Portfolio Newsletter 2Q 2015

I am happy to report the performance of all portfolios continues to exceed my expectations. I hope you will be equally pleased. The continued source of these returns lies within the diversification and sector selection of the equity portion in these portfolios.

In this newsletter, you will be updated on some structural changes, my strategic outlook for the portfolios, an economic update, and the short-term market risks.

Structural Improvements

Our previous newsletter mentioned plans to increase the number of funds in the portfolios with no transaction fees or early redemption charges. This allows for the daily purchase and sale of funds, which enhances my ability to make adjustments through the rising interest rate cycle. In the event of a major broad market drop, it also affords me the option to sell positions without incurring any additional fees.

While corrections are difficult to anticipate and often rebound quickly, this change provides the flexibility to replace underperforming asset classes and to make advantageous changes in the portfolios. As the economy moves through the interest rate hike cycle, adjustments will need to be made (details on the importance of this are discussed later).

I continue to study and research technical analysis. This is a methodology used to forecast the direction of a security (or a sector) based on past movements. It is a tool frequently utilized to validate which sectors are showing positive or negative momentum. The research, and subsequent data, can be very compelling on a large scale basis. As a result, technical analysis has been added as an additional layer to the sector selection process. The hope is that it will assist in more strategic investment decisions.

Bond Allocation

At the end of 2013, duration and maturity of the bond funds were significantly lowered to immunize all portfolios against the effects of rising interest rates. As you may recall, when interest rates go up, bond values drop.

This year, yields on the 10-year Treasury jumped nearly 1%. The unfortunate result was that long-term (high duration and high maturity) bond holders lost a significant amount of money.

Fortunately, my earlier portfolio adjustments worked flawlessly in 2015. Because of the low duration, low maturity focus, all bond funds produced positive returns this year.

Equity Allocation

The sector-focused model is working well. Equity allocation of the portfolios continues to outperform due to hot performing Biotechnology, Technology and International sectors. All other equity weightings experienced above average returns, with the exception of Consumer Staples and Emerging Market sectors. Industrials did not perform as expected.

The Federal Reserve

In June, the Federal Reserve announced they are almost ready to raise short- term interest rates and expect to do so in the near future. The Fed adjusts short-term interest rates by changing the Federal Funds rate. This is the rate depository institutions, or banks, lend money to other depository institutions on overnight loans. This lending relationship exists because depository institutions must maintain a minimum balance each day to meet the reserve requirements mandated by the Federal Reserve.

The immediate fear is that long-term rates will spike. Historically this isn’t the case. While long-term rates frequently move in tandem with short-term rates, they don’t always. Long-term yields will probably rise, but not significantly from today’s levels. The Federal Reserve is very aware that if long-term yields rise too quickly, the economy could rapidly stall.

Bond investors’ primary concern should be that a rate hike will affect short-term bond funds first. It is also why maintenance of a low duration and low maturity focus is so important; to immunize the effects of rising interest rates.

Equity investors’ primary concern should be that the Federal Reserve announcement indicates the next shift in the sector rotation model.

There are five stages to an interest rate hike cycle:

  1. Early Rate Hike: The period one year in advance of an interest rate hike from a zero interest rate policy.
  2. Pre-Rate Hike: The (approximate) six month period before rates rise. We just entered that period.
  3. Early Rate Hike: The first 1 to 1.5 years of a rate hike cycle.
  4. Mid-Rate Hike: The next 1 to 1.5 years of a rate hike cycle.
  5. Late Rate Hike: The last year(s) of a rate hike cycle. A rate hike cycle usually runs three years, but can run as long as five years.

Each change in the cycle dictates a shift in the equity sector model, with certain sectors performing well at each interval. Complacency is not the key to success.

Strategic Outlook

The minutes of the most recent Federal Reserve meeting indicate inflation is below their target of 2%. This is holding the Fed from raising short-term interest rates at the present time.

The Consumer Price Index (CPI), which is the major benchmark for inflation since it shows the rate of price increase or decrease for consumers, is at a 0% rate (year-over-year change) for 2015. The 2% inflation target shouldn’t be surprising since this was the Fed’s primary goal in the January 2012 meetings. While 2% inflation is low, it is the number they want to maintain.

It is also important to note that when the Fed lowered short-term interest rates to zero, they embarked on a path of no return with a much bigger plan in mind.

One way to solve the long-term problem of budget deficits and debt is to devalue a country’s currency in order to maintain full employment through exporting. Oddly enough, the Federal Reserve Bank of New York wrote a piece on currency devaluation, including the benefits and risks, in September 2011.

The tool the Fed is using to navigate this path is interest rates. If the Fed were to target a higher inflation rate than 2%, they would run the risk of interest rates spiking, which could lead to another recession. I assure you the thought of interest rates spiking keeps the Fed awake at night. This is why they have repeatedly stated the increase in short-term interest rates will be done slowly and over a long period of time.

As investors, this information is highly valuable when determining which sectors of the economy to invest.

Sector Updates

Biotechnology: This has been the best performing sector in 2015. Fortunately, all portfolios have a high allocation in this sector. The healthcare portion of biotechnology (which is part technology and part healthcare) benefits from a strong dollar. Since healthcare usually underperforms during a pre-rate hike cycle, and the dollar is weakening, I plan to reduce exposure to this sector. I anticipate exiting biotechnology for the banking sector (more on that in Financials).

Healthcare: This is the second best performing sector this year, but healthcare is a defensive sector that historically performs poorly during a pre-rate hike cycle. This sector is separate from the biotechnology position and will be dropped from the portfolios.

Technology: This sector historically is the best performing sector during a pre-rate hike cycle, because it benefits from a weak dollar and economic expansion. This position will be increased with a focus on Internet companies.

Consumer Cyclical: This sector is currently outperforming and is expected to continue. The retail sector should continue to do well as consumers spend more.

Financials: The financial sector has underperformed, but the banking sector has outperformed. Bank stocks rise when interest rates rise. During the rebalance, this sector will initially be omitted. I believe there will be one last drop in interest rates. At that point, I intend to swap the biotechnology fund for a banking sector fund.

Consumer Staples: The sector will be dropped from the portfolios since it is a defensive sector.

Telecommunications: This sector is not in the portfolios and will remain that way.

Energy: Energy is an inflation sensitive sector, which historically comes into play right now. However, inflation is low (near zero). This sector will be omitted until inflation begins to rise.

Materials: The same comments as Energy.

Industrials: I thought low oil prices would benefit this sector. However, the industrial sector is in a technical recession and will be dropped from the portfolios. It was one of the worst performing sectors this year.

Utilities: The utilities sector is sensitive to interest rates and does well during falling interest rates. This is by far the worst performing sector this year. There was no allocation to the portfolios. It will remain that way.

Small Caps: This quarter, the small cap allocation was focused in the Healthcare sector. That is going to be replaced with a broad-based small cap fund with high allocations in the growth oriented sectors.

Emerging Markets: The current fund has underperformed and will be replaced with a broad-based small value Emerging Markets fund.

Bond Allocation: There will be no changes to the bond allocation of the portfolios until the Fed raises interest rates. When that occurs, each of the positions will be reviewed to make certain the portfolio is properly immunized from rising interest rates.

Other than the Emerging Markets fund, all of the new funds will have a zero-day hold. This means I will have the flexibility to make positional adjustments should a sector underperform.

July Rebalance

I plan to rebalance the portfolios during the second week of July. For those who recently invested and are still under a hold or partial hold period, I will try to make any adjustments I can and then do a full rebalance after the hold periods have expired.