October 2014 Portfolio Outlook

Last month, I asked if we should have expected a “September swoon.”  Well, as it would turn out, we did—but not in mainstream American large-cap stocks.  It was emerging markets that took the biggest beating—Brazilian stocks, in particular, lost over 20% of their value—though yield-sensitive investments such as REITs, mortgage REITs, and high-dividend-yielding stocks also took a major hit.

What’s the story here?

It was a nasty combination of events: the Fed indicated that short-term rates may be rising faster than previously thought, Brazil’s presidential election appears to be shifting in favor of the anti-market incumbent, and the sudden departure of “Bong King” Bill Gross destabilized the bond market.

Where do we go from here?

For now, I am remaining mostly—though not fully—invested.  In my most speculative portfolio—Tactical ETF—I raised a modest amount of cash.  As of October 2, I had a cash position of about 18%. But the portfolio remains heavily invested in the markets that I believe offer the best potential for explosive growth over the next 6-12 months—including Brazil, Russia and China (see “Brazil: The World’s Greatest Value Right Now?”).

The market is clearly very concerned that a more hawkish Federal Reserve will effectively pull liquidity out of emerging markets.  I’m far less convinced.  Investors have been dumping emerging market stocks and currencies for the better part of four years, so at the margin it’s difficult to see how the Fed’s very modest tightening will be much of a game changer.  In my view, the September selloff in emerging markets is simply a repeat of the selloff we saw in January and comes after an eight-month run in which emerging markets as an asset class performed very well.

My other major speculative play in the Tactical ETF portfolio is in mortgage REITs.  I have a 15% allocation to the UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (MORL).

Mortgage REITs have been absolutely pummeled since the start of September, down about 8% as a sector, not including dividends.  And as a leveraged fund, MORL has taken an even greater beating.

But as I wrote in a recent post, mortgage REITs are now fantastically cheap, trading below book value.  MORL’s underlying REITs are trading at a weighted average of 97 cents on the dollar and a yield of 11%.  (Applying leverage gives MORL a yield of about 22%).

If the Fed raises rates earlier than hoped—or if long-term yields drift lower—could dividends be cut?  Absolutely.  But in buying these REITs below book value, our risk is very tolerable.

Rising long-term bond yields would depress book values, which—all else equal—should lead to a sell-off of mortgage REITs.  But how high are yields likely to go?  And how much of an increase has already been priced in by the past month’s declines in mortgage REIT prices?

I’ve consistently made my case throughout 2014 that bond yields are likely to fluctuate in a fairly tight range over the next several years.  (I see the 10-year Treasury yield bouncing in a range of about 2.2% to 3.2% with an average around 2.6%.)  Fed tightening—to the extent it happens at all—will depend on economic data continuing to come in strongly.  Thus far, the data has been mixed at best, and we should remember that we are now more than five years into the current economic expansion.

I’m not forecasting an imminent recession, but in the entire span of U.S. history since the Great Depression the longest stretch we’ve ever gone without a recession was 10 years—and that was during the 1990s tech boom.  Since the Great Depression, the average time between recessions was four years and nine months.

Again, I’m not necessarily predicting a recession around the corner.  But expansions do not last forever, and we should remember that our current expansion has been aided by record federal deficits and the loosest monetary policy in U.S. history.  I think it’s highly likely that we will indeed see a recession at some point in the next two years.

Why does this matter?  Because bond yields tend to fall in recessions.  We should also remember that, with yields in Japan and Europe hovering near all-time lows, demand for U.S. Treasuries should keep a tight yield on Treasuries for the foreseeable future.

Bottom line: The fourth quarter is getting off to a rocky start.  But I believe it makes sense to stay the course in both mortgage REITs and emerging markets, using the recent weakness as a selective buying opportunity.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. 


This article first appeared on Sizemore Insights as October 2014 Portfolio Outlook

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