January 2016 Portfolio Update

Since publication of my fourth quarter newsletter, the market experienced the worst 10-day start in history. This gave people considerable cause for concern. As of last week, it appears the market is carving out a bottom.

Defensive sectors largely led the rebound. This has some experts suggesting more volatility is yet to come. Typically, small-cap and growth stocks lead the market out of a bottom. However, my research suggests that while more volatility may be on the horizon, it’s likely the broad market has bottomed out.

In this newsletter, I will share how the portfolios are doing and strategies for how we will take advantage of this latest stock market correction in 2016. I’ve also included some expanded content in the video version of this update.

Portfolio Changes

I plan to change the equity allocation of all portfolios and reallocate to sectors with the highest potential for return.

Bond allocations of all portfolios will also change. Earnings on the current bond allocations have been anemic due to the continued threat of rising interest rates.

I expect these changes to bring a much-needed boost in returns. The goal is to fully capitalize on the market rebound.

Timing of these changes needs to lag slightly behind the market bottom. Since the portfolios currently invest in mutual funds, I am limited to trading at the end of the day. In the case of some funds, I am required to hold them for 90 days to avoid a transaction fee. To avoid these issues, I need to be confident the market has bottomed before making changes, ergo the slight lag.

Atlas Financial Advisors and I have been working to improve this process and make it more fluid. In the coming months, we will transition to a live intra-day trading system with no transaction fees. This change will allow me to move all, or part, of a portfolio to cash as the markets correct. I will also be able to move back in quickly when the markets hit bottom. We are very excited about these changes and look forward to sharing more details in the coming months!

Performance

I am excited to share that for three consecutive years the High-risk portfolio has beaten the MSCI World Index, net of fees. The MSCI World Index represents 85% of large-cap and mid-cap stocks throughout 23 countries. Some of the biggest and best money managers in the country use it as a benchmark. This serves as validation the investment selection process is working. It is my hope the process will continue to deliver excess returns in the future.

Net of fees, both High and Mod-to-High risk portfolios are slightly underperforming the Vanguard Institutional Index, or S&P 500, symbol VIIIX. Since those two portfolios are designed to outperform when the market is up, it is reasonable that they will lose a little more when the market is down. This is simply because certain asset classes such as mid-caps, small-caps, international and emerging markets that tend to outperform when the market is up, usually underperform when the broad market is down. Their losses are within my expectations and are on par with similar style portfolios.

The Moderate portfolio has been performing on par with the S&P 500. Some days it is slightly outperforming, and other days slightly underperforming.

The Mod-to-Low and Low risk portfolios are outperforming the Vanguard Institutional Index.

The recent rebound was largely led by defensive sectors. With portfolios tilted to the technology and growth sectors, I expect returns will quickly increase once those sectors fully join the rebound.

Due to low advisory fees, diversification, and the sector selection process, all returns are well within their expected range.

Fed Rate Hike

In mid-December, the Federal Reserve announced a one-quarter percent increase in short-term interest rates. This is generally interpreted as a signal that our economy is on solid footing. Historically, the broad market rallies in the years that follow.

In my December update titled, “Federal Reserve Raises Rates,” I reported that since 1994, the Fed raised rates from a floor three separate times. The market corrected within two weeks to two months after each rate hike. A correction of up to 10% was the norm during those three instances.

So far in 2016, the losses the market has seen are right in line with that history.

China

The Chinese stock market has entered into bear territory. This has led to concerns the U.S. stock market may follow suit, and that China will further devalue their currency.

However, it helps to put this into perspective. Chinese companies only represent about 2% of the S&P 500, and about 7% of U.S. exports. In reality, those are small numbers!

We also need to put into context the recent drop in the Chinese stock market. The Shanghai Composite returned 52.87% in 2014. In a one-year period between mid-2014 and mid-2015, it returned over 100%. After those big returns, it should come as no surprise China’s economy and stock market are now cooling off.

The real concern is that China may further devalue their currency, the Yuan. Devaluing their currency may cause China’s exports to be cheaper and U.S. imports to be more expensive. This could make it potentially difficult for U.S. companies to compete.

The bigger issue of devaluation has to do with commodities. If China does devalue the Yuan, and their economy continues to cool, it may continue to put downward pressure on commodity prices.

This also has the potential to cause other nations to devalue their currencies, and possibly drive the value of the dollar even higher. As we already saw in the later part of 2015, a rising dollar can be a headwind to equities and often leads to increased volatility.

Comparisons to 2008

The early drop in the stock market this year has led to comparisons with 2008, which also started the year down. That’s where most comparisons end. I actually believe the market is correcting. Here’s why:

  • The 2008 financial crisis nearly led to collapse of the banking industry. Many banks made bad loans and were undercapitalized. Today, lending is highly regulated and banks are well capitalized due to successive Quantitative Easing programs.
  • When looking at economic indicators, the Conference Board Leading Economic Indicator (LEI) is up and increasing. It usually decreases when heading into a recession.
  • As far as interest rate hikes go, the Federal Reserve wasn’t raising rates off a floor in 2008. In fact, they decreased interest rates.
  • Hard assets, such as gold and oil, were appreciating in early 2008. Although gold is up, it is not rising rapidly. Today, oil has fallen and remains very low.
  • Volatility, as indicated by the symbol VIX, is up. However, it’s nowhere near as high as it was in 2008.

For these reasons, I believe the market is correcting and not crashing. I envision corrections as an opportunity to make adjustments near the bottom, and to take full advantage of the next leg up.

Market Effect of “Commitment of Traders Report”

On rare occasions, economists I follow mention how many “net long” or “short positions” are on the market. The theory is that when the number of short positions exceeds the number of long positions, the market is expected to fall. The opposite is also true.

Most of this activity stems from large traders, or hedge funds. They control huge sums of money and can invest with no restrictions. Obviously, hedge fund traders aren’t always right. However, when enough money takes either a long or short position on the market, the market tends to move accordingly.

The U.S. Commodity Futures Trading Commission publishes the Commitment of Traders Report each Friday with data from Tuesday of the same week. It has taken me a long time to reverse engineer this information during the rare times it appears in the economics report I read daily. The value lies in the data that shows how the big money is being invested.

For example, on Friday, January 29th, the S&P 500 opened up and rose until it met its 200-day moving average. At that point, the S&P 500 hit quicksand where it spent several hours trying to break through the 200-day moving average. The Commitment of Traders Report published at 12:30 p.m. that day. It may be coincidental, but within minutes the S&P 500 broke through its 200-day moving average.

It’s interesting to note my interpretation of the January 29th report showed hedge funds reduced their short positions approximately 16%. When other traders saw this information, it may have been interpreted that big money was starting to move to a long position. As money moves long, the market often rallies.

In the video version of this update, you will be able to see a chart I created that compares the S&P 500 to the number of net long or short positions. Tuesday, January 26th is the first reported day there were fewer shorts on the market. You will also see data from the past two years that shows this is typically a very bullish sign.

The video also shows a chart that compares long-term U.S. Treasury Bonds with the number of net long or short. In this chart, you will be able to see what appears to be a bottom forming in interest rates.

These are just two indices where the Commitment of Traders Report shows long and short positions. Updates of these charts will be made weekly. And several other indices will be added to my current internal research. I expect this will provide an indication of which direction the market is moving.

Equity Allocation

In order to determine which sectors have the most upside potential, I ran a screen of all sectors. Those with the greatest upside potential are Internet (Technology subsector), Biotechnology (Health Care subsector), Banking (Financials subsector), and Health Care and Leisure & Entertainment (in no particular order).

All portfolios are already allocated to the Technology and Biotechnology sectors. And despite my comments in the last newsletter, the Banking sector now presents a short-term opportunity if interest rates rise.

The Banking sector historically performs well during bear steepener cycles. These are periods where long-term rates rise faster than short-term rates. This may happen if the Fed delays raising rates, which could keep short-term rates at very low levels.

On days when the market has rebounded, long-term interest rates have risen, as investors sell their bond holdings to try to catch the rebound in equities. This is another reason why long-term rates may rise when the market rebounds.

Consequently, I plan to substitute the Retail sector with the Banking sector. It hasn’t yet lived up to my expectations. While Retail does offer upside potential in the screens, there is potential for greater opportunity in other sectors.

I will continue to closely watch all sectors and make further adjustments as the market rebounds to capture as much upside as possible.

Bond Allocation

The bond portfolio is largely allocated to take advantage of rising rates. However, three adjustments need to be made.

The first adjustment is with the Putnam Income fund (PINCX). Their managers chose to allocate the fund to longer maturity intermediate bonds and used hedges to manage the duration risk. This strategy has not worked.

With the expectation that intermediate and long-term rates may rise, the Putnam Income Fund needs to be replaced with a lower duration bond fund. When the portfolios are rebalanced, this position will be replaced with the Morgan Stanley Mortgage Securities fund (MTGAX). In comparison to the existing Putnam Income fund, it has a lower duration and a higher Sharpe ratio.

The second adjustment is with the Metropolitan West Low Duration (MWLDX), a short-term bond fund that has had average performance. Considering the Fed may resume raising short-term interest rates at some point, I want to further reduce the duration risk of this position. At the rebalance, this fund will be replaced with the Pioneer Short Term Income fund (STABX). It has a lower duration and higher Sharpe ratio.

You may be interested to know the Sharpe Ratio is a risk-adjusted measure of return. The ratio helps to evaluate the performance of one asset compared to another by making an adjustment for risk. The higher an asset’s Sharpe Ratio, the better its risk-adjusted performance has been. A negative ratio means the risk-free asset would perform better than the risky asset.

The third adjustment is with the AllianzGI Short Duration High Income (ASHAX) fund. It was originally chosen to minimize the duration risk of the high yield position. Since high yield bonds are more highly correlated to equities than to bonds, the duration needs to increase in order to take advantage of the upcoming rebound. Rydex High Yield Strategy H (RYHGX) will replace AllianzGI. The Rydex fund is also a “modular” fund, so it can be sold at any time without a redemption fee.

Rebalance

The purpose of rebalancing is to maintain a portfolio within a given level of risk. This recent correction caused positions in the portfolios to shift enough that I plan to rebalance them near the bottom of the correction. At that time, I will make the previously discussed adjustments.

As I shared with KGET Channel 17’s viewers a few weeks ago, corrections create an opportunity to rebalance and reallocate poor or underperforming positions. Rebalancing and reallocating allows investors the opportunity to fully capitalize on the upcoming market rebound.

While I do not know which day the rebalance will take place, it’s entirely possible the changes will be completed by the time you receive this update.

Thank you for the opportunity and trust you place in me to manage your money. I appreciate having you as my client and all the referrals! Please let me know if you enjoyed the January 2016 Portfolio Update!