The first half of 2022 was the worst one since 1970 with the S&P 500 index ETF (SPY) returning -20.0% including dividends. The top sectors are no surprise. Energy (XLE) was the clear winner with a 27.6% total return as measured by the Sector SPDR ETF. The next 3 best performers were the classic defensive sectors. Utilities (XLU) was the only other positive sector at 0.4%, followed by Consumer Staples (XLP) at -5.3% and Health Care (XLV) at -7.4%.
The worst sectors were Consumer Discretionary (-34.4%), Communications (-30.3%), and Technology (-27.3%). Sector performance went pretty much as I expected in my November 2021 article, “Surviving A Tech-Led Bear Market: Lessons From 1999 To 2002“
Bonds have also performed terribly in the rising interest rate environment. The iShares Core U.S. Aggregate Bond ETF (AGG) returned -9.5% so far this year. Outside of the AGG, other fixed income index ETF’s did worse but had similar results regardless of credit quality. The Investment Grade Corporate Bond Fund (LQD) returned -15.2% in the first half. The High Yield ETF (HYG) returned -13.7% and the Preferred ETF (PFF) returned -14.5%.
My portfolio’s lack of mega-cap growth was a positive performance driver in 2021. A temporary reduction in riskier fixed income allocation also helped, although I could have gone farther. However, the market appears to now be sensing that a peak has been reached in inflation as indicated by recent drops in longer-term interest rates. While a few more short-term rate hikes are likely, now could be a good time to tiptoe into low investment grade bonds with 5-10 year maturities while yields of 5% to 6% are available. Until short term rates have peaked however, do not make the mistake of adding to leveraged bond funds as the cost of leverage remains high.
As far as stocks are concerned, value is still cheap relative to growth and has some potential outperformance remaining. There will be a time to add to growth stocks but I believe it will be closer to the bottom of the current bear market which I have estimated at 3400 on the S&P in a recent article.
My portfolio held up better than the S&P 500 so far in 2022, returning -13.8% compared to the bear market level -20.0% for the SPY. My ending asset allocation was 83.7% equities, 13.9% fixed income and preferreds, and 2.4% cash. That marks a shift of 3.7% out of equities, 1.3% into fixed income, and 2.4% into cash compared to the allocation at the end of 2021.
As for investment income, I had a non-annualized yield of 1.0% in the first half of 2022 based on starting portfolio value. This was significantly lower than half of the 3.2% full-year yield achieved in 2021. Nevertheless, it is better than the first half 2022 SPY yield of 0.6%. The higher starting value in 2022 was one reason for the lower yield. The drop in portfolio value will improve the yield on a forward basis. Still, my portfolio income in total dollars was 11.5% below 1H 2021 levels. Before judging this result too harshly, let’s look at the reasons for the decline.
|CEF Net Sales||-6.58%|
|No JBSS Special||-4.91%|
|ST Bond Trades / Redemptions||-3.36%|
|Existing Stock net raises||6.21%|
|M&A Arb Stock Changes||-0.37%|
Note that nearly 10% of the 11.5% total came from an intentional reduction in my closed end bond fund and short-term individual bond allocations. Much of this amount was reallocated to special situations. These moves avoided capital losses far in excess of the foregone income. Midway through the first half, I covered some of the sold closed-end fund (“CEF”) positions (too early) as well as adding some 2-4 year high yield bonds. See my March article for more details. As medium-term rates show signs of peaking, I am considering deploying additional cash to extend my individual bond ladder out 5 -6 years.
The one potential bad call on my part was holding John B. Sanfilippo & Son (JBSS), a small cap nut distributor that pays a small annual dividend with irregular large special dividends. Although the specials have been reliable in recent years, the company needed cash this year to maintain inventories in an inflationary environment. As a result, there was no special dividend in the first half of 2022 as there was in 2021. The company usually announces its August annual and special dividends during the second week of July, so we will find out soon if this part of my 1H income shortfall was a timing issue or an unexpected cut. If there is no special, I may consider selling this stock and buying a more reliable high yielder.
I am satisfied with the rest of my income variances. Mitsui (OTCPK:MITSY) is simply a timing shift from the end of June to the beginning of July. Beyond that, net raises from my existing stock positions plus income from new positions exceeds lost income from sold common and preferred stocks by more than 5%.
As you can see in the Appendix below, my projected forward yield based on current portfolio value is a more respectable 2.6%, and this assumes none of the potential changes discussed above. If I do make these trades, I should be able to get back above a 3% yield in 2023 and return to income growth on a total dollar basis.
My top 10 common stock holdings make up over half of my total portfolio. As I say in most of these reviews, I made no trades in these names outside of reinvesting dividends. The names on the list are the same as at the end of 2021 except that Eaton Corp. (ETN) has fallen off the list due to price performance and was replaced by Penske Automotive Group (PAG) which has held up well so far in the bear market.
Six of the top ten holdings outperformed the S&P so far in 2022. The other four fall into the unfavored Tech and Consumer Discretionary sectors. The two retailers are among the best operators in their category and their stocks are correcting after a period of strong outperformance. I have no concern about either one for the long term. Qualcomm (QCOM) remains a beneficiary of both 5G growth and expanding non-phone related applications like automotive. Cisco (CSCO) is the one worrisome position due to its poor growth performance, but I am giving the company a chance to show that their expanding order book is real and sales have been constrained by supply chain issues.
My top 5 fixed income holdings make up another 6.7% of my portfolio, and the names remain the same as at the end of 2021. The two closed end funds have performed terribly due to declining NAV’s, widening discounts, and increasing cost of leverage. However, their distributions are well-covered and could even increase as their portfolios turn over with newer higher yielding bonds. Synchrony Financial preferred (SYF.PA) has been a victim of increasing rates and credit worries with its BB- rating, but customer default rates have turned out lower than expected in previous recessions. With a current yield now over 7.4%, I think the risks of any upcoming recession are priced in.
Top And Bottom Performers
My third best performer in 1H 2022 was Raytheon Technologies (RTX) with a return of 12.9%. The stock is getting a sentiment boost with other defense names given the Russia-Ukraine war, but Raytheon also has its recovering commercial aerospace business as a tailwind, which I noted in April.
The second best performer so far this year was Constellation Energy (CEG) with a return of 15.1% since it started trading on 2/2/2022. This spinoff from Exelon (EXC) deserves its premium valuation over other generation-based utilities because its concentration in nuclear power is in line with CO2 reduction targets in the states where it operates.
My top performer of 1H 2022 was AbbVie (ABBV) with a return of 15.3%. The stock is benefitting from its place in the defensive health care sector and its strong 3.7% dividend yield. Additionally, the company is increasing sales of Skyrizi and Rinvoq, replacements for its maturing largest selling drug Humira. AbbVie is also seeing strong results in the Neuroscience and Aesthetics fields that it gained from its merger with Allergan.
The third worst performer has been Target (TGT) at -38.3%, most of that coming when the company slashed its operating margin forecast when reporting 1Q results. Target benefitted from selling high margin categories like electronics during the pandemic but got stuck with excess inventory as consumers switched back to lower-margin areas like food as conditions normalized. Still, the company managed to improve its digital channel capabilities and used some of its strong cashflow in 2020-21 to upgrade its stores. The company should do well in the long term once it gets through this transitional period.
The second worst performer in 1H 2022 was Synchrony Financial (SYF), with a return of -39.8%. The market tends to penalize this stock because the company serves a lower credit quality consumer with its proprietary store cards. Recession worries about reduced auto and home spending are also hitting sentiment. With consumer balance sheets looking better than at the start of previous recessions, the market seems to be taking too negative a view of the coming impact on the company.
My worst performer so far this year has been Warner Bros. Discovery (WBD), with a return of -44.3% since the spinoff from AT&T (T) on 4/4/2022. The company came public at a bad time for the market with a lot of debt and market revulsion toward anything streaming-related given Netflix’s (NFLX) unexpected loss of subscribers. The company has yet to report a quarter reflecting both Discovery and WarnerMedia and CEO David Zaslav has yet to provide post-merger plans on how he will integrate the two businesses and reduce costs. I am waiting for this information before making additional moves.
The special situations area was active so far this year as many deals closed. These include:
– The spinoff of Constellation Energy from Exelon in February as noted above
– The spinoff of WarnerMedia from AT&T and merger with Discovery in April to create WBD as noted above
– The merger of BP Midstream Partners with BP (BP) in April, paid in BP stock
– The merger of MGM Growth Properties with VICI Properties (VICI) in April, paid in VICI stock
I intend to continue to hold the resulting stocks from these transactions for the long-term.
I closed out of one merger arb trade early, selling Shaw Communications (SJR) in May when Canada’s Competition Bureau announced it intended to block the merger with Rogers (RCI) for $40.40 CAD in cash. This left me with a small capital gain of 1.6%, plus a 3.9% profit from 13 months’ worth of Shaw’s monthly dividend. So far, the decision to exit has been a bad one as the arb narrowed again when the companies agreed to sell Shaw’s Freedom Mobile division to Quebecor (OTCPK:QBCRF). Nevertheless, there is still risk to this deal as the regulators may require further mobile asset sales to allow the deal or may still reject it outright.
Two special situations remain on the books but are now only 2.35% of my portfolio. The first is the acquisition of Change Healthcare (CHNG) by United Health (UNH) for $25.75 in cash. The US DOJ has sued to block this deal with a trial starting August 1st even though the company has agreed to sell a claims processing business. The companies have agreed to extend the deadline and CHNG will now pay a special dividend of $2.00 before the deal closes if allowed to proceed. If the deal does not go through, Change is entitled to a breakup fee of $650 million, which is also equal to about $2 per share. Change looks fairly valued around current levels if the deal does not go through.
The remaining deal is the merger of Activision Blizzard (ATVI) with Microsoft (MSFT) for $95 cash. This deal continues to have a wide arb due to regulatory concerns but the potential impact on industry concentration looks low. Given Activision’s recent performance, there is some risk to the share price if the deal is blocked. However, Warren Buffett (or one of his investment managers) (BRK.A) (BRK.B) thinks enough of the deal to take a large stake.
The special situation field does not look as attractive as it did last year with fewer cash deals – or risky ones like Elon Musk’s offer for Twitter (TWTR), and stock-based deals at risk due to a declining market. Once my two remaining deals are resolved, I will likely consider fixed income investments unless more attractive deals come along.
Aside from the Shaw sale mentioned above, I have made only four trades so far in 2022. In January, I sold a portion of each of my closed end bond funds – PIMCO Dynamic Income Opportunities Fund (PDO) and Nuveen Ohio Quality Municipal Income Fund (NUO) to fund the purchase of Activision Blizzard discussed above. This was a great deal, avoiding a 13% decline in PDO and a 10% decline in NUO after accounting for the foregone dividend income.
In March, I thought the CEF declines were nearly done, so I sold Pepsico (PEP) to buy back the CEFs as well as two individual short-term high yield bonds below par: Las Vegas Sands (LVS) 3.5% due 8/18/2026 (CUSIP: 517834AE7) and EQM Midstream 4% due 8/1/2024 (CUSIP: 26885BAA8). I hedged the Pepsico sale by selling 7/15/2022 $170 Puts. So far, Pepsico is little changed and the mark-to-market on the bonds is down about 4% but I remain confident they will survive to maturity at which time I would have a capital gain along with the interest income. Covering the CEFs was poor timing, as they continued to decline in price, although as I mentioned previously, I have confidence they can cover their distributions. I am currently holding cash from the Shaw sale. If PEP is under $170 on 7/15, I will use the cash to cover the assignment from the expiring put options. If PEP is over $170, I will look for opportunities to extend my individual bond ladder to 5-6 year maturities with BBB rated corporate bonds.
In April, I bought more WBD after the spinoff thinking the selloff was over. This was definitely my worst trade of the year so far but on the bright side, the added shares are currently just 0.15% of my portfolio. As mentioned above, I will at least wait to hear more from the merged company before taking further action.
In June, EQM Midstream unexpectedly did a tender offer for the bonds I purchased in March, paying par ($100) plus accrued interest. The company accepted 60% of my previous position for a quick profit and I then applied the proceeds to two other high yield bonds maturing in 2024: Enlink Midstream (ENLC) 4.4% due 4/1/2024 (CUSIP: 29336UAB3) and Tri-Pointe Homes (TPH) 5.875% due 6/15/2024 (CUSIP: 962178AN9).
The big lesson from the first half of 2022 is to have patience. I was too quick to sell Shaw and too quick to buy back my earlier sales of NUO and PDO. I was also too quick to assume WBD had bottomed. In all cases it would have been better to just wait.
I expect the Fed to continue with its Fed Funds rate increases and its balance sheet runoff. At the same time, recession fears are pushing down longer-term rates. This should lead to a flat or inverted yield curve. In that environment, I do not want to add to any leveraged funds due to the high cost of leverage. However, I do want to add individual bonds in the 5-6 year maturity range rated around BBB. This should be low enough to get around a 5%-6% yield to maturity but high enough to avoid default risks in a recession.
In stocks, I expect the bear market to continue down to S&P 3400 although the index may now be in for a few months of sideways to slightly up action before that happens. Similar to the 2000-2002 bear market, I expect value to continue outperforming growth as growth valuations were so stretched coming into the bear market. Growth will be a more attractive investment when the index gets closer to my bottom target.
A full list of my holdings as of 6/30/2022 is below: