Want To Fight The Fed? Here Are The Tools You Need
Summary Everyone says you can’t fight the Fed. While that might be ultimately true, you can fight the market participants. How to aggressively buy investments when everyone else is running away from them. Yes, the Fed will eventually raise rates. Have you noticed lately how many news articles are just absolutely hanging on every possible movement that the Federal Reserve “The Fed” could make lately? It’s as if the chairman sneezes, then the markets get pneumonia. Every single day, I read another headline anticipating this, predicting that. And usually over just a couple of words that anyone in that group of people who either work for the Fed or are former employees there have to say. Stop hanging on every possible chance that the Fed might raise rates this time around. Or the next. You’ll sleep better at night, and your portfolio, as well as your accountant will thank you for the smaller amount of churn. That said, stay vigilant with regard to what the market is doing. I was having a discussion about this with the International Society of Value Investors recently, and I put forward that the truth of the matter is, if everyone thinks something is going to happen, it usually doesn’t. It is still important to understand the nature of the businesses you invest in. As you know, I have been very bearish on leveraged investments overall, particularly the mREITs . Knowing that baseline interest rates can only go up is a legitimate reason to not build a large position in these holdings, even if the current yield makes that very tempting. However, some of you may have also be thinking that these knee-jerk reactions to the media are creating short-term opportunities that you can cash in on if you are quick. You’re right. You actually can fight the Fed. Well, indirectly that is. Passively. While you have no direct power to influence or predict rate changes, you absolutely can react to what traders are doing in the marketplace. I’m going to show you one of my favorite investments to do this in today. It’s all about taking advantage of the one thing that people who buy investments are most afraid of — volatility. There is a certain subset of the marketplace that is completely put off by volatility. They share a similar mindset with the portion of the population that never invests. When non-invested people are interviewed, they say that their greatest fear is that the price of the stock that they are investing in can go down. A certain number of new investors also still believe this. Exploit those fears. Most investors understand yield, but do not appreciate risk. Risk to other investors is typically perceived in one of two ways: the price of a security falling as described above, or for the investors willing to hold for the longer run, that dividend payments could be reduced or cut altogether. It’s this second scenario that created this particular opportunity. I want to begin here with a specific example that I took advantage of recently. It’s the Pimco High Income Fund ( PHK ) . There was a catalyst that set off a wave of selling. A dividend cut of just shy of 2 cents per share took the monthly payment down from $0.121875 to $0.103460. For the folks out there who aren’t lucky enough to own a thousand shares, round the payments down from 12 cents a month to 10 cents per share. Now here is where that fear process kicks in. The market had already been on edge about bond prices and the premium to net asset value that this fund was carrying. It might even have been because I told them they should be concerned. But I digress; before this cut had even occurred, PHK was down from its high of $13.69 back on July 8, 2014 to just $9.45 on September 1, 2015. The dividend cut was announced on September 2, 2015. Before the cut, this fund was already down 30.51% from the high. Here’s what followed: PHK data by YCharts So it dropped another -26.2% in a timeframe of less than two weeks. That is a compounded loss on price of -48.75%. I have been a holder of this fund since 2009. I didn’t sell my shares. On September 10th, I doubled down on the amount I was holding. On September 17th, I doubled the holding size again. Here’s what has happened since then: PHK data by YCharts To clarify what I’m saying, I took what had been a paper loss approaching 20% (my average loss had not been as large as the numbers I cited earlier due to techniques I’ll be explaining in just a moment) and turned it into a virtually breakeven point. So as of right now, I need to either make some sales and capture that windfall, or decide to sit on these shares at my now lower average cost, and continue to collect an annualized yield of 15%. I would have bought more on the 14th, but I had to wait for some trades to settle. But this is not my private journal to talk about the trades I’m making. I’m here to teach you how to do this yourself. So, onto those tools I mentioned. Tool #1: You need cash. You should never be, at any time, fully invested in the stock market. What I mean by “Fully invested” is a portfolio that contains only stocks. Something should be in there that is not correlated to stock market risk. For me, that’s 20% in safe bonds. I use the Vanguard Total Bond Market Fund ( BND ) for this purpose. I was also sticking to an additional 5% allocation in junk bonds like the Pimco fund above, and various other high yield investments. Bonds have a market risk of their own, but it tends to move against the grain of stocks. You can also hold precious metals or just plain old cash if you want. Whatever your choice is, it needs to be a very liquid holding that can be quickly converted into cash. Do not use a leveraged fund for this purpose. You are hedging against loss here, so it is important that there no outside factors that could destabilize this holding. The market is very good at analyzing the past, but very bad at predicting the future. Lots of people understand the inflation risk that bonds carry, and that’s also why I haven’t been holding a higher percentage of them, but they still have the advantage of protecting you from stock market volatility. As it turns out, however, protection is not what you are seeking here. Cash/Bonds might have the disadvantage of losing buying power due to inflation, but when the stock market dives, they gain lots of buying power because the price of your bonds goes up. It is during that volatility that you strike. You sell some of the gain you just received on your “safe” investment, and transfer it into the “risky” investment. All of a sudden those safe bonds that I had on the side earning 3% a year are now earning me 15% from the exchange. That is not a loss in buying power, friends. Mark Cuban has a famous video interview where he is quoted as saying ” Diversificaion is for idiots “. What he’s really talking about is using a large cash position to jump on opportunities. If you have some free time, have a look. He is brilliant, if not just a little abrasive. Tool #2: You need to understand what you own. You can’t just go out there and buy everything based on dividend yield. I had already been through Pimco’s balance sheets long before I made the decision to buy more. I talk about it in this article here . I already knew that I wanted to own more of this fund, I was just waiting for the right price to get more. That is true of every holding in my portfolio. And I am constantly working at getting a better understanding of it. You have to keep reading, keep doing everything you can to get the best possible understanding of how the business or fund operates. Remember when I talked about Prospect Capital Corp. ( PSEC ) a few months back ? I was basically employing this exact strategy in accumulating their shares when the entire rest of the marketplace hated them for cutting their dividends. Now I have an average gain of almost 7% on share price, and am continuing to receive an annual dividend yield of 12.7%! Tool #3: You need self control. The percentages I mentioned above based on asset allocation were decided ahead of time. I have held larger percentages of bonds in the past, and also less. But the point of this is that once you decide what your allocation should be, stick to it tightly. I want this article to serve as a personal admission of being guilty of abandoning this tool earlier this year. I took a very large position in Mattel ( MAT ) , at one time as much as 50% of my portfolio. As a result, I did not have resources available to cost average as I wanted to when the price fell more over the year. I lucked out on this a little bit because of increases in my Nintendo ( NTDOY ) and Chevron ( CVX ) shares. Had I stuck to this advice, I would have had the tools at the right time to get more Mattel shares for a lower price. Maintaining a smaller allocation to that stock would have forced me to wait until the price dropped enough to act. So, you know, do diversify. At least a little. Fortunately, I’m getting back on track now. Also determine a threshold where you will commit to make changes as needed. For myself, I make sales when the amount I have invested in bonds either rises or drops by 5% as a percentage of my total investments. So for example, if I have a 20%/80% portfolio, I start looking for stocks to sell if the ratio becomes 15% Bonds/85% Stocks. Don’t stress about any particular holding showing a small loss during that time. What should ultimately happen in each exchange of assets, is your income should increase. The goal here is to constantly work towards a rising income from stock and bond dividends. I mentioned that I was down less than the market drop on PHK. That’s because I have been shifting funds in between these holdings over time. This current sell-off is at least the third time since 2009 that I’ve been able to take advantage of a quick sell-off to lower my cost on this fund. I have also sold shares when they recovered to get my percentages back in line. Trade fees are a concern here, so the purchase/sell sizes need to be meaningfully large to offset those costs. Otherwise, turn off dividend reinvesting and use a combination of that money and income from your job to add money to where it is needed; don’t focus on selling for the time being. There are apps out there like Robinhood that will let you trade completely for free, as well as Loyal3.com. Tool #4: You need to act quickly when the opportunity is there. We’re coming full circle now. So continuing on here about PHK, with regards to that dividend cut. I think a large number of people more or less expected that it would be cut at some point. But remember that part above about the already reduced price leading up to the cut? Look to the past as your guide. People had been willing to pay as much as $13.69/share when this fund would have given them a yield of 10.68%. The price has fallen a total of -48.75% to $6.87/share, giving you a forward yield of 18% even after that dividend cut. To get the same 10.68% yield, the fund would need to come up to $11.62/share. That is the upper limit of the “bullish” price, a difference of $4.75 above $6.87. Let’s meet the market halfway and we have a safe investment here below about $9.25. In other words, the market tried to anticipate the Fed movement, but they overdid the selling. I made a bullish bet that even if they were right, I would still end up ahead enough from dividends that I would not regret the decision. So I will continue to hold these shares until that price point is reached, my bond allocation is out of whack, or the structure of the fund changes, in which case I will need to perform more analysis. I am genuinely not concerned with inflation when I am earning a yield on cost of 15%. The premium to NAV is not a concern; this is what I’m actually receiving for my invested dollars. Incidentally, I rate PHK a buy under $9 . That’s all for today. More will be coming soon though. This article is going to have a follow-up piece discussing some other opportunities that are out there in closed-end funds. I am going to lay out the most volatile but dependable funds I can get my hands on, so that you can have ideas at your fingertips for what to invest in when the time is right. Follow me for now, and thanks for reading! Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long PHK, NTDOY, MAT, CVX, PSEC. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.