Investing In A Future That Is Enigmatic And Unknowable: An Income-Compounding Approach

Back in January 2022, we thought we knew that the world was recovering from a nearly two-year long pandemic, and that although supply chains were impacted, and labor shortages were starting to hurt the economy, very few people knew or could even predict that Putin was getting ready to invade Ukraine, and that inflation would then soar, forcing the Fed to significantly raise interest rates. The forecasts for the 2022 stock market at the start of the year were mostly optimistic, or at least not overly pessimistic, after a stellar 2021. Other than those who did see potential for growth in energy stocks like Exxon Mobil (XOM), nobody really thought that 2022 would end up being the worst bear market since 2008, with the S&P 500 (SP500) ending the year down 20% and the Nasdaq down more than 33%.

Now, as we start a new year in 2023, the majority of pundits and prognosticators are highly (possibly even overly) pessimistic on average regarding the outlook for 2023 stock market performance. Most SA contributors are expecting negative returns in 2023, and a recent article on Yahoo highlighted 8 recession warnings from “top commentators” including Michael Burry of Big Short fame; Andy Jassy, CEO of Amazon (AMZN); Mark Zuckerberg, CEO of Meta (META); and Leon Cooperman among others. I was particularly struck by Cooperman’s comment,

“My recession thesis is the basic belief that we’ve borrowed from the future and we’re going into a period of time where that borrowing has to be given back.” (Cooperman said recessions typically last around a year, but the next one could persist for longer for that.)

It is his view that others share, that we are about to enter a multiple-year recession with negative to sideways growth in the markets. Other views support the notion that 2023 will essentially result in more volatility in the market with sideways to no growth by year end.

Reasons for Optimism in 2023

Some believe that until we see a Fed pivot, stocks in general, and growth stocks in particular, will continue to suffer. With inflation beginning to come down, it is possible that the Fed could decide to stop raising rates sooner than most expect, as explained in this recent article from SA contributor Atlas Equity Research, where the argument is made that recessions are beneficial to the economic cycle. If the Fed does pivot in the first half of 2023, I prepared a 2022 Christmas wish list of growth stocks that are trading at value prices to consider buying.

Another potential reason for optimism in 2023 is the prognostications of another SA contributor, Avi Gilburt, who uses Elliot Wave analysis to predict the market direction based on investor sentiment, as opposed to market fundamentals. In his December 5 public forecast, he stated:

In very simple terms, as long as this pullback holds the 3700-3870SPX support region below us, we should be setting up to rally to the 4300SPX region, with potential to even exceed it, depending upon the structure the market takes over the next two weeks.

The S&P 500 index closed out the year at 3,839.50, which is at the upper end of the support region. This would imply, given his stated expectations of probability, that his technical analysis supports a move higher to around 4,300 in 2023. Of course, I am simply paraphrasing what he wrote, and his updated expectations may now differ from what he wrote a few weeks ago.

In addition to a possible Fed pivot and market sentiment shifting from bearish to bullish, there are other potential reasons for optimism, including a possible end to the war in Ukraine, as outlined in this article from Victor Dergunov, who has a first-hand perspective.

Of course, there is no way to know what will happen in the future and whether some other black swan event may occur which could tip the scales back to negative sentiment and poor market performance. History is useful in attempting to plan for future outcomes, however, as Jim Sloan explains in his article, annual forecasts are essentially useless, but plan anyway.

Review of Major Asset Classes

One of the unique aspects of the 2022 market performance was that bonds did poorly in addition to stocks and cryptocurrencies and REITs, and even gold. There seemed to be no safe haven for investors other than the energy sector and commodities in general. In his year-end review of major asset classes, SA contributor James Picerno provided this snapshot view of 1-year, 3-year, and 5-year total returns by major asset class:

This really puts into perspective what happened with U.S. stocks over the past 5 years, with nearly 9% total returns vanishing in 2022 to nearly -20% returns. For long-term “buy and hold” or even for DGI (dividend growth) investors, the recent performance of U.S stocks has been discouraging to say the least. For this reason and due to my decision to retire later this year, I shifted my mindset and my portfolio composition in early 2022 to invest more in commodity funds like SPDR SSGA Multi-Asset Real Return ETF (RLY), and some energy stocks such as the MLP fund, Kayne Anderson Energy Infrastructure Fund (KYN), and less in individual stocks and equity funds. I have also been building out long-term holdings in various high yield income vehicles such as business development companies (“BDCs”), fixed income and multi-sector closed-end funds (“CEFs”), exchange-traded funds (“ETFs”), and, most recently, preferred shares of several real estate investment trusts (“REITs”).

Investing with an Income-Compounding Approach

Back in November, I did a review of my newly structured retirement income portfolio, which I call my No Guts No Glory portfolio. That account is held in an individual IRA with TD Ameritrade (now Schwab) and represents about one third of my overall retirement income stream, the others consisting of Social Security (whenever I decide to take it), and a pension that includes a partial lump sum payout along with a monthly pension for the rest of my life.

The approach that I am taking in my No Guts No Glory portfolio includes mostly monthly dividend paying funds that offer high yield income, with most exceeding 10% in annual yields and several offering much higher yields such as the Cornerstone funds – Cornerstone Total Return fund (CRF) and Cornerstone Strategic Value fund (CLM). In some cases, I use dividend reinvestment, taking advantage of the DRIP programs that those funds offer, which often includes a significant discount on the reinvested shares as I explain in my article about CRF, which enables that future income stream to grow exponentially.

I have modeled my income compounding approach by following the ideas espoused by Steven Bavaria, another of my favorite SA contributors, who reviews his Income Factory strategy here. This approach requires a long-term view on the markets and allows income-oriented investors an opportunity to benefit from bear markets by acquiring new shares of income producing investments at lower costs. Those additional lower cost shares then increase the future income stream even further by compounding the investment returns over time. Compound interest is what Albert Einstein suggested is mankind’s greatest invention, the most powerful force in the world (or as some claim, the 8^th wonder of the world). Or as Ben Franklin described it,

“Money makes money. And the money that money makes, makes money.”

The idea of income compounding is that the increasing share count leads to increasing distributions each month. And as long as those distributions get paid out to shareholders each month, the amount grows over time providing a passive income stream in the future. And even if the total return (share price plus distributions paid) may vary from year to year with some negative years like 2022, the income continues to grow.

One way to illustrate this concept is to view the annual returns and annual income generated from investing in CRF and CLM. If an investor bought $10,000 worth of CRF and the same amount of CLM in 1985 and reinvested those dividends, they would have received $13,759 in income from CRF and $17,499 from CLM in 2022. These results are illustrated using Portfolio Visualizer.

While this concept may be obvious to some, there are those who remain unconvinced that the total return on an investment is not as important as the income generated. In fact, I have read several comments from readers on SA who state that the future is unknown and unknowable and, therefore, past performance is really all that matters when determining what to invest in.

As an income compounder, I am less concerned with the previous “total return” over a given time period and more interested in whether the distributions are covered and will continue to be paid in the future, even as I show an “unrealized loss” in my investment portfolio. As long as I do not sell the underlying shares and as long as the fund continues to pay distributions, that interest will continue to compound, and my future income will continue to grow.

Applying the Concepts

Knowing what to buy and when is the greater challenge for income compounders. Naturally, your individual risk tolerance and investment objectives are the most important criteria for deciding when and what to buy. In my portfolio, I have attempted to diversify my holdings to spread the risk and to take advantage of macro trends and opportunities.

As I stated earlier in this article, I moved away from most equity funds earlier this year, with the exception of CRF and CLM, and have been putting my funds to work in fixed income and credit-based funds like Ares Dynamic Credit Allocation fund (ARDC) which I recently covered, and several floating rate leveraged loan funds such as JRO and PHD, which I recently wrote about here and here. I have large allocations to several funds that invest in CLOs such as OXLC, ECC, and XFLT. And I have recently diversified into preferred shares of several REITs, as I discussed in my November article on the Housing market.

I would like to offer one more example to explain why it makes sense to diversify your income investments and take advantage of market trends and macro events that dictate price movements. Over the past 10 years, stocks have outperformed most other asset classes. But the income from high yield investments has grown over the past 10 years even if the total returns for those investments did not perform as well each year during the same period.

As an example, I ran Portfolio Visualizer again, this time using OXLC, CLM, and KYN. These 3 funds represent three different asset classes – taxable fixed income/CLOs, equities, and MLPs. The results are interesting from an income standpoint and help to demonstrate the power of diversification. The analysis used a starting investment of $10,000 in each fund and shows income and annual total returns with dividends reinvested. I also included The Vanguard 500 Index fund as a benchmark. The total 10-year return of OXLC and CLM are quite similar, both substantially outperforming KYN but underperforming against the benchmark. However, the income generated from both CLM and OXLC are also both substantially higher than KYN.

In my case, I am still building out my portfolio and adjusting here and there as trends change. Later this year I intend to add more funds to my portfolio after I retire and receive my lump sum pension payout. If the market continues to decline as many expect, it will be a good time to add to more discounted or mispriced income-oriented investments. With the newest changes from the SECURE 2.0 act being signed into law, I will not be required to take RMDs until I reach age 75, and therefore I will have at least 10 years before I will be required to take any distributions. That should allow me plenty of time to compound my income from my investments to grow my future income in retirement.

I hope that this information is useful to some of you, and I wish you success in your investment endeavors. Regardless of what happens in 2023, I am convinced that my plans for growing my future income in retirement will be easily achieved and I look forward to realizing the fruits of my efforts over time as that income compounds.

Best wishes to all for a healthy, happy, and prosperous new year!