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Portfolio Management Actions Spring 2022

Portfolio Management Actions Spring 2022

Portfolio strategies are closer to their neutral weighting in equities because it pays not to fight the Federal Reserve (Fed). The Fed is removing liquidity from the economy by hiking its key interest rate and reducing its Balance sheet (not buying Treasuries). The S&P 500 index has an inverse relationship to the Federal Balance sheet. When the Federal Balance sheet expands the S&P 500 Index moves higher and when it shrinks so do stock multiples. This year poses numerous headwinds for stocks and bonds.

The U.S. economy is in early Late cycle experiencing stagflation. Certain areas of the equity market have more upside than other areas. Those areas are Energy, Commodities, Materials, Technology, and Consumer Staple sectors. In addition, defensive type sectors such as Healthcare. Portfolios will remain underweight in bonds and near neutral in cash-equivalents and ultra-short bonds until the second-rate hike. Historically, by the Fed’s second-rate hike bonds become a buy.

I am rebalancing portfolios from neutral to overweight equities at the beginning of the fourth quarter before mid-term election day. The headwinds troubling stocks now should abate by then producing a strong year-end rally. Until then hold onto stocks which are the best long-term inflation hedge. Many companies have been able to pass on rising costs, and I see low real rates favoring equities.

Inversion of the yield curve does not always lead to a recession, and if it does then the typical recession is 6-to18 months away and the S&P 500 continues to rise after inversion for a while. Typically, the S&P 500 does not peak until between two and 12-months prior to the onset of a recession or 18 months after an inversion according to Canaccord Genuity.

Do not go all in on recession type investment sectors. An NDR study on crisis events concludes that stocks have seen strong gains in the following months, on average, after the initial event such as the Russia/Ukraine war. Defensive sectors have outperformed cyclical sectors during initial crisis events then cyclical sectors regain leadership months later. It is too late to buy expensive utilities and consumer staple stocks. Investors that do will be painfully whiplashed in a couple of months. Both sectors have the lowest buy ratings by Analyst. Instead, Analyst are most bullish on Energy, and Information Technology. I also want exposure to cheaper late cycle sectors such as Materials and Energy.

I am getting defensive but with areas of the market that will outperform beyond the initial downturn. High quality Large-cap Growth stocks have defensive characteristics such as dependable “earnings growth and free cash flow.” Earnings growth will become more valuable as the economy slows down. Profitable Growth stocks with free cash flow outperform after Fed hikes, after valuation compresses, and when economy slows. For instance, Technology stocks underperform most sectors at the beginning of a tightening cycle; however, the tables turn by twelve months outperforming early defensive leaders in the tightening cycle. In addition, defensive Healthcare stocks, generating reliable sales growth, selling at reasonable prices, should outperform as the U.S. economy slows down. Healthcare is interest rate insensitive.

I am buying Growth stocks selling at reasonable prices (GARP) that are growing dividends. A real hedge against inflation is an investment that is going to increase cash flow over time and use cash flow to raise its dividend. Dividend growth is an inflation hedge because it helps maintain purchasing during inflationary periods. I am buying GARP stocks in the sectors I mentioned.

Energy is my favorite sector. Energy is one of the top performing sectors when the Fed tightens. Moreover, oil prices are highly likely to remain high into 2023 as Europe and the U.S. wean themselves from Russian oil. Over the next few years, the West will try to become independent of Russian energy exports. Even if more supply hits the market, U.S. energy companies can be profitable above $50 per barrel.

Given my view that the economy is slowing in the face of tighter financial conditions ahead, I am favoring Large-caps over Small-caps. Large-caps are more defensive than Small-caps. Small caps are a leading indicator for large caps. Small caps corrected 20%, a bearish signal forecasting slower economic growth. Small-caps underperform when the 2-years Treasury yield increases, and yield curve flattens. When the 2-Year Treasury yield peaks it is time to buy Small-caps again given no recession lies ahead.

I have cut our exposure to European equities and Emerging Market equities to lowest weighting in over a decade as I see the energy shock hitting both regions hard. China’s growth is also slowing because of its mandatory shutdowns of major manufacturing cities to stop the spread of Covid.

Rising rates are a concern for bonds because bond prices decline as rates rise. I am not exposing bond component of portfolio to interest rate risks. I am investing in areas of the bond market that have low interest rate risk such as short-term credits, Senior Loans, and Floating Rate Notes. I can get income that exceeds the 10-Years Treasury bond yield with lower principal risk. My largest fixed income position is Investment grade floating rate notes. Unlike bonds that pay fixed rates of interest, floating-rate notes pay interest at rates that adjust periodically, based on current short-term interest rate. They offer potential inflation protection and a hedge against rising rates which makes them less likely than most fixed income investments to lose value when rates rise.

For high current income that most areas of bond market cannot match, I am buying Preferred stocks. Preferred stocks have interest rate risk like bonds, but some offer floating rate option. Preferred stocks are mostly issued by investment grade banks.

My stagflation risks holdings include energy, Investment Grade Floating Rate Notes, Commodities, and Gold. Gold prices tend to rise in times of geopolitical risk and inflation. Gold usually moves with real yields which consider inflation. If inflation rises and real yields move lower, Gold typically moves higher. I own Energy, materials, and commodities as inflation hedges. Commodities rise in value, as prices rise, and the same for material stocks.
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