certainly since the pandemic), stocks have benefitted time and time again from a “buy-the-dip” mentality anytime they decline.  However, I would caution investors that stocks can go down for protracted periods.  

• Although I am always well long equities, I run (arguably imperfect) portfolio hedges from time to time depending on my outlook, generally in the form of S&P 500 index puts (SPY puts) to provide some downside protection.  This strategy costs money and eats into overall returns, but this is the cost of insurance.  This allows me to stay long equities, and to avoid both transaction costs and realising capital gains (in taxable accounts) which I would otherwise incur if I were to buy and sell large equity positions as my outlook changes over time.

• I also write covered calls on individual stocks, generally short-dated (1-3 weeks) and just out of the money enough to generate some incremental income.  I only write these on 10-20% of a single position, so they are never conviction trades that could cause me to be called out of a stock entirely.  Most of the covered calls I write expire out of the money, so I pocket the premium.  However, occasionally, I close out the call position before expiration because I don’t really want to lose the shares (and this might be at a loss).  I am also not afraid to let shares go if they have been running like mad.  The income from covered calls is not significant in the context of the size of my portfolio, but the premiums do offset some of the costs of the portfolio hedges I run (via SPY puts).

  
  

• I have started to invest again in short dated UST bills because the Fed is certainly going to ease, but I am far from convinced about extending maturities and strapping on duration.

• As far as corporate bonds (credit), I currently think that credit spreads are eye-watering tight and – like stocks currently – have asymmetrical risk to the downside.  But I keep a portion of my portfolio in what I consider the safest tier of corporate bonds, meaning investment grade corporate bonds and high yield loans (“top of the capital structure”) both via ETFs.

• I hold gold and alternatives (mainly private equity / credit) as uncorrelated assets, but I do not own cryptocurrencies just because it’s not my thing.  

  
  

Recall that in my last portfolio update as of June 30^th, my asset mix was as follows:

Many wealth advisors might consider that I am too long stocks for someone over 60, but I do not fear this because I hold enough cash and close-to-liquid positions, as well as several low beta “boring stocks” that might decline but probably would not get hammered if shit hits the fan again.  I also know my burn rate well, and furthermore have a sub-component of my burn rate that could be adjusted should things get really ugly.   For me, this strategy meets two of my principal investment objectives:

• Stocks are empirically proven over a long period of time to provide the best risk-adjusted returns albeit stocks are a volatile asset class which I acknowledge, and

• Since I am not smart enough to predict sudden shifts in investor sentiment that would allow me to time the market, I avoid moving in an out of positions except “around the edges” or in cases in which I have lost confidence (sell / exit) or gained strong conviction (add) based on fundamentals.

I constantly assess the risks on the horizon and try to evaluate these in the context of valuations across various asset classes and geographic markets.  And it is this assessment that can cause me to adjust individual holdings “around the edges” (meaning making decisions at times on fundamentals of certain stocks or sectors that I believe are over baked or undervalued), or can make me ratchet up my hedges to provide downside protection.

We are in a market in which stocks – especially US stocks – look fully valued.  Concerns regarding valuations are coupled with all sorts of questions regarding the U.S. economy, which is characterised by a slowly deteriorating jobs market and inflation that is stuck above the Fed’s target at 3%.  Naturally, credit spreads are feeling the same dynamics, nearing historic lows at a time when the outlook is becoming more complicated.  Even so, going to cash could be a mistake, and a bad one.  Think about what might have occurred had you bailed out around the ill-timed “Liberation Day” blanket tariffs of Mr Trump.  At its low, the S&P 500 closed just below 5,000 (4,982.77) on April 8^th.  Since then, in  little more than five months, the S&P 500 has risen nearly 21%, surpassing its all-time high on June 27^th and continuing to reach record highs every few days or weeks.  Probably like you, I find these sharp gyrations rather difficult to completely understand. 

Of course, the Trump economics team deserves much of the blame, imposing and then backing off a series of egregious and often confusing tariffs, and then pushing through Congress a deficit-increasing fiscal budget (essentially a stimulus measure).  However, the fact is that corporate earnings have held up reasonably well so far, the inflation-effects of tariffs have not materialised as feared, and investors are aggressively piling into stocks as if they will never go down.  I suppose I attribute the meteoric rise in stocks mostly to growing investment flows into the asset class, driven by a combination of:

• Eager retail investors driven by FOMO and exhibiting little fear of stocks declining for a sustained period of time (because they have never experienced a prolonged downturn), and

• Momentum investors like hedge funds seeing the retail-driven trend and jumping on that bandwagon in order to capitalise on it.

It seems that most institutional investors that manage money professionally are not buying into this rally for reasons I have already highlighted, but I do not think that they are selling either, which is paramount to supporting investors piling into stocks and corporate bonds.  Much like me, all they can do is sit by and watch in awe, scratch their heads, and cheer their weekly mark-to-market gains in their portfolios.

If I had conviction that this would continue unabated, I would ratchet up risk by getting even longer stocks or perhaps use the turbo-charged vehicle of leverage.  However, I am far from convinced that this can continue much longer, and seriously doubt that it will.  Something will stop this rather absurd rally but who knows what that might be or when it might occur.  In the meantime, as has been a philosophy for decades that has served me well, I stay long risk (predominantly stocks but some credit), and use macro market hedges via S&P 500 puts to provide downside protection just in case, the cost of which is partially offset with premiums from covered calls on slivers of individual stocks that I own. I believe that I have the emotional and mental stability to stick with this strategy during downturns, which could be prolonged. Having said this, I admit that Mr Trump’s own goal via his “Liberation Day” tariffs in early April nearly caused me to pull my hair out!!