Crash, Timing Indicators & CISP 5 Year review.

By Compound Income / 1 April 2020

Market Background 
I won’t spend long on this part, probably best described in one word – carnage. So rather than getting bogged down in reporting % moves in markets etc. I’ll try and discuss some of the bigger picture features and venture some opinions / guesses as to what might come next. I will however quote some figures for you in the Portfolio review section later on what was one of the worst quarters on record,  just so you don’t feel hard done by. If you are in a hurry then skip to the end where I’ve done a bullet point summary, but I’d encourage you to read the full post if you can possibly spare the time.

Market Timing Indicators
As for the UK Market Timing indicators which I have been producing / following for a while now these have obviously all gone heavily negative and indeed the most negative since I started compiling them back in 2014. They are all between 19% (FTSE) and 22.6% (Mid 250) below their trends at the end of March 2020, so we will need to see quite some recovery before these turn positive again. As such on their own they signal that you should be reducing risk / be out of the market.

Regular readers or those with good memories may recall that I have also been tracking these along with economic indicators which might signal a recession ahead. As the original research that prompted me to start producing these suggested this was the best way to improve the signal and avoid whipsaws from dips below the trend which get reversed. As of the end of March these economic indicators had not triggered. These will though as of Friday 3rd of April when some horrendous Non Farm Payroll numbers are expected to be announced and the US Unemployment rate will blast upwards. In addition Manufacturing PMI’s have come down below 50 in March and are expected to fall further in April too. 

Thus with recession signals triggering the model would suggest this is the time to go defensive, sell everything and switch into treasury bills or cash. This was shown to improve on buy & hold returns and market timing based on the trend without the economic triggers by avoiding the whipsaws. You can see my original post about this here & the authors original post – In Search of the Perfect Recession Indicator.

The slightly unfortunate thing in this case is that this has been such an unprecedented event that the market has already crashed in record time and was already down by around 30% or more before the recent rally left the FTSE All Share with a negative total return of -25.13% for the quarter. Given the last two proper bear markets accompanied by recessions led to 50% or so declines I guess this one could only be half way down, so maybe it is not such a daft idea if you have a small portfolio and can be nimble enough to sell up and get back in. 

​Outlook For Dividends
What we do know is that the shut down of many economies around the world is unprecedented and many forecasters / economists (for what they are worth) are speculating that the economic downturn / recession will be worse than that endured during the Global Financial (GFC) in 2008/9 and some are suggesting that unemployment could spike up to levels last seen in the Great Depression. The knock on effect of that and Companies inability to forecast in the short term is that dividend cuts and suspensions / deferrals have come through much more quickly and to a greater extent than seen back then. 

Indeed on the subject of dividends looking at the Link Asset Service Dividend Monitor this showed that dividends in the UK only fell by around 13% in 2009 to £54bn in total before stabilising in 2010. Since then they had doubled to £110bn, although Link did think they would have fallen back to about £103bn. This time around apparently dividend forward contracts in the derivative markets are indicating cuts of at least 30% and up to 50% in Europe. While there was a good piece from John Kingham looking at a long history of this in the US which suggested that the combined dividend of the 500 largest US companies has decline, multiple times, by more than 20% to more than 50% over the last century. The 50% falls came after wars and around the great depression.

So since current unprecedented conditions have been likened to a war and raise the outside possibility of a deflationary depression, as he says income investors should prepare for the worst and assume that dividend income form the markets might get cut in half this year. Which if it comes to pass would take overall UK dividend back to where they started in 2009.
One would however expect that they would then stabilise and potentially bounce back quite strongly thereafter next year as hopefully normal service is gradually resumed in the second half of this year. Of course individual experiences will differ depending on the make up of your portfolio and may be better or worse than this.

Compound Income Portfolio (CIP)
Which brings me nicely onto this and what has happened to it this quarter and what my plans for it are going forward from here. As this is also the fifth anniversary of the Portfolio being launched I had hoped that this would have been a good time to highlight the longer term performance but sadly I guess no one will be that bothered now, but more on that later.

After the first two months this year the portfolio was holding up well having been up slightly in January when the market was down and was over 6% ahead of the index by being down less in February too. That trend came to an end in March as many Mid Cap and Smaller Companies, which the portfolio has a greater exposure to than the broader index, played catch up and fell heavily. In addition one or two position which were more sensitive to shut downs of activity in the short term also fell more heavily. Thus the portfolio recorded its worst ever monthly fall of -22.16% compared to the -15.07% from the FTSE All Share. Year to date this leave the CIP with a -26.83% total return and therefore -1.7% behind the return from the FTSE All Share (which I use as a benchmark) quoted earlier. 

Which is all very disappointing but not that surprising in the circumstances. So what about the longer term and the 5 year returns, which are quite frankly more relevant and a decent time frame over which to judge whether a portfolio based on and selected from the Compound Income Scores has any merit. Well the picture as shown in the graph at the very end of this piece is not too bad even if I say so myself. This is because the CIS has still returned 48.1% over that time frame or 8.2% per annum versus 1.9% or 0.4% per annum from the FTSE All Share, so I must be doing something right or I was very lucky or somewhere in between I guess. Out of academic interest I decided to check how this compared with other UK funds that had been available over the last 5 years both of an open ended and closed end or investment trust variety.

On checking I noted that the top UK Equity Income OEIC was Trojan Income with a total return of just 12.5%. While in the All Companies Sector out of 250 funds there were just 4 funds which bettered this return which were MFM Bowland +77.9%, Chelverton UK Equity Growth +75.9%, CFP SDL UK Buffetology +60.4% and Slater Recovery +48.7%, with figures taken from Trust net. So they might be worthy of further investigation if you want to go down the fund route or they might be about to blow up if the past is no guide to future as the marketing blurb says? I did notice a few names that the CIP has in common with these so they are probably fishing in similar waters to a certain extent and probably structuring their portfolios completely differently from the index rather than the closet indexing that still tends to go on in mainstream investment houses.

As far as Investment Trusts went I was somewhat surprised to find there were hardly any UK Trusts that had done better over the last 5 years. I say surprised as my perception is that Investment Trusts tend to do better thanks to their closed end nature and maybe lower charges, plus the benefits of gearing. Having said that I guess any gearing may well have been a hindrance rather than a help given the now low returns over the last 5 years unless they managed that very actively and well. In fact the only one that I could find that had done better on a NAV total return basis was a small cap fund – Standard Life Smaller Co.s – which returned 52.6% according to figures from JP Morgan Cazenove, although AIC figures are also available. The only other fund that came close was from the much trumpeted Nick Train and his Finsbury Growth & income which returned 42.1% and he certainly falls into the category of doing things differently too.

As to the income funds they were all surprisingly poor too, but the one that is probably closest to what I’m doing in terms of the make up of the portfolio is probably Gervais William’s Diverse Income Trust which has returned 11.1%. Other than that Troy Income & Growth cropped up again with +17.7%. While a quick look at the Stockopedia guru screens showed only the Geraldine Weiss & Dividend Achievers delivering anything much with 16% & 12% respectively, which if you add in dividends might be around 36% and 32% so close to the CIS, but no cigar! So maybe the Compound Income Scores are a Guru screen you’ve never heard of! For the sake of completeness of all their Guru screens Jim Slater, Peter Lynch, Price Momentum & James O’Shaughnessy Tiny Titans did better so they may be worth investigating if you’re a Stockopedia subscriber. If not you can get a two week free trial here. 

​So I am quite happy with all that but not getting too smug or carried away given we are going through an unprecedented event and nobody really knows what will transpire. Nevertheless once Companies feel able to forecast again and things start to get back to normal I’m reasonably confident that the Compound income Scores will continue to be a decent guide as to where to look for good quality companies which should be able to grow their dividends and thereby provide decent returns over time. 

With that in mind and thinking about the Market Timing Indicators mentioned earlier I have come to the following decision. Since I am sceptical of market timing and I would like to see how the Scores perform during a downturn, I have decided to keep the Portfolio going and remain pretty fully invested. This will also enable subscribers to see which stocks I pick during this next phase rather than just stopping. Thereby I’ll be aiming to benefit from time in the market rather than timing the market and not have to stress out about trying to time the bottom and when to re-enter. Against that I’ll continue to produce the market timing indicators and the follow the economic signals to determine when it would have otherwise re-entered and see what the difference is in terms of the valuation at that time versus what it was at the end of March 2020. So I’ll highlight this months valuation in the table, although I think March 2020 maybe seared on our memories any way. 
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At least it will be a useful real time test of the efficacy of using the timing indicators in this way in these circumstances and the Scores during a downturn. Personally I suspect things could still get worse in the economy and markets from here as markets have usually had their worst losses in bear markets when they are accompanied by a recession, which seems likely on the back of this. Indeed some commentators who I hold in high regard suggest that fundamental value and therefore better long term returns may not be reached until the S&P 500 get down into the 1700 to 2000 range versus recent levels of around 2500 after the sell off and rebound. In the UK I suspect we could end up with FTSE trading somewhere in the 4000 to 5000 range before we see the low, but don’t take that as gospel just my gut feeling based on past downturns. Against that there has been a massive response from Governments and Central Banks as expected and this might well help to offset the worst of the hit from the Corona shut down. Nevertheless I’d be surprised if we didn’t see at least a re-test of the recent lows just under 5,000. It is however worth remembering that it is a market of stocks and all this volatility will likely throw up some decent opportunities along the way in individual stocks. Indeed I have made a couple of successful acquiistions of stock myself through the recent sell off.

With that in mind I made a few changes to the Portfolio this month with three stocks that had seen falling Scores and which i think will be vulnerable to the current and future conditions exiting the portfolio. These were replaced with four new stocks, all of which are still running their operations. Three have cash rich balance sheets and could potentially benefit from the turmoil. Subscribers can see the details of these trades and brief rationale for them on the Transactions section of the Scores sheet. I’ll also reserve the right to perhaps make some intra-month changes rather than the usual monthly screening given the market conditions. 

Summary

• A record breaking negative quarter in the market and a pretty terrible March best described as carnage as the human & economic cost of the Corona virus spread around the world.
• This has caused the UK Market timing indicators to fall a record amount below their trends, which will require a large recovery or quite some passing of time before they turn positive again.
• With economic indicators now confirming a likely slide into recession ahead the model would suggest that if you can you should be out of equities and in risk free assets lik e treasuries & or cash. (Not a recommendation, just how the model works)
• Dividend cuts, suspensions and deferrals have become widespread as companies are understandably unable to forecast at the moment given the unprecedented economic shut down and uncertainty as to when it might end.
• Consequently total dividend paid by UK Companies this year could be down 30% to 50% I reckon, although one would hope they would stabilise and potentially bounce back quite strongly thereafter next year as hopefully normal service is gradually resumed in the second half of this year. Of course individual experiences will differ depending on the make up of your portfolio and may be better or worse than this.
• The Compound income Portfolio (CIP) after outperforming in the first two months of the year succumbed to a sell off in Mid & Small Cap names where it has greater exposure and had its worst ever down month in March & under performed badly.
• The CIP was therefore slightly behind the index for the quarter / year to date but…
• This was the 5th anniversary of the launch of the CIP and it is still produce nearly 50% returns over this time frame compared to next to nothing from the Index. 
• Comparing this to open ended UK Equity funds available over the last 5 Years this is better than about 98% of those with only 4 All companies and no income funds managing a better return. (see full text above for details of those).
• Compared to Investment trust it was a similar picture with just one Smaller Companies Investment Trust providing a better return.  
• Looking at the Stockopedia Guru strategies this also beat all of the Income ones there, even allowing for estimated dividend which their numbers don’t include. Only the Geraldine Weiss and Dividend Achievers (which is closer to what I’m trying to do) came close. While more broadly there were only 4 Guru strategies from some well known names that did better (see full text above for details of those).
• Going forward I have decided to keep the CIP largely fully invested, despite the market timing signal above, so subscribers can still see what stocks I pick on the back of it through this period.
• This will therefore  be a useful real time test of the efficacy of the timing indicator getting out and back in versus what the Portfolio can do over however long that period turns out to be. Of course if you have sold up you can keep checking back to see when that might be.

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Conclusion
 Firstly thank you if you have got this far as these are extraordinary / unprecedented times & I sincerely hope you and yours are keeping safe and well through all this even if your portfolio may not be. 

I have to say I wasn’t and i don’t think anyone else was expecting this​, although clearly there had been some on going concerns about valuations in the US prior to this. So maybe the virus was just the pin that the market had been waiting for? Of course how economies and markets come through this remains to be seen, will we see a V shaped recovery or will it be a more protracted affair given the economic damage done by all the shut downs?

All we do know is that dividends have fallen in the short term in an unprecedented fashion, although I’m hopeful that they will stabilise and bounce back at some point later in the year. 
Markets will discount this and bottom out at some point and given all the support offered by governments and Central Banks this may come sooner rather than later​, but as is often said: “Bear markets have three  stages —sharp  down,  reflexive rebound and a drawn-out fundamental downtrend.” As it looks like we have entered a bear market I would therefore at least expect a re-test of the recent lows.

Indeed a good US commentator that I follow thinks 2300 on S&P 500 may be fair value based on median PE’s, but we often see an overshoot so 1700 to 2000 is his suggested Zone for getting more positive and reinvesting etc. This would tie in with my thoughts in the UK that the 5000 low or thereabouts may well get re-tested and better opportunities may present themselves in the 4000-5000 range.

As ever though it is a market of stocks and rather than focus on headline indices time is probably better spent focusing on individual stock threats and opportunities as we go forwards from here. We may well be in for a bad and possibly even a deflationary recession in the short term. Beyond that with all the money printing etc. one would probably expect inflation to become more of a problem this time around down the line. This would still suggest that Equities & real assets will be the place to be for the long term.

Personal Note
​It sometimes feels like I’m the only person in the Country who has not had their daily routine disrupted by all this as I’ve been “working” from home and self isolating for 11 years before this any way! So absolutely no change to my daily routine with the markets still being open and all, apart from not being able to go out for shopping, dining, leisure and entertainment when I want. Routine is important if you are new to this, perhaps I’ll try and do a blog about that.

As for my portfolio and what I’m doing personally. Well to coin the old phrase I’m keeping calm and carrying on investing. Yes my portfolio and net worth has taken a big hit, but then they went up a lot prior to this so I’m OK with that as I always say you have to take the rough with the smooth. 

At times like these it is more important to avoid losers and losing too much. While it may be a bit late for that now it is always worth re-assessing and adapting as events unfold as far as you can, Indeed I’m glad I did a bit of that last month as the crisis started to hit and sold a few stocks which seemed more vulnerable to all this. In reality though I was never going to be willing or able to sell everything and I wouldn’t want to. Who know maybe I’ll come to regret those words when this is all over with?

As I mentioned in the previous update I came into this fairly well placed having moved more defensive and reduced cyclicals. On top of this I had built up substantial cash reserves. So even if some of my day to day income portfolio stocks end up cutting their dividends I’m sure I’ll survive even with no bailout, government loan or furlough payments (can I get those for my Butler and House maid I wonder – no only joking). Any way I guess that’s the point of / beauty of financial independence. Meanwhile I’m still investing our ISA’s for the long term but sitting on a bit of cash in those too pending forthcoming opportunities and about to top them up with this years allowance next week too. 

Any way at the end of the day its only money, as ever health, family, friends and your local community should be more important. Here’s to hoping we all pull through and as the song says….