Portfolio Management Update Spring 2024

My view is that the U.S. economy is skipping the recession phase and moving on with its expansion. The end to Federal Reserve rate hikes calls for a balanced asset allocation strategy that addresses slower economic growth, potential cuts in interest rates, 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 response to lower interest rates. Also, a balanced strategy would dampen portfolio drawdowns that are likely to come in any year, especially an election year. Goldman Sachs reports that bonds are yielding near their historical average now and bond prices are once again inversely correlated to equities in corrections. 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%.

Historically, tight yield spreads have been positive for stocks as is the case now. When the market has tight yield spreads and falling rates it is even better for stock returns. The S&P 500 gained an average of 19% in the twelve months after periods in which high-yield spreads were in the bottom quartile and 10-year Treasury yields were falling according to Fidelity. If there is a rate cut coming by year-end that would support a strong year-end rally – own stocks to potentially benefit. This combination of tight spreads and rate cuts does not happen often. Moreover, the high yield spread recently reached the bottom quartile of its historical range, suggesting that recession worries have faded. In the past, when high-yield spreads were in the bottom quartile, the S&P 500 index returned an average of 12% over the next 12 months according to Fidelity.

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

Currently the market agrees, cyclical sectors are leading 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. The US economy must fall into a recession for the laggards (defensive sectors) to outperform for one year period. If Q1 earnings and guidance falter than defensive sectors such as Consumer Staples and Utilities could become the leader. I am sticking with cyclical sectors instead of rotating into defensives by selling Growth stocks and cyclicals because they remain the most profitable stocks with the highest sales growth albeit at a premium multiple.

The S&P 500 Index trading at forward P/E valuation of 21 is historically expensive. Just the same, the equally weighted S&P 500 Index is trading at a forward P/E of 17 is not cheap either. The most attractive area of the US stock market is Small-cap 600 stocks trading at a more reasonable valuation. Small-cap stocks trade on a Price-to-book value that in the past has led to strong future returns when economic fundamentals improve. The current P/E valuation is still attractive at a forward Price-to Earnings ratio of 16. CFRA projects S&P SmallCap 600’s earnings growth of 18% this year higher than the S&P 500 Index. The set-up is favorable to overweight Small caps. Small caps start outperforming when yields peak. Yields have cyclically peaked and recently backed up to year-to-date highs because the Fed has backed off on rate cuts for the time being, so prices have pulled back. I am using this as a buying opportunity. The market is more likely to broaden out into Small caps when rate cuts seem more certain. Historically, highly economically sensitive Small-cap stocks lead in a recovery cycle.

At the sector level, the Information Technology sector is expected to see the largest price increase, as this sector has the largest upside difference between the bottom-up target price and the closing price. The Communication Service and Energy sectors have the highest percentages of Buy ratings, while Consumer Staples sector is among the lowest percentages of Buy ratings according to FactSet.

I am overweight in the Technology sector. The Technology sector is almost 30% of the S&P 500 Index. Its importance in the global economy continues to expand. It is early days for AI, there are only rough estimates on how large the potential market will be. PricewaterhouseCoopers estimates it could be $15.7 trillion by 2030. The AI market could be larger than those of previous technological advances such as the internet and smart phone. The advent of AI has started a super cycle for the semi-conductor industry. Semis conductor sales are experiencing a cyclical recovery that could last for the next decade as AI uses proliferate across all economic sectors from industrial, financial, to healthcare. Technology stock valuations are not at extremes like at the peak of the tech bubble trading at a forward price-earnings (PE) ratio of sixty and higher without profits! The Invesco S&P 500® Equal Weight Tech ETF trades at a Forward P/E of 23 with an ROE (profit measure) of 30! The Fidelity MSCI Information Tech ETF trades at a Forward P/E of 29 with an ROE (profit measure) of 39. Most Technology stocks are trading at a premium because their sales growth, earnings growth and profit margins are superior to other sectors and stocks.

So what else 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. Next, the Energy sector is an overweight position and hedge sector for the rest of the portfolio. It should hedge against geopolitical risks and oil supply threats. Absent of those risks, the energy position could 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 energy sector is expected to see the largest price increase among all sectors and has among the highest percentages of Buy ratings according to FactSet.

I continue to invest in intermediate to long investment-grade corporate bonds yielding about 5.5%. The excess yield over 10-year Treasury is over 1% and the credit risk is not much over US Treasuries which have greater interest rate risk. If the Fed cuts, I expect some price appreciation of about 5 to 9% depending on 1- 3 rate cuts over next 12 months. I prefer intermediate bonds with less interest rate risk than long term bonds for the moment. There could be upward pressure in long term bond yields in the form of selling and a buyers strike if the US Government continues to spend and borrow beyond its means – Government debt is now a whopping $34 trillion!

I prefer Investment Grade over Non-investment grade because they are cheaper. The difference between investment-grade and high yield credit spreads are below its historical average according to State Street Global Advisors. Also, Fitch Credit Rating agency projects non-investment grade bond defaults to rise this year. Moreover, high-quality bonds have tended to provide the important benefit of diversification from equities. In the past, investment grade Long-term bond prices have risen during periods of recession or crisis. Those bonds function as “portfolio insurance” that help offset equity risk in portfolio.

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. Overall, bond allocation is tilted to short-dated bonds that thrive in a higher for longer rate scenario and protects against interest rate risk. The intermediate bond exposure which I favor now protects against reinvestment risk, and I own long-dated bonds address a hard landing outcome for the US economy and purchasing power risk. I am more cautious on long term bonds now that there will be fewer rate cuts coming and the Government may destabilize the long end of the yield curve with its borrowing needs from running budget deficits in the trillions.

Lastly, cash equivalents remain attractive for now but could become less attractive as compared to longer dated fixed income investments when the Federal Reserve eventually cuts – that could be sometime from now.

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.