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Frequent Contributor

PRWCX report

(link) so many nuggets in this report.

HIGHLIGHTS

Both U.S. equity and fixed income markets delivered strong returns in the first half of 2019, despite widespread expectations for decelerating domestic earnings growth.

  

Your fund generated a 17.4% absolute return compared with the S&P 500’s 18.5% return. The fund outperformed the market on a risk-adjusted basis. We captured 94% of the S&P 500’s return while taking on only 64% of the market’s risk.

  

Given that we are in the latter stages of an economic expansion, faced with an inverted yield curve, potential for increased policy uncertainty, and strained relations between the U.S. and China, we have taken a cautious view, reducing the fund’s equity exposure and fixed income duration.

  

We do not know what future gross domestic product growth will be, and we are not in the recession forecasting business. We deal with probabilities. When the market becomes convinced that there is no risk of a recession and valuations rise, we will take the over and be more conservatively positioned. When the market becomes convinced that there is a high risk of a recession—as it did in November and December of last year—and valuations become more attractive, we will take the under and be more aggressively positioned.

 

So, what is going on?

In the fourth quarter of 2018 the market essentially became gripped with fear, to put it bluntly. Fear of a Federal Reserve-induced recession as it was raising rates too aggressively. Fear of an inverted yield curve and the historically very negative intermediate-term consequences. Fear of a trade war with China. Those fears drove the market down 20% from its September peak and pushed the market multiple down to 13.8x forward earnings.

Based on our calculations, at the market bottom on Christmas Eve of last year, the market was pricing in a 50% chance of a near-term recession. As recently as September of last year, the market was essentially pricing in a 0% chance of a recession. As a result, the market went from being expensive to being attractive in a relatively short period of time. We took advantage of this opportunity by aggressively adding to equities and went overweight equities on Christmas Eve of last year. This decision has also aided our performance in the first half of 2019, as we will talk about later.

Fast forwarding to the first half of 2019: From a fundamental perspective, not much has really changed despite the strong equity and fixed income returns. The threat of a trade war with China is still a risk. The yield curve remains inverted. U.S. earnings have not surprised to the upside. The large fiscal stimulus that drove outsized gross domestic product (GDP) growth in 2018 is likely to wane in 2019 and potentially be a headwind to growth in 2020–2021. We are at the beginning of an election cycle with two parties that generally have very different views on tax and regulatory policies, which could result in increased policy uncertainty in 2020 and 2021.

The only thing that has really changed is that the Federal Reserve has reversed course and is now likely to start cutting interest rates as opposed to raising them. This has reduced the fears of a Fed-induced recession. However, in an era of very low absolute interest rates, structurally lower growth rates, and a more service-based economy, the impact from small changes in Federal Reserve rates is vastly overestimated by the market. With the notable exception of the housing market—and, to a lesser extent, the automotive market—whether the Federal Reserve sets its target for the federal funds rate at 1.5% or 2.5% is far less important than it used to be. Taking interest rates close to zero and later deploying massive quantitative easing in the U.S. did not result in structurally faster GDP growth coming out of the last recession. Similarly, the move to negative interest rates in Europe and Japan has not revived their moribund economies.

With the market now surpassing its September 2018 peak, investors are betting that the Federal Reserve will cut interest rates and that the lower rates will reignite GDP growth and keep the U.S. out of a recession. It is quite possible that GDP growth may get better (and possible it could get worse), but the impact on growth from Fed policy is very unlikely to be a major factor either way.

So, once again, we find ourselves in a situation in which the market is essentially pricing in a 0% chance of a recession. Given that we are undoubtedly in the latter stages of an economic expansion with an inverted yield curve, potential for increased policy uncertainty, and strained relations with China, this strikes us as being both optimistic and illogical. As a result, we have been gradually paring the risk profile of your fund by reducing our equity exposure and lowering the duration of our corporate debt holdings.

We don’t pretend to know what GDP growth will be in 2019, 2020, or 2021, and we are not in the recession forecasting business. We deal with probabilities. When the market becomes convinced that there is 0% risk of a recession and valuations rise, we will take the over and be more conservatively positioned. When the market becomes convinced that there is a high risk of a recession—as it did in November and December of last year—and valuations become more attractive, we will take the under and be more aggressively positioned. When an outcome is uncertain, like with GDP growth or interest rates, but the market prices in a very high probability of one outcome, taking the opposite view can create a very positively skewed risk-adjusted return. This works for macro variables such as GDP, interest rates, and currency, and it can also work for sectors that can be influenced by these variables.

Last year, your portfolio management team went from being underweight utilities at the start of the year to being massively overweight in February–March, and by September, we were about 1,000 basis points overweight to the sector. There were multiple reasons for this decision, including the fact that utilities’ growth rates have increased due to structural factors, other defensive sectors face secular risks to their business models, and utilities are the one sector that could potentially benefit from a regime change in the U.S. 2020 presidential elections. However, in the very short term, the reason we got this opportunity was because the market was convinced interest rates would go straight up, and no one wants to own utilities when interest rates are going up. Yet, utilities were already trading at discounted valuations that mostly reflected this market perception. Hence, if interest rates increased and valuations fell to absolute trough relative valuation levels, we thought we could still likely generate low-single-digit returns over the intermediate term. Given our mandate of preserving capital over the intermediate term, when a worst-case outcome is low-single-digit returns, that is something that excites us.

But what if interest rates declined? No one thought it was possible, and, again, the market was embedding in the valuations of utilities a very high probability that rates would increase. When interest rates fell, many of our utilities appreciated by 40% or more over the next year or so and vastly outperformed the market. The market had essentially said the odds of interest rates going up were 90%+, when in fact they were probably closer to 50%. We did not know which way rates were going to go, but because the market had put way too high of a probability on an uncertain outcome, we had the opportunity to invest in a very positively skewed risk-adjusted return opportunity that ultimately generated significant alpha for our shareholders.

Finding these types of market inefficiencies and exploiting them for our shareholders has been a meaningful driver of the alpha we have generated for our clients over the last 13 years. It is also what makes this job so much fun at times.

44 Replies
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Contributor ○

Re: PRWCX report

Thanks for posting that. I have taken notice that PRWCX has been doing quite a bit better than one might expect from its allocation. Don't ask me why I watch it, being a closed fund of which I don't own a share of. PRWCX envy I guess. :-)

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Explorer ○

Re: PRWCX report

Thanks FD for posting it.

I thought I need an investment adviser to adjust my holdings for me when recession comes.

But I think PRWCX manager will do it in the fund.. more reasons to add more to the fund.

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Participant ○○○

Re: PRWCX report

Even before I read this, I had upped my stake in PRWCX because I noticed they were accumulating dry powder.  I owe Limoman for his posts on balanced funds over many years that convinced me to put some money in them, including PRWCX, now my biggest holding by far, more and more each year.  I don't see him posting nowadays, but if he is reading this - Thank you.

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Participant ○

Re: PRWCX report

FD1001,

Thanks. It is instructive to see to how well the manager handled the downturn in 4Q of 2018. I will increase my allocation to PRWCX in my IRA account. 

I have a small amount of PRWCX in taxable account. I am hesitant to have a bigger position. I am thinking of using SDY and USMV ETFs. But my instincts/decisions are contrary to what PRWCX has done in the 2018-19 time periods. 

In the Overall portfolio I have 20% in PRWCX. .

SRT

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Frequent Contributor

Re: PRWCX report

Gratifying to read, since this is exactly what I TRY to do - albeit with less information and expertise than (I hope) management employs.  The only difference is that I was buying PCI/PDI after the pullback rather than equity. 

I suspected as much, given their modest movement during recent 'up days'.  PRWCX is my largest holding as well (unless one considers cash in MM), but that is as much luck as anything.  For sure, all of my high-flyers have been pruned!  ;-)

On the minus side, I exited my inflated PDI too soon and only bought half of it back (as PCI)!  Oh well; can't hit home runs without the occasional strike-out!  8^b

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Explorer ○○○

Re: PRWCX report

...."So once again we find ourselves......"

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Contributor ○

Re: PRWCX report

That’s why I have approximately $2M in the fund (albeit the lower ER institutional class shares - TRAIX).  

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Contributor ○

Re: PRWCX report

"We took advantage of this opportunity by aggressively adding to equities and went overweight equities on Christmas Eve of last year."

PRWCX management is either lucky or they have more going on than they are not elaborating on. I am sure the latter. I can understand a contrarian approach and also buying when valuations are lower, but what are they not sharing that motivated them to buy on Dec which was THE bottom of the dip. Not on the way down nor on the way up somewhere near the bottom, but this was the very bottom, THE day to buy in. Did they know that the market wasn't going to fall lower, or that there wouldn't be a bounce? If so how?

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Frequent Contributor

Re: PRWCX report

It sounds as if it wasn’t as much knowing as it was playing the odds. The operative question of the time was: is this the end, or are we thinking correction. If correction, at what point do the odds shift our way?  The rest is just luck. 

For myself, I wasn’t entirely sure that it wasn’t the end! What I did think was that yield was going to become important.

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Explorer ○○○

Re: PRWCX report

and what percentage of your portfolio total is that?  for all we know, it could be but 10% and, if so, wow and good on yee!

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Frequent Contributor

Re: PRWCX report


@fffloyddd wrote:

and what percentage of your portfolio total is that?  for all we know, it could be but 10% and, if so, wow and good on yee!


Not sure who you're asking.  If me, then I'm about 18% PRWCX and 13% PCI/PDI.  Probably near 50% MM at the moment.  To me, EVERYTHING is looking a little long in the tooth, and I want dry powder for buying!  My usual issue is being too early; so missing a little here wouldn't be out of the question.

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Contributor ○

Re: PRWCX report

For me, TRAIX (institutional class shares of PRWCX) is nearly 80% of my personal portfolio. 

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Explorer ○

Re: PRWCX report

Are PCI and PDI leveraged? Thank you.

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Frequent Contributor

Bond CEF Leverage


@OverTheHill wrote:

Are PCI and PDI leveraged? Thank you.


Of course. Check M* and CEFConnect and they underestimate leverage impact.

https://community.morningstar.com/t5/Closed-End-Funds/CEFs-Have-More-Risk-Than-Implied-by-Their-Repo...

YBB
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Explorer ○

Re: PRWCX report

If i own PRWCX in one account, is that sufficient to buy it in another account?

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Contributor ○

Re: PRWCX report

No, it is not sufficient. But check with TRP to verify.


Sent from my iPhone
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Explorer ○

Re: PRWCX report


@chick wrote:

If i own PRWCX in one account, is that sufficient to buy it in another account?


I've heard of people that rolled over a 401k into TRP closed funds, and then bought those same funds in their other retirement accounts at other brokerages. It may be possible, but I have not yet done it myself (although I hope to try in the near future with my wife's old 401k). 

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Contributor ○

Re: PRWCX report

Good point.  If you are transferring a 401K to TRP, then you may have access to certain closed funds.  But call TRP to learn the facts based on your particular circumstances.

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Participant ○○○

Re: PRWCX report


@buddy17 wrote:

@chick wrote:

If i own PRWCX in one account, is that sufficient to buy it in another account?


I've heard of people that rolled over a 401k into TRP closed funds, and then bought those same funds in their other retirement accounts at other brokerages. It may be possible, but I have not yet done it myself (although I hope to try in the near future with my wife's old 401k). 


Yes.  I originally transferred a 401(k) into a rollover IRA and roth IRA and bought PRWCX in both.  Since then I have been transferring 1 share of PRWCX to various accounts outside TRP where I want to buy PRWCX.  No problem.

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