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Portfolio Management Update January 2024

Portfolio Management Update January 2024

The late-cycle phase marked by an end to Federal Reserve rate hikes calls for a balanced asset allocation strategy that addresses slower economic growth, lower inflation, and an eventual rebound in interest rate sensitive investments. A balanced strategy, investing more evenly in both stocks and bonds offers current income, and potential appreciation in equity and bond prices as the stock and bond markets rally in response to lower interest rates. Also, a balanced strategy would dampen portfolio drawdowns as Goldman Sachs reports that bonds are yielding near their historical average now and bond prices are once again inversely correlated to equities in corrections. Historically, S&P 500 index returns are usually positive after peak in yields based on an NDR study. The same can be said for areas of the bond markets. What is more, current bond market yields are historically attractive enough to compete directly with stock returns so on a risk-adjusted basis it makes sense to invest in both.

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 based on research by Capital Group. After the Fed’s final hike in the last four cycles, both equity and fixed income returns produced above average annual returns in the year that followed. After Fed hikes ended, outperformance over cash lasted up to five years, with the first year contributing most returns. The study shows that the Bloomberg U.S. Aggregate Index rose 10.1% on average versus the index’s long-term average is 4.8%. The returns for the S&P 500 Index of 16.2% versus the index’s long-term average of 8.5%. A balanced portfolio of 60% S&P 500 Index/40% Bloomberg U.S. Aggregate Index blend retuned on average 14.2% compared to the blend’s long-term average of 7.4%. Whereas, the U.S. 3-month Treasury-bill retuned 4.7% for the year-after and its long-term average return is 3.2%.

Within equities, I am holding onto Large-cap growth stocks that benefit from AI tailwind and future rate cuts, as well as more cyclical areas of the markets like smaller size companies, and longer duration fixed income assets. This investment allocation may provide more growth and income in a soft-landing economic scenario.

Recent cyclical sector strength suggests the economy is in decent shape which supports a bull market. Recent market breadth is a green traffic light for investors to broaden out their portfolio into cheaper areas of the equity market that are more economically sensitive such as Small-caps, and ones that lagged last year like Healthcare, Consumer Staples, and Utilities.

Currently the market favors cyclical sectors over defensive sectors. If a recession is avoided and the economy skips into a recovery phase, then cyclical sectors outperform defensive based on a study by NDR. In the past, a cyclical peak in bond yields has favored defensives (Health Care, Utilities, and Consumer Staples) over cyclicals over the next 12 months as the US economy struggled with higher rates impact on economic growth. This time it may be different for numerous reasons not to load up on Defensives particularly if the US economy avoids a recession. It still makes sense to invest in selected Defensive sectors that were left behind in last year’s rally if their valuation is cheaper than cyclical sectors. Most Defensive sectors have high valuations, as measured by the Price-to-Earnings Growth (PEG) ratio, a measure of price to future earnings growth, imply that investors may be overpaying for future earnings growth of defensives compared to most cyclical areas of the market. For example, Consumer Staples has a PEG of 2.6 versus 1.2 for the Financial sector, which explains why Consumer Staples and Utilities have a higher percentage of sell ratings than most sectors according to FactSet. I do like healthcare, another laggard, however, it is an election year, and our government could create a “political black cloud” over the group that would weigh on sentiment. I still think selectively buying Healthcare stocks with sales growth makes sense. Research by Bespoke shows that the laggards do initially outperform the S&P 500 Index. However, subsequent short-term performance, over the following six months, was even between the laggards and the S&P 500 index performance. The US economy must fall into a recession for the laggards (defensive sectors) to outperform for one year period.

I am sticking with cyclical sectors instead of rotating into defensives by selling growth stocks and cyclicals like some investors have decided to do. Eventually investors will find their way back into the most profitable stocks with the highest sales growth.

So what sectors am I bullish on? Financial services, a cyclical value sector, is inexpensive and would benefit from a steepening in the yield curve with higher net interest margins for commercial banks. Further loosening of financial conditions would drive loan growth. The financial sector has the lowest forward P/E valuation. What else? The Energy sector has been a laggard in 2023. The energy sector will profit from the re-industrialization of America theme and possible global economic acceleration. The energy sector is the cheapest sector based on forward P/E of all sectors. It generates tremendous free cash flow used for dividends. Energy companies have strong balance sheets that return capital in the form of dividend payments. The sector is expected to see the largest price increase among all sectors and has the highest percentages of Buy ratings according to FactSet. Rising Oil prices in 2H, lower yields followed by a weaker US dollar would be a tailwind for energy in 2024.

Quality Technology and Communication stocks should get a boost in valuation when the Fed eventually eases its key interest rate. A rate cut in 2024 would lower yields providing justification for higher valuations – growth technology stocks typically experience higher sales growth as interest rates decline. The technology sector has the highest forward 12-month P/E ratio, so investors may boycott Tech for a while, but eventually money goes to where it is treated best. Stocks that are reasonably priced with higher sales growth, higher earnings growth, high profit margins, free cash flow, healthy balance sheets. Moreover, chips and software providers benefit most from secular tailwinds such as AI investment thesis. The time to sell Tech is when the Fed is tightening not easing.

What else is a worthwhile broadening out trade? U.S. Small-cap stocks and U.S. Mid-cap stocks are trading at valuations below their ten-year average according to Morningstar. Small-cap stocks are more sensitive to tighter credit conditions that are associated with downturns. Credit conditions should ease in 2024 as monetary policy eases. Small-cap stocks trade on a Price-to-book value that in the past has led to strong future returns when economic fundamentals improve. Current P/E valuation is still attractive at a forward Price-to Earnings ratio of 15. CFRA projects 18% earnings growth this year for Small caps. The set-up is favorable to overweight Small caps. Credit conditions are not unfriendly, Small caps start outperforming when yields peak, and rates are likely to be cut spurring economic growth. Historically, highly economically sensitive Small-cap stocks lead in a recovery cycle.

When the Fed Funds Rate peaks and the US dollar weakens, it is time to invest in foreign developed markets equities. Generally, the U.S. dollar peaks as rates peak. A weaker dollar is associated with higher returns from foreign investments. Morningstar research points out that international equities, Developed Foreign Market Equities, measured by the MSCI EAFE Index, is trading at a discount to its Ten-Year average multiple. I continue to add to developed foreign equities while prices are cheap. I remain underweight in Emerging market equities because of the geopolitical risks surrounding China. My strategy going forward is to buy emerging market equities ex China ETF. I have enough exposure to China in accounts through US multi-national corporation selling products and services in China.

Investment-grade corporate bonds are a major part of each Risk Managed Portfolio’s current income generating strategy this year. Last year, I added to existing position in quality long term corporate bonds. Corporate bonds, whether investment grade or high yield, offer higher yields than government bonds so I choose to invest in Corporates over Treasuries even though there is credit risk in doing so. The difference between investment-grade and high yield credit spreads are below its historical average according to State Street Global Advisors. This implies that non-investment grade credit is more expensive compared to investment grade. Also, Fitch Credit Rating agency projects non-investment grade bond defaults to rise this year. Therefore, long term investment grade bonds seem like a better choice to me. Moreover, 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. In the past, Long term bond prices have risen during periods of recession.

There could be upward pressure in bond yields if the US Government continues to spend and borrow beyond its means – Government debt is now a whopping $34 trillion! Therefore, I have laddered the bond component of each portfolio strategy to protect against various forms of risk: interest rate, reinvestment, and purchasing power. The yield on the short-dated bonds still exceeds long-term bonds so I will use it for current income in accounts until the data says otherwise. The short-dated bonds thrive in a higher for longer rate scenario, the intermediate ladder protects against reinvestment risk, and the long-dated bonds address a hard landing outcome for the US economy.

Lastly, cash equivalents should become less attractive as compared to longer dated fixed income investments over the course of the year as the Federal Reserve is expected to cut interest rates sometime, perhaps as early as May. There will be a decay in yield from cash equivalents and a higher total return (income + potential price appreciation) from longer dated fixed-income investments. Therefore, throughout the year I will be deploying more cash into longer dated fixed income investments depending on macro-economic data.

Past results are not predictive of results in future periods. Sources: Capital Group, Morningstar. data represents the average returns across respective sector proxies in a forward extending window starting in the month of the last Fed hike in the last four transition cycles from 1995 to 2018 with data through 6/30/23. The 60/40 blend represents 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Index, rebalanced monthly. Long-term averages represented by the average five-year annualized rolling returns from 1995. Past results are not predictive of results in future periods. Data represents the average returns across respective sector proxies in a forward extending window starting in the month of the last Fed hike in the last four transition cycles from 1995 to 2018 with data through 6/30/23. The 60/40 blend represents 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Index. Long-term averages are represented by the average 5-year annualized rolling returns from 1995. Past results are not predictive of results in future periods. * For the three-month periods following the final hike, cumulative bond and stock returns outpaced 3-month T-bills by 3.1% and 2.1% and for six-month periods by 4.2% and 5.6% on average, respectively. While money market funds seek to maintain a net asset value of $1 per share, they are not guaranteed by the U.S. Federal government or any government agency. You could lose money by investing in money market funds. The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. The S&P 500 Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks. The S&P 500 is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group.
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