From a Fundamental perspective, the U.S. stock market is currently trading around a 13.5 Forward Price/Earnings multiple. This is down from an 18.5 Forward P/E just a few weeks ago (the 25-year average is roughly 16.3). From first glance, this indicates that we are already significantly undervalued, which is not necessarily true. It is difficult to price in the forward impact of the Coronavirus on earnings. The modern economy is certainly in unchartered territories.
It is still yet to be determined what will cause more destruction: the virus itself or the fear of the virus on the economy. If the earnings revisions are modest to the downside (10-20%) over the next 6-12 months, this correction is already very overblown. If corporate America significantly lowers (30-40%) the 2020 earnings outlook, then we may still be trading at valuations above historical norms.
On a purely fundamental basis, the market could go lower before we get below the true fair value. From an action standpoint, while there are specific opportunities (specifically quality, dividend paying stocks at a discount), it isn’t quite time to go on a full market shopping spree. We have rebalanced portfolios during the decline to execute the buy low (buy stocks), sell high (sell bonds and alternatives). We also sold some additional positions (mentioned in sections below) and kept the cash uninvested to accelerate the recovery of our portfolios.
We began the process of de-risking the bond portfolio more as the high-yield space is facing some serious headwinds over the next several quarters. This was expressed by a rotation to core fixed income and overweight in the strategic income opportunities fund, which is approximately 50% cash. The municipal markets were hurt more than the corporate bond market in the last 4 weeks. There is a supply issue in the muni market because demand is not there…the trading costs have increased significantly.
The Alternatives portfolios have performed well relative to their stock and bond counterparts. We took the opportunity to rebalance the alternative portfolios to better reflect the larger portfolio and harvested some cash to approximately 25% of the portfolio. We expect to deploy the cash to stocks in the event of continued deterioration.
Changes included the re-inclusion of the strategic income opportunities fund to offset volatility in the fixed income (mostly higher yielding) portion of the underlying managers. We de-risked the portfolio by adding it as a 30% holding.
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Martin and Reid