75%
BALANCED STRATEGY
INSIGHT
Markets that are correcting tend to fall much faster than those that rise. Anyone who was invested in 1987, 2000, 2007, and 2020 knows this all too well. You feel the impact of a serious market correction not just financially but emotionally. The Federal Reserve, understanding the importance of investor sentiment and the financial markets as a driver of the economy, has consistently acted as a backstop. Fed printing began in earnest after the tech bubble burst in 2000, accelerated during the Great Recession of 2008, and went parabolic after Covid struck. This type of Fed policy has conditioned investors to buy every dip.
A genuine bear market, particularly one dragged down by recession, will have staying power. “Sticky inflation” will make it hard for the Fed to take rates back down to the historical lows they held them at for much of the last decade. The pressing question remains: how do we discern when we are heading toward a recession or already entrenched in one?
An inverted yield curve, where short-term interest rates exceed long-term rates, has long been a highly reliable precursor to recessions. Since October 2022, the U.S. 3-month Treasury yield has topped the 10-year yield, marking the longest inversion on record—a duration that often signals more severe economic fallout once a recession takes hold. Recently, however, the curve has been flirting with uninversion, hinting at a return to its typical upward slope. Historically, it’s this upward shift after a prolonged inversion that frequently signals a recession has already begun. Recessions impact markets in real-time, even if officially declared later by the National Bureau of Economic Research. Consistent with this outlook, the Federal Reserve began its anticipated rate-cutting cycle in September 2024, aiming to stabilize economic conditions amid these developments.
Inversion Upward Sloping Yield Curve Recession BEAR MARKET
OPPORTUNITY
The equity markets, driven by the "magnificent seven," have taken stock market valuations to extreme levels only seen prior to the crashes of 2000 and 1929. Dividend payers, on the other hand, more desired for their balanced returns, have been left behind. The Fed's aggressive tightening of interest rates, coupled with that “sticky” inflation, has put a ceiling on their upside. The average TI target is 35% below its all-time high. TI has identified approximately 40 dividend investments it will accumulate when within range of our price targets.
Three key areas on the S&P 500 chart below provide a roadmap for our entry points. When the market corrects to targets 1, 2 and 3, which represent the 2022 low, the pre-COVID high, and halfway down the COVID low, respectively, TI will begin acquiring its dividend investment positions. The drop in price of these investment positions is anticipated to mirror that of the drops in the equity markets. While we may not see a full 47% drop in the equity markets, it should be noted that corrections of 50% occurred during both the 2000 and 2008 bear markets. The Fed-induced parabolic move since the Covid low puts that kind of move on the table. TI will very likely hit its buy targets regardless.
When the equity markets begin to correct, stocks and government bonds will break in opposite directions as there is a “flight to quality” coupled with a panicked Fed cutting rates. Case in point, the chart below reflects the performance of the US Treasury market, the S&P 500, and one of the TI investment positions during the 2008-2009 correction. Notably, the TI position in this example is a closed-end bond fund comprised of investment-grade corporate bonds—not stocks. Why does this happen?
Intense selling pressure in the equity markets causes a disconnect from the rallying treasury bond market, exemplifying the indiscriminate selling of stocks that occurs during corrections. This common yet counterintuitive pattern was most recently seen in the 2000, 2008, and 2020 corrections. In addition to the three S&P 500 drawdown targets noted in the above chart, this divergence is a confirmation signal for TI to begin accumulating its dividend positions at levels offering steep discounts to their dividend cash flow.
EXECUTION
Tactical Investments has targeted four diverse market sectors and investment vehicles for its balanced allocation - all of which exhibit the above patterns to varying degrees:
SECTOR 1: Fixed Income Funds
Closed-end bond funds are portfolios that can be comprised of a myriad cross-section of bonds - from government, agency, and municipal bonds to corporate bonds and preferred stock (a bond equivalent). At first glance, they appear similar in structure to ETFs and open-end mutual funds. However, during bear market corrections, closed-end funds present favorable pricing opportunities that the others do not due to their unique redemption mechanism. Closed-end funds do not redeem shares directly from investors. In contrast, open-end funds and ETFs allow investors to buy or redeem shares directly with the fund at the net asset value (NAV). This direct creation and redemption mechanism helps keep the share price of open-end funds and ETFs close to their NAV.
Closed-end funds, on the other hand, have a fixed number of shares, which means they do not have to deal with inflows and outflows of capital. Since closed-end funds do not have to redeem shares on demand, they are not forced to sell assets in a declining or oversold market to meet redemptions. This can help preserve the net asset value of the portfolio during market downturns. As importantly, the intense selling pressure will most often push the price of a closed-end bond fund towards a steep discount to its NAV. When you purchase a closed-end bond fund at a discount, you are effectively buying the underlying assets of the fund for less than their actual market value. In general, this can provide an immediate value advantage and also secure a yield significantly higher than an open-end fund and ETF holding similar positions trading at their net asset value.
SECTOR 2: Real Estate
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs typically pay out the majority of their taxable income as dividends. REITs can be comprised of different types of real estate - from commercial office space and shopping malls to residential real estate and assisted living facilities. With the trend towards working from home, sectors like office space have taken a huge hit, and many will likely have cash flow pressured by this over the long term. The healthcare sector, on the other hand, can offer a unique investment opportunity during bear market corrections.
Healthcare services are essential and non-discretionary, leading to consistent demand for healthcare facilities, regardless of economic cycles. Demographics also provide a backstop to the sector. As the population ages, the demand for healthcare services and facilities such as hospitals, medical office buildings, senior housing, and skilled nursing facilities is expected to grow. Also benefiting the sector, healthcare facilities often operate under long-term lease agreements with tenants, providing healthcare REITs with a more reliable and stable income stream over extended periods. Many healthcare services are supported by government funding and insurance programs, which can add an extra layer of financial stability for the operators of these facilities. Healthcare is the sector TI will be attempting to overweight in its REIT positioning.
SECTOR 3: Blue Chip Stocks
Plain vanilla large-cap companies that pay high dividends are often well-established, mature firms with stable cash flows and a history of profitability. These firms are typically less volatile than younger, growth-oriented companies that do not pay dividends. They also tend to raise dividends over time, which generates higher cash flow and also acts as an inflation hedge. This sector has not participated in the major run-up in the equity markets since the low put in in 2022 but will be pulled down in a bear market just the same. TI is targeting mostly non-cyclicals, including telecom, utilities, and food and beverage companies.
SECTOR 4: Energy
Publicly traded Master Limited Partnerships (MLPs) are typically found in the oil and natural gas sector. They combine the tax benefits of a partnership, such as tax-deferred income, with the liquidity of publicly traded securities. There are three types of companies in the MLP sector: upstream, midstream, and downstream producers. TI will focus on midstream companies.
Midstream companies tend to have the most stable earnings of the three. This stability stems from several key factors:
-
Upstream companies produce oil and gas, thus depending on the strength of the economy and consumer demand, which drives pricing and profitability.
-
Downstream companies refine the oil and gas and are again dependent on the strength of the economy as well as their own refining margins.
-
Midstream companies transport the oil and gas. They typically enter into long-term, fee-based contracts with upstream producers and downstream refiners. These contracts often include minimum volume commitments, which ensure a more steady revenue stream regardless of short-term fluctuations in oil and gas prices. This makes them less directly exposed to commodity price fluctuations and refining margins. Midstream earnings are more reliant on the volume of hydrocarbons transported and stored rather than market prices.
MIDSTREAM
UPSTREAM
DOWNSTREAM
WHAT TO EXPECT
Expect the Fed to cut rates...and then cut some more
When the markets inevitably break, the Federal Reserve will cut interest rates to support the economy and financial markets. Although the prices of dividend investments will fall along with the equity markets, the resulting favorable interest rate comparisons will make these investments particularly attractive. Higher dividends and their status as more logical alternatives to pure growth stocks during market downturns will enhance their appeal once a more durable bottom is reached.
Expect some mostly temporary dividend cuts
A recession, concurrent with a market correction, will pressure earnings across the board. During these periods, it is not uncommon for dividend payers to reduce or cut their dividends to preserve capital. This is why it is crucial to invest in sectors that are traditionally less susceptible to the ebbs and flows of the business cycle. However, these investments are not immune to price drops when the overall stock market takes a hit. Counterintuitively, in more stable markets, a company cutting its dividend can sometimes lead to a rise in its stock price. Investors recognize that this move can help strengthen a company's balance sheet, allowing it to weather the storm and remain ready for future opportunities. While not all companies will follow this path, most will likely reinstate their dividends once the economy and markets stabilize.
Expect / Hope for some early losses
From our observations over nearly four decades of navigating the financial markets, significant corrections tend to unfold in waves. The bull or bear head and shoulders pattern is one of the most widely recognized and fairly reliable roadmaps over time. Given the market's overvaluation and the tendency of investors to buy every dip, there will be points on the way down where large bursts of buying occur. We might become fully invested over several months, or it could take up to a year. While it is nearly impossible to hit the exact trough of each wave, the goal is to target the areas within these waves that represent the most likely support levels. For this reason, we aim to undercut our first entry point to secure an average price below our initial purchase. This approach offers a higher average yield and more upside potential. Deploying assets over at least two waves improves the likelihood that we will become more fully invested in case there is a quick vertical spike. This will put us in a better position to achieve a higher balanced return.
Expect low portfolio turnover
Once the Balanced Strategy is fully invested, this portion of the portfolio will experience little trading. It will be “managed around the edges” in a way that keeps it fine-tuned to current market conditions, occasionally shedding and adding stronger dividend candidates as opportunities arise.
Most importantly - get paid while we wait.
While rebounds follow a fairly recognizable pattern during market turns, their duration and magnitude are uncertain. Assuming favorable entry points, we will benefit from high dividend cash flow while waiting for a recovery. In past corrections of dividend targets such as TI is targeting, it is common to see a retracing of half of the drop from all-time highs within two years. While past performance is not indicative of future results, buying these types of investments in the region of their lows has offered yields of between 10% and 12%, followed by marked capital gains over time (as seen in the second chart above). This is where our strategy is poised to deliver a robust total return, showcasing the strength of maintaining a well-balanced portfolio.