Deron McCoy (DM): SEIA is a full-service registered investment advisory firm headquartered in South California that offers investment management and financial planning services that are tailored to meet the unique needs of affluent investors and corporations. SEIA’s mission is to provide clients with a partnership that complements and exceeds their long-term goals and objectives.
 
MutualFunds.com: What are the top concerns of your clients in the current economic environment?
 
DM: Generating income and protecting gains without incurring a lot of taxes—especially 10 years into a bull market.
 
MutualFunds.com: What do you think are the top risks that can potentially derail the longest bull run in history?
 
DM: Excessive leverage—we are avoiding sectors of the economy where debt levels have exploded.
 
MutualFunds.com: What is your outlook on the equity markets with respect to risks and opportunities?
 
DM: U.S. Large Cap stocks have marched to new highs, but the real action is under the hood. We are in the early innings of a massive sector/factor rotation away from what had been working (Growth, Momentum) for the last 18 months or so to what has been lagging and downright dormant (Value, Financials, Developed Markets, etc.) for the better part of two years.
 
Why?
 
The market is trying to sniff out some green shoots here. But the problem is it is not showing up in the data yet. And now that stocks are at elevated levels, the indices might only do mid-to-high single-digit gains next year, the real action will be in your sector overweights and underweights.
 
MutualFunds.com: What is your outlook on the fixed income markets with respect to risks and opportunities?
 
DM: If investors are to expect mid- to high single-digit returns from equities, it begs the question: Should investors be entirely invested in stocks? Especially at this late stage of the bull market. But an allocation to treasury bonds doesn’t seem that exciting. Two percent yields? If you factor in inflation and taxes, there is not much to be gained from a heavy treasury allocation.
 
So just like how investors take risks in stocks, we can take risks in bond markets as well—but we have to take the right risks. Those risks come in a couple of different forms:
 
Inflation and interest rate risk – We are not recommending investors move their treasury bond maturities out to 30 years. The yield pickup is minuscule and the risks are enormous. If rates ever move up a couple of percent over the next 30 years, investors could lose 10-20 percent or more in a 30-year treasury. The risk-reward is just not there.
 
So, we could take risks in bonds tied to corporate credit. But unfortunately, this is one of the markets that has a bit of excess. The amount of high yield and bonds on the cusp of high yield is enormous—and it’s all held in daily liquid vehicles. Meaning if investors start to hit the sell button, everyone will be rushing for the exits at the same time. And these companies are struggling and heavily indebted now. And we are in an expansion. Imagine what would happen in a downturn. And oh, by the way, investor protections are being stripped away. So in case these bonds do default, the recovery rates are going to be a lot lower than previous cycles. This is just not the risk we want to take 11 years into an expansion.
 
So that leaves risks tied to what caused the last recession. And we like these. Why? Well, what usually caused the last recession usually doesn’t cause the next one. The savings and loans didn’t cause the dot com bubble. The dotcoms/tech bubble didn’t cause the real estate/bank crisis and we don’t think real estate and banks are going to cause the next one. Why—because there aren’t the leverage and the excesses there as everyone always fights the last war. Plus, rules and regulations come in as well to prevent another crisis.
 
So, these assets are really interesting.
 
Bank debt – These are much stronger balance sheets than a decade ago. And they can’t take the same amount of risks as they could a decade ago. The credits are so strong, we believe you can move down in the capital structure into preferred stocks and pick up yields that rival high yield and the mid-to-high single-digit returns from stocks.
 
The same is true with non-agency mortgages. They are not as cheap as they once were but still offer good yields and the outlook is great. There are 10 to 15 years of home price gains so the collateral is much better here. There are 10 to 15 years of wage gains so the interest coverage ratios and the ability to pay are tremendously improved. And 10 to 15 years of not defaulting, if the borrower hasn’t defaulted yet, then they probably won’t default in the future.