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Portfolio Management Actions Winter 2023
The late-cycle economic phase with stagflation conditions and high recession risk calls for a balanced diversified portfolio. With the path of the economy highly uncertain, an asset allocation that addresses both recession scenario and slower economic growth is the prudent portfolio strategy. Bonds offer better risk-adjusted returns than equities for the time being. Although selective economically sensitive stocks offer greater long-term growth potential. I am staying balanced with a laddered approach towards investing in investment grade bonds, and own quality dividend growing stocks both defensive and cyclical ones.
The S&P 500 Index forward 12-month P/E ratio is 17.3, which is below the 5-year average, and trading at a valuation associated with economic expansion. The S&P 500 Index is not cheap by any means. The S&P 500 Index normally trades at a P/E of 14-15 times in a slow growth economy and much lower in a recession. I would rather buy quality bonds over stocks for the time being out of concerns for further cut to earnings in a recession. There are other parts of the global equity markets that are trading at cheaper levels discounting a mild recession already. Foreign Large cap equities and U.S. Mid-Small-cap equities are two areas that come to mind. I am dollar-cost-averaging in both areas now. The stock market low, if not already in, should be sometime this quarter, presenting the best buying opportunity for economically sensitive stocks in years. Fed policy is a headwind for stock earnings until the Fed is finished hiking FFR. Cyclical stocks outperform Defensive stocks mid-way through a recession when the Fed starts cutting interest rates according to NDR.
The yield curve is deeply inverted signaling a recession this year. The spread between the yields on the 10-year and 3-month U.S. Treasuries reached a level where a recession is a highly likely event this year according to Bespoke. Quality Long term bonds had one of their worst years on record in 2022, as higher rates deeply discounted into prices lower coupons of seasoned bonds. The rise in rates and spreads has vastly improved bond valuations back to more normal levels. History shows that investment grade bonds had positive returns during recessions and Late cycle after Fed stops hiking rates based on research from Capital Group. Clients' accounts fixed-income component has a laddered approach towards bond portfolio construction. Assets are now spread across short-term bonds, intermediate bonds, and long-term bonds. I am tilting away from short-term bonds toward long term bonds this year. Last year it was the opposite. I’m only buying investment grade bonds…no junk given recession risk.
What areas of the stock market are attractive to me? Quality cyclical value stocks that are growing dividends. It was a record year for S&P dividend payments. S&P Global projects that 2023 will be a banner year too. Dividends represent as much as 40% of long-term total returns from the S&P 500 index according to S&P Global. Dividend growing stocks are in favor because many are low P/E cyclical value stocks that investors prefer over high P/E Growth stocks in an environment of declining earnings. Investors can’t overpay for company earnings in a tight monetary environment.
Historically Cyclical Value stocks outperform Growth stocks after market bottoms unless Growth is cheaper based on NDR research. I continue to invest in Energy, Material, and Financial stocks, all cyclical value stocks, appear cheap based on current price-to-earnings and free cash flow. Energy is also a buy because China’s economy is opening. When yields peak, other cyclical sectors such as Consumer Discretionary, and Technology should be a buy, and rally.
Hold on to Technology and other sectors that have fallen. Following down years, with expectation of an up year ahead, investors should buy what has underperformed and sell what outperformed. Technology and Consumer Discretionary stocks have underperformed Utilities and Consumer Staples. Since 1990, when the market had a down year, the four worst-performing sectors went on to beat the S&P 500’s typical gain of 14.0%, 56% of the time according to CFRA. Consumer Discretionary, Information Technology, and Communication Service sectors are expected to see the largest price increases among all S&P 500 sectors in 2023 according to FactSet.
What else is attractive to buy in equities? Besides Small-caps, Mid-cap stocks are a buy since poor fundamentals appear to be priced into current valuations. Price-to-earnings of Mid-cap versus Large-cap stocks are at bottom-decile levels not seen since the early 2000s according to Fidelity.
The US Dollar Index is in a down trend which I expect to continue as Fed hiking cycle is nearly finished. Developed Foreign stocks outperform US large caps when the U.S. Dollar declines. Foreign stocks have outperformed U.S. stocks since early December. Foreign stock valuations have priced in poor economic fundamentals and are selling at a historical discount to U.S Large-Cap stocks. I am increasing exposure to developed market foreign stocks in accounts to a neutral weighting from extreme underweight position.
I continue to invest cash-equivalent holdings in investment grade ultra-short bonds, and floating rate notes. Those investments offer the best combination of current income, low interest rate risk, and capital preservation.
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