April 22, 2020

Reflections on Market Risk

April 16, 2020

The old adage, “this too shall pass”, can be quite apropos in times like these; however, it fails to encapsulate the pit in the stomach when markets sell off quickly and volatility increases dramatically. While the quote has its shortcomings, it does give us hope for a better tomorrow and helps put momentary market movements in perspective. Its suitability transcends time and association but, in our opinion, is the most fitting when discussing markets. Edwin Lefevre, author of the investment classic Reminiscences of a Stock Operator, described why this quote is so applicable to markets, when he wrote in 1923, “Another lesson I learned early is that there is nothing new in Wall Street. There can’t be, because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again.” While we are students of history and agree that, “this too shall pass”, we believe in utilizing modern techniques and leveraging dislocations such as these, to your benefit.

Since we last wrote you on March 16, 2020, the S&P 500 has rebounded +16.8%, the NASDAQ has gained +21.6% and the MSCI EAFE is up +11.8%. While there remain too many uncertainties to predict where the markets go from here, we thought it would be an opportune time to provide additional context while discussing the potential pitfalls of “temporarily de-risking” and some potential solutions to shift risk without jeopardizing upside.

Market Update

Under normal conditions, we would expect a bear market to retest an initial bottom and be of longer duration. As illustrated below in Exhibit I, historically in severe market sell-offs, equities tend to have momentary rebounds before ultimately falling to new lows – we may be in such a period. However, we recognize that these times are anything but normal.

In the past two months, we have seen both the swiftest bear market and the fastest rally on record. From February to March, the S&P 500 plunged 34% over 23 trading days and then recovered 24% over the next 23 days. We have seen consistently higher levels of volatility, the likes of which were last experienced during the 1930s.

In comparison with the Great Financial Crisis of 2008, the Federal Reserve (“Fed”) has acted extremely fast, cutting rates twice to nearly zero and expanding its balance sheet to over $6 trillion (see Exhibit II below). Their mandate not only includes agency MBS and Treasuries, but agency CMBS, commercial paper, investment grade bonds, municipal bonds, and even high yield ETFs. Given trillions of dollars in unfunded pension liabilities and broad passive market ownership in 401(k) plans, we believe the Fed will choose to inflate rather than allow asset values to stay depressed.

As noted above, historically bear markets tend to persist longer than we have seen to date and we may see additional retracements from current levels. This being said, the Fed and government actions have been rapid and large in size and should be considered when comparing the current market to historical periods.

The Risk of De-Risking

The biggest risk of de-risking a portfolio amidst increased market volatility is overdoing it and missing the inevitable rebound. Exhibit III below illustrates the S&P 500 calendar year returns and their respective intra-year drawdowns. If investors were to sell during the largest drawdown periods, they then tend to miss the upside later on in the year, or the following calendar year.

To further illustrate the effects of de-risking, we have recreated a historical study done by Alliance Bernstein, which analyzes portfolios during the Great Recession in Exhibit IV below. All of the portfolios in this study assume the owner spends 5% a year. In Part I of this study, which we expanded, there are three portfolios. The allocations of the first two are both ‘”static” and do not change due to market movements. The third portfolio, which consists of 80% equities and 20% fixed income, shifts its allocation to cash when the market drops 20%. This portfolio does not reinvest itself until the market drawdown is over. Note we have ignored the theoretical tax bill ‘going to cash’ would produce.

As Exhibit IV illustrates, if an investor shifts a portfolio to cash during times of heightened volatility, they inevitably will miss market rebounds.

We have expanded this study by creating another example, which is shown below in Exhibit V. Rather than shifting the original 80/20 portfolio to cash after a 20% decline, the portfolio instead modifies its allocation to 50% equities and 50% fixed income. While this allocation shift helps to protect principal and participates in the rebound, it still under performs the static portfolio by a wide margin over longer time periods.

History shows that staying invested is economically beneficial in the long run, but times of heightened volatility often test an investor’s fortitude. We believe it is imperative to stay properly diversified, keep long-term goals in perspectives and invest accordingly.

Nevertheless, if one is still adamant about de-risking his or her portfolio, because volatility is the architect of opportunity, we do have ways of leveraging instability and de-risking a portfolio without materially altering its potential for participating in a recovery.

The following are some tactical methods to think about when making any portfolio adjustments.

Donating Appreciated Securities

One option for reducing portfolio risk is donating appreciated securities directly to a charitable organization. This allows one to receive a current year deduction for the fair market value of the donated securities without the tax cost of realizing capital gains by selling the securities and donating the cash proceeds. Additionally, as a result of the new CARES Act legislation in 2020, clients may deduct up to 100% of their 2020 Adjusted Gross Income. Utilizing a Donor Advised Fund (“DAF”) can be an effective strategy that allows one to contribute appreciated assets to a charitable account and receive a current year full charitable tax benefit for the contributed asset value. A DAF allows one the time to decide which public charities will receive specific donations later in the future. Please let us know if you would like to speak to one of our tax experts about these techniques or the new provisions in the CARES act.

Tax Loss Harvesting

Depressed asset values also create opportunities for “tax-loss harvesting”. If an investor has a loss on a security, he or she can sell that security and capture the loss. The investor is not permitted to reinvest in the same security for 30 days, but there are many suitable proxy investments for the proceeds. The proxy investment must be considered “substantially different” otherwise the loss is not recognized. After 30 days of holding the substantially different security, the proceeds may be reinvested into the original security or held. This technique can be used to create a tax asset and offset gains in other portions of your portfolio

Embrace Dislocation

A 30-year U.S. Treasury bond is currently yielding 1.22% and the 10-year is yielding 0.61%. Inflation has consistently ranged between 1.8% and 2.0% a year for the past decade and, given the Fed liquidity flooding the economy, there may be some inflation down the road. Therefore, if an investor were to rotate out of equities and into Treasuries, he or she would be buying an asset with negative yields in ‘real’ terms. At Geller Advisors, one of our core investment philosophies is to invest in change. We believe the “Great Lockdown” has created an opportunity to invest in dislocated markets, at attractive valuations, without materially altering a portfolios inherent risk.

Portions of the fixed income market, which hold assets that are not currently being purchased by the Fed, are trading at distressed prices, yet there has not been any deterioration in these credits. We believe active managers in low duration and opportunistic high yield markets can provide attractive risk/returns to investors by selectively purchasing these mispriced securities.

Additionally, while credit and distressed hedge funds suffered sharp, mark-to-market, drawdowns in March, we believe they are well positioned to take advantage of market turmoil. We have access to many closed and invite only credit and distressed hedge funds, which are positioned well to pick up “money-good” securities at distressed values. Please let us know if you would like discuss these strategies more.

In the private markets, we are currently evaluating longer-term opportunities that are structured around fundamental changes in the economy. To access these investments, we have created Geller Special Opportunities II. These investments tend to be invite-only, have limited capacity or are special situations. For example, we are looking at special access vehicles, only available to investors with assets in excess of $100 million that are seeking to purchase securities from forced sellers at discounted prices. Other examples of investments made by its predecessor fund, Geller Special Opportunities I, include investments in the fractured storage facility market (which are considered essential businesses in this COVID crisis), late-stage healthcare opportunities, structured secondary venture capital and international early-stage venture capital.

Finally, there are certain techniques that employ short selling and options strategies to hedge (or speculate) on market direction. We are happy to discuss these strategies with more detail with you, as these are speculative instruments and not appropriate for all investors

Estate Planning Techniques

In addition to the portfolio activities discussed above, these times also provide opportunities for estate planning activities. The combination of depressed asset values, near zero interest rates, and the additional unified credit amount (available until 2026), provides an optimal combination for wealth transfer. Grantor retained annuity trusts (“GRATs”), sales to defective grantor trusts and intra-family loans are examples of transactions that can meaningfully reduce future estate tax exposure. Tim O’Hare (TOHare@gellerco.com), who heads up our Financial Planning team, is available to discuss options available to you because of recent tax law changes and the CARES act.

In sum, we quote Sir John Templeton who said: “The four most dangerous words in investing are: ‘this time it’s different.’”. We do not expect a V-shaped economic recovery, and do expect to the market to remain volatile, as the full effects of the COVID shut down on the economy are better
understood. We do believe over the course of time, the economy will reopen, people will go back to work and the markets will return to normalcy. It is important for us all to keep a long-term view, stay diversified, stay invested, make adjustments where applicable, and take advantage of dislocations.

Geller is fully committed to helping you through this period and assisting you with any of the topics discussed in this note.  Please contact either Robert Wedeking (rwedeking@gellerco.com) or Jonathan Barbato (jbarbato@gellerco.com) at any time to discuss these ideas further.

The views expressed in this letter reflect those of Geller Advisors LLC as of the date of this letter.  Any views are subject to change at any time based on market or other conditions, and Geller Advisors disclaims any responsibility to update such views.  Any performance information contained herein is unaudited and estimated.  Past performance is not necessarily indicative of future results and investors should not base investment decisions simply on past performance.  The information presented in this letter is for informational purposes only.  Different investments involve varying degrees of risk and the specific investments or investment strategies mentioned in this letter may not be suitable for your portfolio.  This letter is not to be construed as investment advice and does not constitute an offer to sell or the solicitation of an offer to provide investment advisory services or purchase an interest in a fund.  Any such offer or solicitation will be made to qualified investors only under a formal engagement letter and Investment Policy Statement or by means of an offering memorandum and related subscription agreement as applicable.