Quarterly Observations

Spring 2020

Did you know?

To many investors, the stock market price action lately seems bipolar; vacillating between euphoria and panic. Investors seeking explanations to these price gyrations for signals that will help them sell before market declines and buy when the market is poised to rally may be asking, “How is it that prices can gyrate this fast and violently, and in both directions?”

They may believe these price movements are based on the “smart money” interpretations of the constant rhetoric coming from politicians and central bankers. However, what they may not realize is that the largest traders in the stock market today are no longer fundamental stock pickers, but a group known as quantitative hedge funds, which rely on rules-based computer models to automatically buy and sell stocks and ETFs.

Among the inputs to many of these computer algorithms is price momentum. For example, when stock prices decline to a pre-determined level, the computer model is programed to sell. This can result in swift, and sometimes dramatic, sell-offs as sell signals are triggered by the rules imbedded in multiple programs in rapid succession. As prices drop more, many are programmed to sell even more.

These algorithmic traders now account for more stock market activity than any other group, and their share of market volume has doubled since 2013, now exceeding that of

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Income Every Month

Income Growth

Competitive Total Returns

Over TimeThomasPartners income strategies seek to provide:

Of Black Swans and Bulls“My life has been filled with terrible misfortune; most of which never happened.” –Michel de Montaigne

It now seems hard to believe, but on February 19th, the broad stock market was at an all-time high after setting 12 new records since New Year’s Eve. These gains came on the heels of the second best annual stock performance of the last 20 years. Crude oil prices, as measured by WTI, were in the mid $50s. Private-sector employment in January was much higher than consensus estimates. The services sector of the U.S. economy had grown at the fastest pace in six months. Finally, the U.S. trade deficit fell in 2019 for the first time in several years—it seemed a perfect climate for risk taking. Although it was being discussed in the mainstream media in January, what came to be known as the COVID-19 virus was thought to be a contained “China problem.”

In retrospect, the stock market was in denial as to the severity and the far-reaching effects of COVID-19, both in terms of its human tragedy and economic pain. Equity markets reacted quickly and violently as the unknowns surrounding the extent and duration of the impact surrounding COVID-19 weighed heavily on investor confidence in owning risk assets. Within just six trading days after its February 19th all-time high, stocks declined by more than 10%, reported to be the fastest move into a “price correction” in 70 years¹. A market “price correction” has been commonly defined has a move lower by at least 10% from a recent high.

As investors saw the daily stock losses mounting, their concern turned into fear, and then into all-out panic. By the end of trading on March 11th, stocks had shed another 10%, entering what is commonly called a bear market². This has been reported to be the fastest the broad market has gone from a record to a bear market ever recorded³. And so in just 16 trading days, the longest bull market for U.S. stocks in history was now dead—nearly 11 years to the day since it was born on March 9, 2009.

As the bull market in equities was ending, bond yields were setting record lows as investors sought safety from the turmoil in equities. Money poured into U.S. Treasury securities at such a pace that it drove the 10-year yield briefly to a new record low of just 0.32%4.Investors who were willing to lend the federal government money for 30 years received a record low rate of just 0.70%4.

As the stock market gyrates between extreme risk-on and risk-off views, the volatility is particularly unsettling for those investors who have pinned their retirement security to rising markets.

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Black Swans…

NYU professor Nassim Taleb coined the expression “Black Swan” to describe rare events that are difficult to predict and which have a dramatic impact. They are extreme outliers. The outbreak of a global viral pandemic and a 24% single-day drop in oil prices could each be termed a Black Swan. Taleb suggested that one could sit on the banks of a pond for many decades and observe only white swans; an observation that could easily foster confidence that all swans are white. Absent any observations to the contrary, eventually, all-white swans would become accepted as “common wisdom.” In reality, not all swans are white; rarely, a black swan is born. The odds against observing a black swan are enormous; being an extreme outlier in the bell-shaped curve of statistical outcomes. However rare and infrequent, Black Swans do occur. The analogy to current events is obvious.

Black Swan Epidemics of the past…

As illustrated in the chart below, there have been a number of health-related Black Swan events over the past 40 years. The accompanying table shows that none resulted in the sort of violent and precipitous drop in the prices of risk assets as has emerged from COVID-19 and the simultaneous and parallel collapse in oil prices and interest rates. The Black Swans that killed the stock market bull came in rapid succession causing many to question their well-laid investment approaches.

Unpredictable and extreme events occur; not knowing “when” should not be used as an excuse for poor portfolio risk management. We do know that something (a new Black Swan), sometime, will again seemingly come out of nowhere to test our resolve. We just do not know when, or what, or why; we just know that it will and that we should be prepared. Hoping it will not occur is not an investment strategy.

Reward diversification…

Attempts to manage risk that rely on historical return correlations are the most vulnerable to disappointing results from future Black Swan events. Their vulnerability comes in two forms: the likelihood that future Black Swans will defy historical price correlations (remember Black Swans are totally unpredictable); and that the investor’s reward is pinned to rising markets. Although there may be asset-class diversification, there is little reward diversification. When all the assets go down, at the same time, the results could be, as they have at times in the past, disastrous, especially for retirees with neither the means nor the time horizon to recover. Balanced risk management strategies (a combination of stocks and bonds) may offer better Black Swan protection because the expected rewards are diversified; i.e., not highly correlated. When equity prices fall, bond prices may rise

or at least hold their principal values. Historically, the interest income from the bond allocation was sufficient to support current consumption needs, irrespective of falling equity prices. But looking forward, this sort of Black Swan protection now comes at a much higher opportunity cost and investors need to assess whether they can afford this approach. Bond coupons are at record lows and are fixed once purchased. Likewise, bond principal also remains fixed; neither will grow. As such, barring non-existent inflation, the bond allocation will likely lose purchasing power over time and, thus, inhibit the total return potential of the entire portfolio. While bonds help mitigate a portfolio’s overall volatility, many income investors may find current bond yields insufficient to meet their needs.

In the current ultra-low interest rate environment, dividend-driven strategies (predominantly common stocks that pay growing dividends) may offer better short-term protection of purchasing power than bonds, but without foregoing the potential for long-term total returns. Even better, if the portfolio’s dividend income grows every year at a rate greater than inflation, the portfolio’s purchasing power also grows, irrespective of stock price movements. In effect, the dividend-driven portfolio’s expected rewards are diversified; there are multiple sources of expected rewards —current income, growing income, and capital gains—each of which is uncorrelated with the others. Dividend-driven risk management provides the means for investors to “survive” Black Swan events, not to try and “evade” them.

Dividend-driven portfolios offer growth diversification, as well. Returns come, in part, from capital gains and, in part, from dividends. Growing dividends provide a cost-of-living increase to those consuming them, while those reinvesting their dividends use the power of compounding to grow their wealth and income by acquiring additional shares. Should capital gains expectations not be immediately realized, the investor is “getting paid to wait.”

It’s important to note that dividends and capital gains from stocks are not by any means guaranteed. The current market environment serves as a reminder that companies are operated for survival first. Those companies fighting for survival may cut or eliminate dividend payments, which is most often preceded or accompanied by stock price deterioration.

Dividend-driven solutions…

It’s for this reason that the critical element of a dividend-driven Black Swan investment approach is not simply the accumulation of some dividend stocks; rather it comes from actively assessing and thoughtfully managing the magnitude, dependability, and growth of the portfolio’s total dividend

Market returnsEpidemic 1-month 3-month 6-month

HIV/AIDS -0.46% -4.64% -3.25%Pneumonic Plague -2.79% -4.67% -4.30%SARS 8.64% 16.36% 21.51%Avian Flu (H5N1) -0.18% 2.77% 10.05%Dengue Fever 1.07% 7.09% 9.68%Swine Flu (H1N1) 10.90% 19.73% 39.96%Cholera Outbreak -2.35% 7.02% 13.61%MERS -0.29% 2.15% 8.58%Ebola -0.09% 2.37% 4.37%Measles/Rubeola -1.71% 1.92% 2.29%Zika -6.05% -0.88% -0.57%Ebola -7.42% -13.74% -3.49%Measles 6.46% 4.51% 12.02%COVID-19 -0.68% -21.44% –Average 0.44% 3.08% 8.50%

MSCI World Index

’70

HIV/AIDS 6/81

Pneumonic Plague 9/94 SARS 4/03

Swine Flu 4/09

Cholera 11/10

MERS 5/13Dengue Fever 9/06Avian Flu 6/06

Zika 1/16Ebola 3/14

Measles/Rubeola 12/14

Ebola 10/18Measles 6/19COVID-19 1/20

0

50

1000

1500

2000

2500

Inde

x le

vel

’75 ’80 ’85 ’90 ’95 ’00 ’05 ’10 ’15 ’20

Source: Charles Schwab, Factset data as of 3/31/2020. Past performance is no guarantee of future results.

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income stream. The magnitude comes from owning dividend-stocks and managing their combined current yield as a portfolio; selecting only the lowest-yielding stocks defeats the short-term protection of purchasing power, while including only the highest-yielding stocks limits portfolio diversification and inhibits the maintenance of purchasing power through muted income growth. The dependability comes from assessing the ability and willingness of the company to maintain the dividend and is implemented by owning stocks with demonstrated histories of regular dividend payments coupled with strong current and projected financial characteristics. The growth comes, in part, from annual dividend increases among the individual stocks held.

The ThomasPartners dividend-driven strategies attempt to do more than just own dividend stocks. The strategies are “income-aware” and actively manage the aggregate dividend stream by implementing trades that, when taken collectively, have the goal of growing income year over year. Finally, we most want to execute trades precisely because the net result might be an increase in current and future aggregate portfolio income.

The concept of consistent total portfolio income growth is not as common as one might think. Many investment options try to substitute growth for income—a structure that inhibits proper reward diversification and, in our opinion, exposes the portfolio to Black Swan risk. Many others sacrifice

total portfolio growth in the pursuit of current income and/or safety. In our opinion, however; achieving growth, with safety, requires a growing portfolio income stream with no substitutes. The income stream delivers consistent and, hopefully, growing purchasing power. The protected purchasing power allows the portfolio to enjoy higher allocations to equities; higher equity allocations that should, over time, provide more substantial total portfolio returns.

Although we counsel poise and patience in the face of uncertainty, we are respectful of the anxiety it creates in our clients. The ThomasPartners Dividend Growth Strategies remain actively managed consistent with our stated goals of providing monthly income, growing income, and price appreciation over time. Dividends provide our clients with an important, and always-positive, source of investment returns. Of course, dividend incomes have not offset the most recent decline in prices; but, they have mitigated the damage to an extent and, for some, reduced the need for distributions of principal while the market endures this current sell off. Knowing that there will be future Black Swans perhaps explains our focus on disciplined portfolio risk management, risk management that is designed to secure lifestyles, not by evading the Black Swans, but by surviving them, through multiple paths to financial reward. What history has shown us is that unsettling environments such as this one typically fade over time.

Research Insights

The spread of COVID-19 has led to unprecedented market volatility, not only in stocks, but in high quality fixed income asset classes as well. Volatility in Treasuries, mortgages and municipals was driven by selling among these asset classes, which we think have created unique opportunities in the latter two categories. As part of its monetary response, the U.S. Federal Reserve (Fed) has entered these markets with both unlimited quantitative easing (QE) across the spectrum of fixed income asset types. With these interventions, the bond market functioning has improved and is approaching normal, though liquidity is still tougher in some pockets of the market. Short-maturity T-bill yields have declined to negative territory alongside a significant flow of assets toward government money funds, though these yields could be pressured in coming months as the Treasury begins to fund the massive fiscal stimulus with unprecedented T-bill issuance to help finance the U.S. deficit.

Fed intervention has not only helped the Treasury market normalize, but has been instrumental in the normalization of the mortgage and municipal bond markets. The Fed purchased agency mortgages resulting in an estimated $250bn of Agency Mortgage Backed Security (MBS) buying over the last two weeks of March, an unprecedented pace. We expect the Fed to be the biggest buyer of MBS for the remainder of 2020, providing stability to that market. We expect continued headlines about mortgage and rent holidays, as well as delayed forbearance which raises questions about MBS credit quality in this cycle. However, the explicit Ginnie Mae insurance protection and the Treasury lines of support to the Government Sponsored Enterprises are ample protection for timely payment of Principal and Interest for Agency Mortgages, which is where we focus for the ThomasPartners Strategies’ clients.

High quality municipal bonds are attractive in the current environment, offering absolute yields that are higher than Treasury yields, more than compensating for the modest increase in credit risk. Municipalities were a major beneficiary in the recently signed U.S. Government’s $2 Trillion CARES Act, with estimated total funding to municipal entities of ~$350bn according to J. P. Morgan6. While we do think the fiscal and monetary actions to date are enough to see the municipal bond market through this crisis, the CARES Act does permit the Fed to step in to provide direct lending to or participation in the municipal bond markets should things deteriorate further, providing downside protection for high quality municipals in our view.

On the corporate bond side, the past few weeks have brought extremes in all aspects of the market, with March serving as a record month for investment grade bond issuance, in sharp contrast to other markets which have been limited or closed to new funding. Despite the strong issuance, the asset class has seen a contrasting record in fund outflows, which have totaled more than 5% of investment grade credit AUM according to J. P. Morgan7, focused on shorter maturities where prices had held steady prior to those massive flows. Again, the Fed came to the rescue, announcing programs to support the investment grade corporate bond markets, which was not part of the 2008–2009 playbook, and resulted in a swift snap-back in short-term corporate bond prices. High quality investment grade issuers are using the bond market as a “bridge to normalcy,” with interest rates at record lows, borrowing costs remain at historically low levels despite higher credit spreads.

We continue to monitor these unusual times in the bond markets and will make opportunistic adjustments as we seek income, income growth and competitive total returns over time.

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Past performance is no guarantee of future results; the value of investments and the income derived from them can go down as well as up. Future returns and the achievement of stated goals are not guaranteed, and a loss of principal may occur. Portfolio Management for the ThomasPartners Strategies is provided by Charles Schwab Investment Management, Inc. (“CSIM”). CSIM is a registered investment adviser and an affiliate of Charles Schwab & Co., Inc. (“Schwab”). Both CSIM and Schwab are separate entities and subsidiaries of The Charles Schwab Corporation.

Please refer to the ThomasPartners Strategies Disclosure Brochure for additional information.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Information provided herein is for informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.

Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed and CSIM expressly disclaims any liability, including incidental or consequential damages, arising from errors or omissions in this publication.

Indexes are unmanaged, do not include fees, and cannot be invested in directly.

Sources:

1 Steve Goldstein, “U.S. Stock Set for Further Selling After Quickest Retreat Into Correction in 70 Years,” Barron’s, February 28, 2020. https://www.barrons.com/articles/u-s-stocks-set-for-further-selling-after-quickest-retreat-into-correction-in-70-years-51582890179

2 Jessica Menton and Nathan Bomey, “Dow endures worst day since ‘Black Monday’; S&P 500 enters bear market as coronavirus spreads economic gloom,” USA Today, March 12, 2020. https://www.usatoday.com/story/money/2020/03/12/dow-plunges-trump-speech-fails-quell-coronavirus-fears/5029964002/

3 Connor Smith, “The Dow Fell 10% Today for Its Worst Drop Since 1987,” Barrons, March 12, 2020. https://www.barrons.com/articles/dow-jones-industrial-average-stocks-worst-drop-since-1987-51584045217

4 Thomas Franck and Yun Li, “10-year Treasury yield hits new all-time low of 0.318% amid historic flight to bonds,” CNBC, March 8, 2020. https://www.cnbc.com/2020/03/09/10-year-treasury-yield-plunges.html

5 Gregory Zuckerman, etal., “Behind the Market Swoon: The Herdlike Behavior of Computerized Trading,” The Wall Street Journal, December 26, 2018. https://www.wsj.com/articles/behind-the-market-swoon-the-herdlike-behavior-of-computerized-trading-11545785641

6 Peter DeGroot, Daniel Zheng and Ye Tian, “Municipal Markets Weekly,” pg. 128, J. P. Morgan North America Fixed Income strategy, March 27, 2020.

7 Eric Beinstein, Sheila Xie and Pavan D Talreja, “U.S Fixed Income Strategy, Corporates,” pg. 94, J. P. Morgan North America Fixed Income strategy, March 27, 2020.

©2020 Charles Schwab Investment Management, Inc. All Rights Reserved. IAN (0420-0BGA) MKT106833-04 (04/20)00245717

Dividend Increases

Thirteen U.S.-based companies in the ThomasPartners portfolios increased their cash dividend payments in the first quarter of 2020*

Company TickerIncrease declaration date

Annual dividend

Percent increase

Watsco Inc WSO 2/13/2020 $7.10 10.94%

Comcast Corp CMCSA 1/23/2020 $0.92 9.52%

Chevron Corp CVX 1/29/2020 $5.16 8.40%

Eversource Energy ES 2/5/2020 $2.27 6.07%

The Williams Cos Inc WMB 1/28/2020 $1.60 5.26%

Intel Corp INTC 1/23/2020 $1.32 4.76%

Arthur J Gallagher & Co AJG 1/29/2020 $1.80 4.65%

Genuine Parts Co GPC 2/18/2020 $3.16 3.61%

Cisco Systems Inc CSCO 2/12/2020 $1.44 2.86%

The Coca-Cola Co KO 2/20/2020 $1.64 2.50%

Colgate-Palmolive Co CL 3/11/2020 $1.76 2.33%

3M Co MMM 2/4/2020 $5.88 2.08%

Walmart Inc WMT 2/18/2020 $2.16 1.89%*Data source: Bloomberg as of 03/31/2020.

We appreciate your investment in the ThomasPartners Strategies. Please contact your Investment Professional if your investment objectives or circumstances have changed such that a review of your ThomasPartners strategy account(s) might be necessary, or if you have any specific questions about how your account is managed.

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retail investors. With index funds, high-frequency traders and others who aren’t trading on fundamental analysis added, nearly 85% of stock market volume is now on autopilot5.

Stock price movements do not determine dividends and trading on autopilot, as measured by dividend funds tracking indices, has not been shown to grow income consistently in all market environments.

At ThomasPartners an extensive bottom-up fundamental research process is used to evaluate every candidate for our portfolio. This time-tested stock picking process results in a portfolio of dividend-paying stocks strategically combined with an equal emphasis on monthly income, income growth and competitive total returns. We are not on autopilot.