Walls and Doors
Clients of the Firm,
The first six months of 2024 closed on a high note for major U.S. stock indices. The market cap weighted S&P 500 advanced +15.3% while the equal weight rose a more modest +5.1%. The 10-Year Treasury yield sits at 4.42% today, substantially higher than just two years ago when it was 2.88%. More pronounced is the rise in short-term rates that have exceeded 5% for the better part of a year, up from 0% during the pandemic. The VIX, an indicator of near-term market volatility, remains low near 12.
Major indices have been unduly influenced by a few major tech companies in the past two years. This has led to a bifurcated market with the top ten weighted market cap stocks representing over 40% of the index and driving most of the gains. While we have benefited from owning a significant number of the top companies in the S&P 500, we are finding more value in the underbelly of the index at this time for incremental equity investment. Here we are finding companies with low P/E ratios relative to historical norms and higher yields than in the recent past. Some value opportunities are turnaround restructuring ideas while others are at cyclical lows due to market dynamics in their specific industries.
Forecasting industry specific shifts can be a challenging task. A thesis is generally formed based upon underlying assumptions of supply and customer demand, interest rate levels and curve slope, technology shifts or even political posture. The best companies are able to navigate these dynamics and shift strategy, capital allocation and customer focus to adapt. Larger companies face the same risk we do as investors. The challenge is not to be lulled to sleep by current market forces and instead anticipate, change position and capitalize on it. Much like a chess master, we must anticipate several moves ahead in order to be successful.
A good example of this type of thinking has been our bond positioning for the past few years. We correctly identified that there would be significant price exposure to long-term bond assets in the face of inflationary conditions and a corresponding Fed tightening cycle. The strategic action we took avoided significant duration risk in fixed-income tactically creating short-term bond ladders and holding Treasury backed money markets with expanding interest. This allowed our clients to avoid a material price correction in longer term fixed income while harvesting coupons on the shorter end of the curve.
Our hedged equity portfolios continue to offer a downside protection mechanism using put options. We call this a tail risk protection strategy which allows clients to maintain equity exposure at current levels while placing a downside hedge below target levels. This has the effect of partially protecting against rare and unexpected events as well as valuation overheating and other normal market corrections. This strategy has particular value in single stock risk portfolios generally created either through employee stock holdings or exceptional performance. Systemic hedging aids in scenarios like the great financial crisis or COVID and provides downside protection during this type of market crash scenario. Of course, general asset allocation provides some level of risk management. The incorporation of various hedging techniques can allow us to allocate capital to more potential opportunities while preserving a downside risk protection strategy for portfolios.
The second half of 2024 is likely to bring significant uncertainty. The known variables include: the US presidential and congressional elections, inflation and Fed policy. Polling, economic data and Fed speak can help guide us in our investment posture, but uncertainty will remain which will likely increase volatility. Volatility increases the likelihood of price dislocation and can present good investment entry points for the rational investor.
Ralph Waldo Emerson wrote, "Every wall is a door". Markets tend to climb walls of worry, meaning as uncertainty is removed the discount to price goes with it. Conversely, when all seems rosy, a premium can accrue on risk assets making them too pricey to be viable investments. Our strident task is to discern between the two.
We thank you for your continued confidence and referrals to our firm.
Sincerely,
Peter C. Wernau
President, CEO
Wernau Asset Management
http://www.wernauassetmanagement.com/
Important Legal Disclosure
This letter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Wernau Asset Management, Inc. ("Wernau Asset Management) is a registered investment adviser with its principal place of business in the Commonwealth of Massachusetts. Wernau Asset Management and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which Wernau Asset Management maintains clients. Wernau Asset Management may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. This letter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Wernau Asset Management with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Wernau Asset Management, please contact Wernau Asset Management or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Wernau Asset Management, including fees and services, send for our disclosure statement as set forth on Form ADV from Wernau Asset Management using the contact information herein. Please read the disclosure statement carefully before you invest or send money.