Portfolio Management Fall 2021
Portfolios are overweight equities going into year-end. I see positive earnings outlook until1Q220. Intermediate economic growth will remain above long-term average rate and interest rates historically low (supportive of earnings growth). Mid-cycle fundamentals suggest favoring cyclical value stocks and quality dividend appreciation stocks. Portfolios staying with underweight in long term bonds for now and increasing fixed income investments credit quality.
Stock leadership is shifting from growth stocks that outperform in times of slow economic growth to economically sensitive areas of Small-caps and cyclical sectors. Historically, when yields rise and economy grows at three percent, Value stocks beat Growth stocks, and cyclical stocks beat defensive stocks.
Small-cap stocks are positively correlated to economic growth and rising yields, and so are energy, financial, material stocks. Those sectors also hedge against inflation and rising yields. Current valuations of value equities, Small caps, are more attractive than growth stocks and defensive sectors. Given that the dollar and yields continue to rise due to stronger economic than Small caps should outperform their larger brethren into year-end.
Mid-cycle investment environment favors quality dividend appreciation stocks over pricy growth stocks. With rates still well below their historical levels, portfolio returns will come more from stock appreciation and dividend income than from bond interests. Dividend paying stocks are particularly good inflation hedges—as stocks are real assets, unlike bonds. Companies can pass along the cost pressures they face in price increases for their goods— dividends and earnings kept up with inflation in the high inflation environments of the 1970’s and ‘80s. I have been buying dividend stocks in the Tech, Energy, and financial sectors.
I favor quality stocks and quality bonds from this point going forward. Before first rate hike leadership switches from low “Quality” coming off a recession to “Quality” before economy enters late cycle stage. For stocks that means companies with high profits, sales growth, companies growing dividends, and free-cash-flow. And for bonds investment grade only.
At the sector level, besides Technology, I am buying stocks in cyclical sectors such as Energy, Financial, Communications, Technology, Industrials, and Consumer Discretionary. Analysts are most optimistic on the Energy, Communication Services, and Technology. Consumer Staples, a defensive sector expected to underperform. At the sector level, information Technology has the highest number of companies issuing guidance and positive revenue guidance of all eleven sectors for the third quarter. Tech sector earnings, revenue, profit margins are rising faster than broader market – its defensive! Industrials, Overall, Consumer Discretionary, Energy Communications, and Technology sector have the best earnings and revenue growth projections for 2022 according to FactSet.
Financials are an interest rate hedge in portfolios. The prospects of a re-steepening yield curve and future higher loan growth means higher profits ahead. Financials are cheap selling at valuations that are thirty percent lower that the S&P 500 Index. Furthermore, banks are free to buy back stock and increase dividend payouts after passing latest stress test.
Holding and adding to positions in Energy sector. Biden administration is anti-carbon fuel which supports higher oil and gas prices. There is supply constraint and demand for energy is steadily rising according to OPEC. Most projections are for oil demand to climb by 7% on average through 2030. The oil market is transitioning from supply-driven to demand-driven. Global economy runs on oil, and natural gas, and it is consuming more it than ever before. Lastly, Energy is an inflation hedge, for dividends, and growth.
I am underweight Foreign and Emerging market equities. I like European stocks over Chinese stocks. The economic restart has been broadening in Europe – aided by an acceleration in vaccine rollouts. This has supported a sharp rise in European corporate earnings revisions. Valuations remain attractive relative to history. Regulator concerns and slowing economic growth weighed on Chinese equities. There is unquantifiable Policy uncertainty in China’s market.
With rates rising, bond sectors that are not so rate sensitive are outperforming. I am overweight Senior Loans, quality Floating Rate loans, Treasury Inflation-linked bonds, and Short-Term bonds.
The most favorable bond sectors offering a real yield that compensates for credit risks are Preferred stocks, and Corporate Senior Loans. Moreover, Senior Loans and Preferred offer the best yields per unit of duration risk. High quality and short duration bonds do not yield much but they preserve value better than long term bonds as yields rise.
Preferred dividend yield is 4% plus that can grow, with duration risk lower than the Aggregate Bond Market Index. I think they will become more in demand given income tax rates hikes for high income earners. Many preferred dividends are qualified and taxed at a lower rate than bond interest income. On qualified dividends, most preferred shareholders owe only 15%.
I still like Treasury inflation-linked bonds (TIPS) over Treasury bonds due to higher inflation expectations. TIPS have no credit risk and would outperform Treasuries given inflation stays elevated.
I am gradually moving from non-investment grade to investment grade over the next quarters. Credit spreads remain near cyclical lows. Distress ratios and default risks are none threatening. Yet, it is time to move away from non-investment grade securities based on their all-time high prices. The percent of high yield bonds trading over 1,000 basis points at an all-time low. Eighty-five percent of them have a negative real yield! Non-investment grade bonds are unattractive at current price level, no risk premium for credit risk and liquidity risks. Lastly, the lower the yield, the lower the return that investors can expect from their bonds going forward.