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Portfolio Management Update Spring 2023

Portfolio Management Update Spring 2023

The late-cycle economic phase with high risks of recession calls for a balanced diversified portfolio. With the path of the economy either slipping into a mild recession or narrowly averting one, an asset allocation that addresses both recession scenario and slower economic growth is the prudent approach. Investors cannot ignore the end to this tightening cycle and the opportunity for future growth. There are reasons not to be overly risk off and invests entirely for a recession only. After a recession comes the early cycle recovery which has historically yielded strong U.S. equity returns.

My priority is to continue buying bonds over equities at this point. Bonds offer better risk-adjusted returns than S&P 500 Index (large-cap U.S. equities) for the time being given the risks to earnings and S&P 500 Index forward valuations. However, long-duration assets such as equities and long-term bonds have posted positive forward returns over the next twelve months when interest rates peak. In the expected recession long-term bond prices would rise. I am investing in long term investment grade bonds, and selectively investing in quality dividend growing stocks in both defensive and cyclical sectors that are trading at reasonable valuations. Dividend stocks outperformed the S&P 500 Index market by 4.5% during the 2001, 2008 and 2020 recessions based on research by UBS.

I am underweighting more expensive defensive equities versus cheaper cyclical stocks. Analysts are most optimistic on the Energy sector, and most pessimistic on the Consumer Staples sector according to FactSet. I would rather accumulate more shares in high quality economically sensitive stocks while they are cheap versus investing in overpriced defensive stocks. However, I am selectively investing in defensive stocks, mostly Healthcare, and some Consumer Staples, given recession risks. Cyclical stocks outperform Defensive stocks mid-way through a recession when the Fed starts cutting interest rates according to NDR. The Fed is likely to cut rates early 2024 or sooner depending on inflation level. Defensive sectors would outperform cyclical sectors if recession forecast won out and typically for a few quarters after rates peak based on NDR research. Again, a lot depends on how high interests rise - "higher for longer" favors Defensive sectors. To hedge against "higher for longer" I prefer Ultra-short adjustable-rate investment grade bonds that should preserve capital better than defensive Utility stocks and Consumer Staple stocks.

I am continuing to add to long term fixed-income investments that perform well during periods of recession and yield more than Utilities and Consumer Staple stocks. Bonds historically have risen in most years when stock returns declined, thus helping to diminish losses in portfolios. Most bonds offer some ballast, although long duration US bonds have provided larger stock-market downside protection than short term US bonds and foreign bonds according to Morningstar research.

I have a laddered approach towards bond component management. Assets are spread across short-term bonds, intermediate bonds, and long-term bonds. Recent bond investments have a bias towards long term bonds. Investment grade bond prices fell about 30% last year. Those bonds mature at par offering opportunities for capital gains. Meanwhile, the yield on those bonds exceeds 5%. Bond investing prior to a final rate hike has provided positive bond returns, as measured by investing in the Bloomberg US Aggregate Bond index, a proxy for the US Bond market. There were six tightening cycles over the last forty years. Investing in bonds using a dollar-cost-averaging strategy over 12 months, six months before the final rate hike, would have returned a range of 3.3% to 10.2% in the first 12 months. Annualized returns over five years range from 5.9% to 15.6% according to research by Capital Group.

Investment grade long term bonds are a better recession hedge than short-term maturities. Long Treasuries offer protection against stock market declines caused by caused by a recession. Treasury bonds have outperformed Treasury Bills during deep recessions in the past twenty years according to Morningstar study. Even though long-term bonds yield less than short term bonds, investors profit could be higher based on price gains from long term bonds that short term bonds cannot provide to investors when the Fed eventually cuts rates. Since 1974, intermediate-term bonds outperformed short-term bonds after the peak Fed Funds rate according to Charles Schwab research.

What areas of the stock market are most attractive to me? Areas in the market and individual equities that are trading at more reasonable forward multiples. Foreign stocks for one, Healthcare, Energy, selected Financials, and US Small-cap. US Small-cap is economically sensitive, however, US Small cap’s valuation has discounted a slowdown. If lower inflation allows the Fed to wrap up its tightening cycle while the economy and job market are not in recession, cyclical sectors would be the outperformer over defensive sectors. Moreover, U.S. Small caps lead equity markets on the way out of a down market after yields peak. Rate volatility is expected to decline this year. As it declines U.S. Small caps should catch a bid probably in 2H.

Healthcare and Energy are attractive based on valuation and cycle analysis. Studying sector performance following the last hike of a tightening cycle over the last four tightening cycles, shows the general trend of most sectors was higher. Energy and Health Care were the only two sectors that showed the highest consistency in positive returns over twelve months forward according to BIGS research. My favorite defensive sector, Health Care, has a consistent record of outperforming around the end of tightening cycles and the start of recessions. It is less economically sensitive than most other sectors.

Energy’s outlook has tended to be more closely tied to the economy. Oil prices have fallen when the economy has been in recession, a negative for the sector given its strong correlation with the commodity. However, the US Government has severely drawn down its strategic oil reserves – lowest level since 1980’s. It is now buying back oil thereby propping up prices as the economy slows down. China’s economic growth is gradually improving, inadequate capital investment in carbon fuel, OPEC plus oil supply cuts, supporting higher oil prices ahead. Demand exceeds supply. Lastly, Energy is one of the few sectors reporting margins above its 5-year average and is the cheapest sector according to FactSet.

I am slightly favoring Growth stocks over Value stocks because of better sales and earnings resiliency. Sales growth becomes scarce as the economy slows down. Certain growth stocks can perform better in that type of environment than Value stocks that are highly economically sensitive. Furthermore, high quality growth stocks tend to outperform when bond yields peak and in an environment of declining yields that would occur if the U.S. economy contracted. Technology has been acting defensive for the first time since COVID outbreak mini recession. Growth stocks tend to outperform Value stocks in the first three months after a peak in rates. Thereafter, in a recession, Value tends to outperform as economy gradually re-gains its footing based a study by NDR.

What else is attractive to buy in equities? The U.S. Dollar Index is in a down trend which I expect to continue as Fed hiking cycle is nearly finished. Developed Foreign stocks outperform U.S. large caps when the U.S. Dollar declines. Foreign stock valuations have priced in a lot of bad news and are selling at a historical discount and higher earnings growth than the S&P 500 Index. I am increasing exposure to developed market foreign stocks in accounts to a neutral weighting from extreme underweight position. Developed Market Foreign Equities are outperforming the S&P 500 Index year-to-date and receiving greater investment inflows according to State Street Global Advisors.

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. The Floating Rate ETF investment I invest in has a higher yield than 1 Month, 3 Months, 6 Months Treasury Bills, and 1 Year Treasury Note.
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