A Year in Review: Adjusting the Sails

Trillions of dollars in monetary and fiscal stimulus have navigated its way through America’s plumbing, leaving some with green lawns and others with dirty dishes. As we collectively flirt with the idea of a new economic regime – one likely characterized by slower growth and higher costs of borrowing – we’ll explore what it means for you as an investor and what we at Silicon Hills have been doing to prepare for the year ahead.

For many of us, it was hard to imagine a year more bullish than 2020. Despite the sharpest market selloff in U.S. history, equities came roaring back as soon as the Federal Reserve reinforced its commitment to market stability in March 2020 – slashing the benchmark interest rate to zero and launching a new round of quantitative easing that has since cost over $5 trillion. Large-cap equities – particularly those of a growth orientation – quickly rebounded as investors flooded into high-multiple, stay-at-home names, with small-cap and value-oriented equities rallying in late November to finish off the year in a state of euphoria. Everyone – including my own grandparents – was curious about financial markets for the first time in their lives, and as Elon Musk was quietly accumulating the combined GDPs of Ethiopia, Puerto Rico and Ecuador in personal net worth, the idea of a post-pandemic recovery quickly evolved into the next frontier.

But as investors welcomed 2021 with open arms, greater expected returns were promptly greeted with greater volatility as a number of macroeconomic concerns began to bubble under the surface. Not only did this serve as a stark reminder that most assets do in fact have similar risk-adjusted returns, but it also reintroduced a sense of cautious optimism that so many of us had grown accustomed to in 2020. Take for example inflation – a risk largely considered transitory until recently – that sparked a mid-February selloff in speculative assets and has since served as a check-and-balance to America’s financial system. Lest we forget the chaos that unfolded at Archegos Capital Management, whose potent combination of overleverage and poor risk management quickly sparked a fire sale of more than $20 billion in global assets. As the consumer price index (CPI) rose from 1.4% in January to 6.8% in December, the benchmark 10-year treasury yield quickly followed suit – at one point peaking at nearly 1.75% after bottoming at 0.55% just one year prior. Rising interest rates and a weakening dollar have since called into question the longevity of many high-multiple equities – with companies such as Peloton and Zoom Video posting year-to-date (YTD) returns of roughly -70% and -50% (respectively) while the energy sector surged nearly 50% over the same timeframe.

This combination of hot inflation, rising interest rates, and general market froth has resulted in simultaneous headwinds to equities and fixed income – prompting a rotation into quality that has many investors questioning the effectiveness of traditional buy-and-hold strategies. Even Goldman Sachs recently published an article titled Is the 60/40 Dead? – to which they conclude, “we think investors have many reasons to be concerned that the 60/40 might be dead.”

We would tend to agree with Goldman Sachs – and considering labor shortages, supply chain constraints, and geopolitical tension are only exacerbating these issues – we began a periodic repositioning of our investment program earlier this year based on the following tenets:

1. Equities may seem overvalued, but there is still plenty of opportunity in the market.
2. Despite the risks and recent market volatility, the opportunity cost of not participating in equity markets is substantial.
3. Diversification within asset classes can be obtained just as effectively as diversification across asset classes.
4. Alternative investment strategies are becoming increasingly vital to portfolio construction – especially when compared to traditional fixed income.

In doing so, we introduced two new sub-strategies – Global Equity and Global Hedge – to complement our existing quant-based strategies that actively rotate between risk-on and risk-off assets:

1. Global Equity was created to address tenets 1-3 above and is based upon decades of academic research – targeting certain investable characteristics (referred to as factors) that have historically produced returns above and beyond the market portfolio. These factors explain returns in such a way that portfolios can be optimized to isolate specific sources of risk and return, and at Silicon Hills, we’ve chosen to isolate factors that emphasize smaller companies with greater profitability and lower valuation multiples. As shown below, this approach not only keeps you in the market but provides greater diversification within equities – emphasizing earnings over growth and evidence over speculation.
2. Global Hedge was designed to address the inherent limitations of fixed income as a risk-managing tool in a historically low rate environment – or put differently, to address the fourth and final tenet listed above. With interest rates sitting near all-time-lows, inflationary pressures and subsequent monetary policy tightening are likely to force rates even higher – the result of which could be detrimental to investors relying on some combination of cash and fixed income for capital preservation. Not only would equities encounter headwinds along the way, but inflation would result in a negative yield for cash and rising interest rates would produce a negative return for most fixed income – the combination of which could be devastating to those nearing retirement. This is one of the many reasons we agree that the 60/40 portfolio is in fact dead. Not to say that fixed income doesn’t serve a valuable role in portfolio construction (such as producing a fixed stream of income in retirement), but investors relying on fixed income as an equity hedge are likely to be disappointed come the next bear market – especially if the selloff is inflation-induced. Recognizing these limitations, we set out to find alternative risk managing tools that not only work as a hedge in downward-trending markets, but are also dynamic enough to participate with equities in upward-trending markets. One example of these alternative strategies is trend-following managed futures, which leverages a series of quantitative models to take long and short positions in various futures markets – including commodities, currencies and other derivative instruments. Provided below is an illustration of just how valuable managed futures can be to a diversified portfolio – not only reducing portfolio risk and maximum drawdown (while keeping annualized return intact), but also carrying a dynamic correlation to equity markets in both up and down markets.

The introduction of these two new sub-strategies are mere examples of the ongoing work that we at Silicon Hills are doing to provide a disciplined, yet opportunistic approach to portfolio construction. We believe that the four tenets discussed previously will become increasingly relevant over the next several years, and though the risk of a major near-term market drawdown remains modest, we can’t stress enough the importance of sound risk management as market breadth continues to narrow. For example, just five companies (Apple, Microsoft, Alphabet, Tesla and NVIDIA) – who collectively represent more than 20% of the S&P 500 – have contributed more than 51% of the index’s returns since April of this year. While a passive allocation to the S&P 500 has worked tremendously over the past decade, those relying on it for diversification are likely to be disappointed if there is a change in market leadership.

By emphasizing quality over speculation and introducing efficient risk management tools, our clients can rest easy knowing that true diversification has been obtained across and within asset classes. We understand that time in the market is far more effective than timing the market, and as such, our investment program is designed to remain dynamic across all market cycles. So rather than trying to predict or time markets, you’ll find us constructing durable portfolios that reflect the sage wisdom of William Arthur Ward – the pessimist complains about the wind, the optimist expects it to change, but the realist adjusts the sails.

Here’s to adjusting the sails.

About the Author

Dean Rogers, CFA

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