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Portfolio Management Update July 2023

Portfolio Management Update July 2023

The late-cycle economic phase with declining risks of garden variety recession calls for a balanced diversified portfolio with a tilt to cyclical stocks. With the Federal Reserve nearing the end of its tightening cycle and a resilient US economy pushing out any recession, an asset allocation that addresses both slower economic growth and a reacceleration in future earnings is the way to position a portfolio at this stage of the market cycle. Primarily, when the Fed stops tightening then historically it is time to buy stocks, Long-term Bonds, and not Treasury-bills. Typically, stocks and bonds have outpaced cash after a Fed hiking cycle ends.

Stay balanced, own both stocks and bonds. Bonds offer an attractive risk-adjusted return based on the earnings-to-yield ratio comparison. Higher yields mean that bonds are better equipped these days to dampen equity market volatility. Moreover, higher income from bonds also means higher returns. Bonds have tended to recover strongly after rate increases end. Whereas stocks could provide capital appreciation that outpaces inflation as the headwind of rate hikes end.

The Citigroup Economic Surprise Index has been positive for most of the year, historically bullish for cyclical sector leadership. Strong consumer spending and low unemployment could help push off the start of the recession into 2024. Consumer sentiment is improving, a good sign spending may continue even with the current level of interest rates. The University of Michigan consumer sentiment for the US increased in July to the highest level since September of 2021.

U.S. Large-cap stocks have higher valuations and PEG ratios (Current Price/Projected EPS Growth) along with all sectors outperforming this year such as Technology and Communications Services. Higher large-cap valuations imply that company earnings must grow over the next twelve months for the S&P 500 Index to rise. U.S. Small-cap stocks and U.S. Mid-cap stocks are areas of the market not selling at expensive valuations. Earnings growth expectations are set much lower and it is easier to clear the bar. I am investing in U.S. Small-cap stocks. Moreover, in the past U.S. Small-cap stocks have outperformed U.S Lage-cap stocks when the S&P 500 Index has outperformed by this much year-to-date coupled with exceedingly high concentration level in the S&P 500 Index according to NDR.

Wall Street analysts project the S&P 500 Index to rise by 9% over the next 12 months according to FactSet. The bottom-up target price for the S&P 500 is 4823. At the sector level, the Energy and Health Care sectors are expected to see the largest price increases. Whereas the sectors that have led the market in the first half of 2023, Technology and Consumer Discretionary, are projected to produce the smallest price increase. Energy and Healthcare are tactical positions portfolios that I am maintaining.

I am holding onto an overweight position in secular growing Technology stocks. Technology stock valuations tend to rise after Fed Funds Rate peaks. If there is a cut in rates sometime in 2024 because core-inflation is trending towards 2%, then Technology valuations are likely to see a further boost in valuations as interest rates fall. Moreover, if the recovery in 2024 is anemic then growth stocks should outperform on a relative basis over cyclical value stocks. There is a risk that any recovery in 2024 may be weaker if the Fed keeps rates higher for longer. Normally, stronger recoveries are associated with a tailwind of easier monetary policy.

Small-cap stocks are more sensitive to changes in economic conditions. Many of them are more susceptible to tighter credit conditions that are associated with downturns. The recent regional banking crisis has held them back. Tighter credit makes it harder to refinance existing debt. Small caps were discounting at least a slowdown or a mild recession. Small caps start outperforming when credit spread begins to tighten and yields peak. Both conditions are forming now. Small caps may outperform over the next twelve months given economic growth remains positive, interest rates peak in July, and credit spread narrow. The U.S. economy could be transitioning from late stage, a rolling sector by sector recession in 2022, to an expansion in 2024. If the prospects for a soft-landing pan out, then I expect Small- caps to outperform expensive defensive Large-cap stocks over the next twelve months. It has been said that Small Caps lead stocks out of a recession.

When the Fed Funds Rate peaks it is time to buy foreign developed market equities. the U.S. dollar usually peaks as rates peak. The US dollar peaked and has been trending lower over the past few quarters. A declining dollar favors foreign equities over US equities. I am moving from an underweight to neutral position in developed foreign equities. I remain underweight in Emerging market equities because of the geopolitical risks surrounding China. My strategy to buy emerging market equities ex China ETF. I have enough exposure to China in accounts through Apple and other multi-national companies.

I am maintaining quality positioning in bonds even though a garden variety recession does not seem to be unfolding. There is still credit risk as fundamentals could deteriorate under a higher for long-term interest rate regimes. What is more, if growth slows, high-quality bonds have tended to provide the important benefit of diversification from equities. If a recession does occur, more investors could turn to bonds in search of relative stability and income.

Schwab research points out that intermediate term bonds have outperformed short term bonds after a peak in the Fed funds rate since 1974. Shorter-term fixed income has greater reinvestment risk. However, based on Chair Powel’s recent comments, reinvestment risk should be low for 2023. Fed has no intention to cut rates this year. I have an overweight position in short end of the yield curve and gradually overweighting long-term bonds which would begin to outperform when Fed is finished hiking.
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