Evan Harp: What’s keeping your clients up at night?
Brendan Ryan: The obvious answer is the market. But I would also say that we’ve been surprised with how little fear or concerns or pushback we’ve gotten. I don’t know if that is just a function of everybody being burned out from COVID and it being the summer coinciding with this huge drawdown. I’ve been, personally, extremely worried about our clients as financial advisors. This is probably the most difficult period that they’ve had in 14 years because of how poorly fixed income is doing. So even advisors’ most conservative clients are feeling pain, which they wouldn’t have expected to feel outside of a really historically bad event, like a 2008 or something, which isn’t happening.
I think we’ve all been positively surprised with how little concern there is. But, at the same time, that fixed income component is problematic. There’s been this underlying and probably incorrect view for the last cycle that rates were always going to rise and fixed income was this horrible asset class. I think that was wrong. For a lot of reasons, we can’t actually have extremely high interest rates, and maybe you’re already seeing them top out a bit. But I think having that underlying fear of everyone sort of waiting for this surge — and then it happened, is going to aid in the fear. But, again, like I said, I’m surprised, given how I’m concerned for advisors in this environment, how little fear we’ve seen so far.
Evan Harp: Do you have any recent changes in allocations?
Brendan Ryan: We haven’t made a lot of major changes to the models. We came into the year pretty underweight equities. As the market fell, we’ve gone to a slightly below-neutral equity stance, and we’ve stayed around there. I expect we’ll continue to stay around there.
What is changing is the selection within equities. There’s been a major consistency to growthier tech equities that has been beaten up more than the market. For the most part, those are better companies than the average. So we understand why, even though our system is entirely quantitative, why those might be attractive right now.
But then, on the margin, we’re seeing things come in and out just given the volatility in the market. Some weeks we’re leaning towards a more cyclical exposure outside of that core tech growthier position, and some weeks we’re leaning towards more traditionally conservative equity exposure.
I think that’s probably what we’re going to continue to see, as I doubt our models are going to get comfortable going really overweight equities, given the volatility, unless something clears up quickly — or really underweighted, given how far they’ve already fallen. The odds are stacked in your favor in a vacuum when the price declines. So, I think that neutral/below-neutral stance is going to remain, and then we’re going to see some security selection. This is, I think, an exciting environment for security selection, because of all the different factors at play that are affecting different industries in different ways.
Evan Harp: What do you think of the markets right now?
Brendan Ryan: I alluded to it already, but I’m cautiously optimistic.
I think there are a lot of really good companies now that have been punished by the market that are probably having a temporary setback of some kind, that COVID created these really weird effects where some companies were over-earning, maybe the retailers were over-earning because people were stuck at home and they could only buy physical goods, they couldn’t travel. That’s totally reversed, and even though that was somewhat predictable, it caught some companies off guard or happened faster, so they’ve overspent and now their margins are compressing.
But I really think that that’s temporary for most of these better companies. Maybe the simplest examples are Amazon and Netflix, that are just comparing to an over-earning period. I don’t think that they’re structurally weakened, but the markets punished them. I think, with patience, businesses like that are going to come out ahead. That’s what you’re seeing at a granular level, but from a higher level, we’ve already taken a lot of pain. I don’t think that we’re looking at a 2008 type scenario, because there isn’t much debt in the system at all right now. It’s all on the government, all the debt that accumulated in this cycle is on the government’s balance sheet, not on businesses which have record low debt to EBITDA, or consumers which have really healthy assets to debt and financial obligations to income.
If there is a slowdown, both of those groups can start spending quickly because they’re not over-encumbered with these debts they had to pay down, which is why 2008 was so bad, and the recovery was so slow afterwards. All of your incremental savings had to go to paying down that debt or worse, in business cases, some of them had to go bankrupt. A big theme I think we all have here economically is that this last 15 years of a more digitized economy has really sped up the feedback loops and how things happen. So, for instance, on any given day as a consumer, I can look at my portfolio and know exactly how much money I have. I can look at Zillow and see exactly how much my house is worth. If those variables change, I can adjust my own patterns in real time, and I think businesses have the same situation where they’re getting data so quickly, they can adjust quickly.
I think that’s why we’ve already seen the market correct so quickly, and maybe growth in the economy is slowing quickly, but at the same time, the heat or over-exuberance in certain areas of the economy are also maybe healing and correcting extremely quickly, which is why I think we can have a quicker rebound from the slowdown or whatever it is that people may be anticipating.
Evan Harp: Are there any ETFs you want to highlight?
Brendan Ryan: Yeah, so there’s three ETFs that our models like right now that also align with my own thinking.
The first is the iShares Semiconductor ETF (SOXX ). That’s been one of the favorites of our model. From a quantitative standpoint, I think it makes sense in that it’s done really well for a long time and it’s been beaten down more than the market, but in a way isn’t looking like an outlier. So, it doesn’t look like something special is happening to that sector in a negative way outside of just in a broad risk-off sense. But also, if you look at those businesses, the market in semiconductors has rationalized. They’re still cyclical, but they’re not as cyclical as they used to be. In the down cycle, they’re not going to lose money because the industry is healthier, there are more endpoints than there used to be. I think you’ve taken a lot of pain in that sector, but it’s one of those that if you look out just a little bit longer, it’s not going anywhere. The businesses maybe had a period where there was a supply/demand imbalance, so they were making a little bit too much money, but that doesn’t mean that they’re going to suddenly shift to losing money like a more traditional cyclical — like a steel or aluminum company might have to deal with. And they’re not over-levered. Like I said, in the whole market, there’s not a ton of debt, so in a downturn they’re not going to have to pay down that debt, they’re going to have excess profit.
Then the other two. I alluded to one, the First Trust Dow Jones Internet Index Fund IDN. That’s the internet companies, so that would include Amazon and Netflix. We think this is an area where, again, that part of the sector has gotten ahead of the rest of the market. There’s obviously been a huge rationalization and a lot of these early-stage tech companies that were maybe subsidizing their businesses, but we don’t think that for the top companies in the internet sector — we don’t think that was happening at all. And now these businesses are suddenly looking attractive, and a lot of them fit that description I mentioned earlier, where there’s some sort of temporary setback that has investors concerned about the next couple quarters, but over the next couple years is going to revert to the original trends you were seeing in a lot of these secular winners. Many of them will likely end up being really attractive investments from this down point.
Then the third one is a little bit different and not as core of a holding for our models. That’s the iShares US Home Construction ETF (ITB ). There’s obviously a ton of fear for home builders right now because everyone’s expecting prices to come down, mortgage rates have risen so much it’s infringing materially on affordability because prices haven’t come down yet either. But all of those companies are 50% off their highs and whatnot, they’ve already taken tons of pain. We think that the demand for new homes is still there. There’s this massive demographic tailwind of people in their early 30s, that core Millennial demographic, that are just moving into homeownership. You’ve had this long, long cycle of under supply by the industry, and you don’t have any of the real major risk factors that caused 2008 where people were getting loans they shouldn’t have, so we haven’t extended bad credit. I don’t think there’s a lot of forced sellers that are really going to drive home prices down unless the economy truly gets terrible. So, I think this is another area akin to those internet companies where you’re seeing a demand pause, but not demand destruction and not a misallocation of capital that really requires a painful, extended wash out. I think homebuying activity can resume quickly, and it may resume very quickly as we settle in and people get accustomed to these new higher mortgage rates.
Evan Harp: What is one thing that sets your firm apart?
Brendan Ryan: I think the biggest thing for us is sophistication. Our model really isn’t dependent on any singular factor. It’s difficult if you’re a value or growth investor in your work, or maybe even something a little more obscure than that. Even if you’re international or small-cap or something, you’re kind of pigeon-holed into some sort of bias that you have to wait to play out. Our models are purely working on probabilities, which means that theoretically, any sort of environment or situation, it should have an opportunity to find something attractive, and we give it this huge pool of options so that’s possible. This year has obviously been difficult in that, even with a huge pool of options, there aren’t that many things that have gone up. But I think that’s the biggest differentiator for us. If I’m investing with us, I’m betting on the model working but I’m not betting on some sort of fundamental factor that has to play out.
We think it makes our model a little bit more robust than if you have something that’s too simple, that worked in the past, often those things don’t work going forward because other people figured them out, or they were just an artifact of history rather than something consistent in the market.
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