Portfolio Management Update Summer 2024

My view is that the U.S. economy is in a rare soft landing. The Federal Reserve is likely to cut interest rates in response to cooling inflation and slower economic growth. A balanced asset allocation strategy that addresses slower economic growth, potential cuts in interest rates, and an eventual rebound in interest rate sensitive investments is an appropriate strategy for this type of market environment. A balanced strategy, investing 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. 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.

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 according to a Bloomberg note. 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% when Fed eased. 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. 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 by year-end that would support a year-end rally. 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 Small cap stocks, and an allocation to longer duration fixed income assets. This investment allocation may provide more growth and income in a soft-landing economic scenario.

Based on analysis of leading economic indicators suggests earnings may increase, stocks may have more room to gain, and cyclical sectors may be poised to lead the market. At the sector level, analysts are expecting double-digit growth this year from Communication Services, Information Technology sector. Next year, the Information Technology and Health Care sectors are projected to see double digit growth in earnings according to FactSet. Those are the Growth sectors in which I am investing. Earnings beat rates have generally been better for Growth stocks than Value stocks. The sectors with the highest beat rates are Technology and Health Care. The Tech Mega-cap stocks had the best beat rates by far of all sectors based on Ned Davis research.

I remain 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. Tech stocks’ return on equity is at record highs on an absolute and relative basis. Strong balance sheets with lowest debt since 2018. Normal interest rate levels should not be a headwind for many Technology stocks.

Technology stock valuations are not at extremes compared to the peak of the tech bubble trading at a forward price-earnings (PE) ratio of sixty and higher without profits! However, The Technology sector’s relative forward P/E ratio is trading at a level that has only been higher a few times over the last 20 years according to NDR. The Invesco S&P 500® Equal Weight Tech ETF trades at a reasonable Forward P/E of 23 with an ROE (profit measure) of 29! The Fidelity MSCI Information Tech ETF trades at its higher end of the range at a Forward P/E of 30 with an ROE (profit measure) of 42. Most Technology stocks are trading at a premium because their sales growth, earnings growth and profit margins are superior to other sectors and stocks. High expectations combined with elevated valuations could leave the most richly priced Tech stocks vulnerable if earnings miss expectations. I am sticking with cyclical sectors instead of rotating into defensives by selling Growth stocks as they remain the most profitable stocks with the highest sales growth albeit at a premium multiple.

The most attractive area of the US stock market is Small-cap 600 stocks trading at a more reasonable valuation. Small-caps have significantly underperformed Large-caps. Small-cap stocks are trading at an attractive Price-to-book value that in the past has led to strong future returns when economic fundamentals improve. Small caps are also trading at levels that have seen a bottoming out of underperformance. The current P/E valuation is still attractive at a forward Price-to Earnings ratio of 16.9. CFRA projects S&P SmallCap 600’s earnings growth of 25.8% in Q4 versus 14.6% for the S&P 500 Index. Bloomberg reports a wide valuation gap exist between large-cap Tech sector’s and Small cap sector.

The set-up is favorable to invest in Small caps now based on its underperformance to Large caps, current valuations, and potential earnings growth. The Tech sector price to sales ratio (P/S) is 9.8x versus the Small-cap Russell 2,000 Tech sector’s P/S ratio is just 2.8x. Far easier for Small-caps to beat earnings estimates than Technology stocks in a friendlier interest rate environment. Furthermore, the market is more likely to broaden out into Small caps when rate cuts start. The Mega Cap stocks could enter a period of underperformance versus Small-caps and other areas of the market that are highly interest rate sensitive. Historically, highly economically sensitive Small-cap stocks lead in a recovery cycle.

What else have I added to portfolios and why?

Buying “AI” utility stocks in geographic regions with strong energy demand growth and provide electricity to AI data centers. AI data centers process the rapidly growing amounts of data used by computing systems and require multiples of more energy than traditional computers. The growth of AI means data center growth which means growing demand for electricity. Utility stocks that provide AI energy supplies to AI users are even more defensive than plain old utilities because of the need to process AI data in the global economy. What is more, Utilities have done well historically prior to the first Fed rate cuts. Lower rates make Utilities dividends more attractive. However, fast easing cycles (5+ hikes over 1-year) are more bullish than slow cycles based on NDR analysis. I think this cycle will be a slow one because the US economy avoided a recession this time around – no need for fast cutting. Lastly, Wells Fargo sees 80% growth in electricity demand by 2050.

I added copper exposure. Copper is a key input to the ongoing transformation to AI, and clean energy. Copper demand is expected to reach 40 million metric tons in the next 15 years.

I am adding gold to portfolios. State Street Global Advisors reports that higher gold prices have been supported largely by purchases from central banks. China and other Central Banks are diversifying away from US Dollar and increasing their gold holdings to become less financially reliant on the Western financial system. If the US Government continues to run trillions of dollars budget deficits, then Gold is considered to be a hedge against it. Lastly, the World Central Banks are entering easing mode again, lower rates are stimulative and who knows maybe even inflationary. The opportunity cost of not owning Treasury-bills for income may fade making Gold a more attractive investment.

I am underweight Developed Market Foreign Equities and Emerging Market Equities. The US economy has the best fundamentals for earnings growth.

Bonds now offer the highest income potential in 23 years. Current long term bond yields are attractive compared to historical levels and provide protection against reinvestment risk and purchasing power risk. Credit spreads are near multi-year lows base on FRED data signaling no recession ahead and buying in quality and non-investment grade bonds. Bond yields are a good indicator of future annualized return. I would expect long-term bonds to produce positive total returns over the next cycle. The Bond market is anticipating rate cuts this year, US corporate debt markets are drawing interest from investors.

I prefer intermediate Investment Grade over Non-investment grade, and long-term bonds because of credit risk issues that could arise from budget deficits. Treasury is expected to issue $9 trillion in Treasury issuance in 2024, in 2025 it expected to be $12 trillion! US Government is struggling to sell long term in 2025, 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! 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.

Lastly, cash equivalents current yield remains attractive compared to bonds until the first rate cut. Cash equivalents are invested in Treasury Bills inflation adjusted, and investment grade floating rate notes with maturities less than one year.