Portfolio Management Actions Winter 2022

Portfolio Management Actions Winter 2022

I’m gradually reducing overweight in equities towards neutral by quarter end. Large-cap Growth stocks are not likely to repeat last year’s performance. It is time to balance between Large-cap Growth and Value stocks. Market and macro-economic conditions suggest that Value outperforms. This year is a return to normalcy for earnings, economic growth, yields, and inflation compared to history. Normalcy supports equity markets. The US economy is moving away from Mid-cycle fundamentals towards early Late cycle. Portfolios will remain underweight in bonds until the Ten-Years Treasury yield peaks this cycle.









The U.S. economy is normalizing, and the risk of a significant correction looms this year. I have been gradually reducing equity exposure in accounts. I am shifting my equity exposure into different sectors and types of stocks than last year but remain overweight in equities.

TINA is still the playbook for investing in 2022. Inflation rate of change is peaking but inflation will remain elevated. S&P 500 stocks have done well in inflationary periods. When inflation has averaged 2-3% stocks averaged 14.2% annualized average returns. When inflation rose to 3% level returns fell to 10.8%. Stocks returns are negative when inflation is persistently above 6% according to Bloomberg.

A gradual Federal Reserve tightening cycle is friendly to real assets such as stocks. In general, given rates and yields modestly rise, stocks typically outperform bonds. The greatest risk to stocks is a faster tightening cycle that inverts yield curve thereby precipitating a recession. Which one we get depends on inflations future path.

I am buying stocks that do well in rising rate world that can raise prices. Inflation is not going away soon. In a period of rising inflation own real assets such as stocks and not bonds and cash-equivalents. In a market environment with higher inflation, I prefer reasonably valued large-to-mid size companies characterized by high profit margins, sustainable earnings growth, and dividend growth. I sold high Price/Sales stocks except for a few small positions.

I think dividends will play a bigger role in investor returns this year given. Earnings per share growth leads greater dividend growth rates by three quarters. I anticipate higher dividend payouts this year particularly in Energy stocks flush with cash that will not be reinvested into oil drilling and exploration. Goldman Sachs research projects firm oil prices in the 70’s or higher. The is a structural shortage and US energy policy is extremely supportive of higher energy prices.

I have bought Value stocks. Value stocks tend to outperform Growth stocks in periods of economic strength, rising rates and higher inflation. Growth stocks are more expensive than Value stocks. At current levels, the ratio between the Value P/E ratio and the Growth P/E ratio at its current level has only been lower during two other periods over the last 25 years.

The US economy is slowing from hyper growth rate to an above average rate of growth this year. It is not projected to grow at stall speed which would require a more defensive tilt to stock holdings. It is too early to hide in defensive large-company stocks found in utilities and consumer staples. The shift upwards in the Yield curve implies that the U.S. economy is entering its early Late cycle economic stage that favors energy, basic materials, and financials into several rate hikes. The late cycle sectors are cheaper and offer more growth than the defensive sectors.

My favorite sectors are a mix of Value sectors and Growth sectors: Energy, Financials, Healthcare, Consumer Discretionary (re-opening III as Omicron fades and employment rises), and Technology. Analysts are most optimistic on Energy, Communication Services, Technology, Healthcare, and Consumer Discretionary this year. Those sectors are economically sensitive ones, except for healthcare and not defensive ones such as Utilities, and Consumer staples. Although the Utility stock dividends may appeal to income investors, their already high valuations compress if interest rates rise. Furthermore, sales growth is extremely low. Sell-side analysts are bearish on Utilities more than any other sector. The same is true for many consumer staple stocks.

Earnings and sales growth are highest for Industrials, Consumer Discretionary, Energy, Communication Services, Technology, and Healthcare. Those are the sectors to have at least a market weight exposure. I have added Financials to that list which typically are more profitable in a rising interest rate environment. Energy and Financial sectors have the highest profit margins among eleven sectors reporting. Both sectors rank at the top in sales and earnings growth for this year.

I really like Healthcare. Healthcare valuations are trading at attractive levels compared to S&P 500 Index at full valuations. Healthcare stocks have exceedingly high profitability, pricing power, and are insensitive to rising rates. Demand will still be there when rates are one percent higher. In addition, Pharma stocks are raising dividends 4-10% annually. I screen for stocks that have high ROE, high FCF, and healthy Financials.

I trimmed Technology from an outsize overweight to overweight. Technology sector underperforms when rates rise. A one percentage point increase in Fed Funds rate decreases Technology stock valuations by 10-20%. The high multiple Tech stocks have gotten slammed. Valuations are still at a premium but sales, earnings, free cash flow, and margins justify premium valuation.

I also like Energy a classic late cycle sector. The underinvestment and restrictive development policies could keep supplies limited and prices trending higher over the long term. Earnings revisions for Energy Sector are the highest among all sectors. Furthermore, current geopolitical risks favor higher oil prices if Russia escalates tensions in Ukraine.

Its time start adding to our underweight position in developed foreign stocks based on a regression to the mean trade. U.S. equities are selling a premium to foreign equities. The ratio of the S&P 500’s P/E Ratio to the MSCI World Ex US Index is currently just under 1.49 which means that US stocks trade at nearly a 50% premium to the rest of the world compared to an average of 4% over the last 25 years. The Omicron variant is projected to peak in February thereby opening the world economy this Spring again. Foreign central banks are removing stimulus and global bond yields are rising a sign of better global growth ahead. If US dollar weakens against basket of foreign developed economy currencies then foreign stocks should perform well.

When the Fed starts tightening, it is wise to buy high quality bonds versus non-investment grade bonds. Return of your money becomes more important than extra yield on your low-quality fixed income investment. When Fed tightens, credit spreads tend to widen, and volatility in bond market picks up. Credit defaults and downgrades projected to be below average for 2022 so I still favor credits over Treasuries. I will remain overweight in Adjustable-Rate Senior Bank loans. A modest widening of credit spreads would not be a problem for economy and markets given current tightness of spreads.

I have a significant underweight in Treasury securities exposure. Purchases of U.S. Treasuries has started to decline as the Fed is ending its asset purchase program in March. Treasury prices are declining, and yields are rising. Eventually, quality bonds will offer an attractive entry point. When the 10-Years Treasury yield peaks it is time to extending the duration of the bond component to high quality long and intermediate corporate bonds. Inflation will be retreating when the time comes. I continue to increase cash-equivalent and high-quality short-term bond positions in response to market volatility.