Now What?
Our view is to expect volatility and drawdowns in the weeks and months ahead and to prepare accordingly.

In March, we began asking and writing: when it comes time to buy, will you do it? The time of maximum pessimism is often the time of maximum opportunity, as widely stated by wise investors from Warren Buffett to Sir John Templeton and more. We relied, as always, on our rules-based, tactical approach to define entry points for our clients and that sent us back into a buying mode when various asset classes rose, despite the overflowing pessimism.

This has proven productive, but has everything come back a little too far too fast? The reality is that nearly everything takes the stairs up and the elevator down. In other words, investments generally go up a lot more slowly than they decline. Recently, though, the snapback has been nearly as fast as the decline was. Surely, then, the probability of high volatility and painful drawdowns in the next months is high.

The run-up in risk-on looks like zombie markets: zombie investors, those that will buy anything, into buying even zombie assets, those issued by companies that can only survive from continued borrowing. Discipline is key to manage the current risks this presents. In a time where the economic data is disastrous and the markets are shrugging, the possibility of high volatility and painful drawdowns are real.

Investing means answering three questions: when to buy, when to sell, and the third question, what to buy? We focus the rest of this piece on that third question.

To meet our goals of managing drawdowns while seeking productive returns:

• We favor emerging markets debt (EMD) over emerging markets equity. The credit quality of a substantial part of EMD is typically investment grade, but these bonds can still offer juicy yields. Also, the coupon cushion against price declines while the stocks of emerging countries frequently take a wilder ride to similar returns.

• We favor preferred stocks over financial common stocks. Preferred stocks are generally issued by financial institutions, but versus financial stocks, we believe preferreds nearly always have a superior risk/return profile. Preferreds are senior in the capital structure and generate a high enough yield that often results in cushioning drawdowns and better returns than bank stocks.

• We recommend high-yield corporate bonds over small-cap stocks. Issuers of high-yield corporate bonds are typically smaller companies that need growth capital, much like the stocks of small companies. Again, though, the returns are often similar, but the risks are lower for high-yield corporate bonds than small-cap stocks.

To summarize, the plunge into recession was foreshadowed by the Four Horsemen. When the stock market began to creak, dropping 10% in the last two weeks of February, history has shown that the next move is down when the economy is approaching or at the start of a recession. In fact, that first 10% drop was rapidly followed by further sharp declines on the elevator down. Since the March 23 bottom, risk-on assets have staged a remarkable recovery, in large part a product of the Fed’s creation of zombie markets.