March 2016 Portfolio Update

The morning before Janet Yellen was set to make a noon-time talk and expected to confirm the Fed’s plans to raise interest rates, investors poured money into bonds and ultra-defensive stocks. The following day stocks rallied, led by the growth sectors, and bonds sold off.

At the recent G-20 meeting rumors cropped up about a secret agreement to devalue the dollar. After the G-20 meeting, the dollar dropped. This is usually bullish for equities. Instead, stocks started to run out of gas and began trending downward.

Like the rabbit hole in Alice in Wonderland, Japan is talking as if there is no end to how low they will take their already negative interest rates.

If this all sounds like a circus, it is not. This is the state of our global economy.

Unfortunately, this quarter marks the worst quarterly return in the history of the portfolios. The good news is growth sectors are starting to emerge from their winter slumber just like the tulips in my wife’s garden.

Closing out the first quarter, net of fees, the year-to-date returns are: High -5.80%, Mod-to-High -5.53%, Moderate -4.30%, Mod-to-Low -3.48%, and Low -2.35%. As the growth sectors continue to come back I expect portfolio returns will increase.

Over the past few months I have compared our returns against the returns of many other advisors. As we’ve often discussed, when the markets move up our allocation tends to outperform. And the comparisons prove that many times over.

While we are down right now, we are still in line or above returns of similar portfolios. This is because of the outperformance of 2015. There is little doubt in my mind that when the markets truly rebound we will rocket out of the gate.

Introducing Portfolio Shield™

Knowing our portfolios perform well on the upside lead me to look for ways to mitigate downside risk. There are a couple different market orders that can be used to mitigate downside risk. Neither of those can be used under our current system, but as we migrate to a new system we will have full access to both of these strategies.

Many of you may be familiar with a “stop order.” A stop order is set at the time of purchase. It establishes a price. If the security falls to that the price, it will automatically become a market order and sell. While this is a good strategy, it must be set at the time of trade. Since stop orders are price controlled, they are not an ideal solution.

Some of you may have heard of a “trailing stop order.” A trailing stop order is also set at the time of purchase. It establishes a percentage value that is tied to the highest value the security reaches from purchase. If the security falls from its highest point by an amount equal to the established percentage value, it automatically becomes a market order and sells. While this is a more ideal solution, these types of orders are also established at the time of purchase and generally cannot be modified.

Using a highly advanced trading platform and software package, I will now be able to establish and modify stop orders and trailing stop orders on each position of the portfolio after the trade has been placed. This is a huge competitive advantage – one that we will implement in the next few months.

Portfolio Shield™ is an algorithm I developed that establishes the initial and future trailing stop order percentages based on volatility and momentum of each position in the portfolio. Portfolio Shield™ will mitigate downside risk by automatically selling positions to cash if they fall to a predetermined percentage off of their highest value. As an investor, you can enjoy all of the upside of a position and still have peace of mind that the downside risk is minimized.

Here’s how the Portfolio Shield™ algorithm works:

  • During a sideways market, a percentage will be set for each position in the portfolio based on its past trading range. This will minimize how often a sale is generated. If a sideways market persists without showing a significant move to the upside, the percentage will be tightened, or reduced, to minimize losses should that position drop.
  • When buying near the bottom after a sell-off, the percentage will be widened to larger than normal because of the increased volatility normally associated near a market bottom.
  • As a position moves up off of the bottom, the percentage will be periodically tightened to protect as much of the gains as possible as the position reaches a peak.

This may be confusing for some investors. Going forward, I will put together some graphics that help visually explain this concept so you can see how it can be used to minimize risk.

So far, back-tested results are very impressive. A beta-test will be launched shortly and I will share the results with you. If they are half as good as the back-tested results, I believe you will be very happy.

Managing Portfolio Shield™ will take significantly more work on my end.  So, you may be wondering how much all of this will affect the fees you pay. I’m happy to say I have even more good news. Once we move to the new system, the total fees you are currently paying will drop. Yes, you read that correctly. Total fees are going to drop.

Economic Update

Recent economic data has been mediocre, but is improving. Initial claims for unemployment are at historically very low levels. The labor force participation rate is moving up. The housing market remains strong. Consumer confidence is rising again, most likely due to the recent stock market recovery along with a strong job market. Manufacturing is showing an uptick. Personal incomes are slowly starting to rise. Outside of consumer spending, which is fairly flat, and business inventories which are high, our economy is slowly moving in a positive direction. This is enough so that fears of a recession are waning.

I believe much of this economic weakness is due to the aftereffects of several Quantitative Easings, coupled with a zero interest rate policy. Only time will tell for sure if I’m right. I’ll have more thoughts on this in future updates.

Wall Street is largely discounting that the Fed will raise rates again this year. I think the Fed is likely to act mid-year as economic data continues to show signs of stabilization and improvement. Despite previous unemployment targets being met, the Fed is now citing international economic risks as the reason for holding off at the moment.

Internationally things are still messy. Japan’s economic policies are one failure after another. China is proving that its economy is reliant on exporting to the U.S. and other parts of the world. The slow pace of this economic recovery has caused many to fear a global recession. However, I believe the U.S. economy will lead the world out of this current slump.

Portfolio Update

You may recall after the Fed raised short-term interest rates in 2015, I adjusted the portfolios into sectors that perform well in a rising dollar and rising interest rate environment. We’ve seen the dollar rise. This is common in the first few rate hikes. And, historically, once the Fed begins to raise rates they will continue. So, my decision to adjust the sectors was right on point.
What I didn’t anticipate was the rotation of the market into defensive sectors. This was due to investors’ fear of an imminent economic recession. Part of this can be attributed to not having data showing the amount of short positions on the market. I’ve rectified this and now track the data on a weekly basis. The other part is that I make every attempt to validate my research and decisions with those of several other economists. While I did see an opportunity in one of the ultra-defensive sectors, only one economist called it correctly. I went with the consensus view.

Obviously, it is impossible to always be right. My goal when it comes to managing the portfolios is to be more right, on balance, than wrong. I view any mistake as an opportunity to learn. Fortunately, this means the portfolios are only a couple percent points behind where I would like them to be. I feel this is a very recoverable amount.

In truth, this was the genesis of my yearlong quest to decipher data from the Commitments of Traders reports so we will know which direction Wall Street is moving on key indices. I spend a significant amount of time doing research behind the scenes. The combination of research and implementation of our new Portfolio Shield™ in the months to come should greatly help minimize the downside risks of any adverse investment decisions and rapid downward shifts in the markets. I am very excited about the benefits Portfolio Shield™ will bring to the portfolios!

The good news during the last few days of March is the growth sectors we are allocated to show strong signs of life. Because they are starting to outperform, I believe our returns will quickly improve. Absent the recent correction, this means the allocation is correct. We just got to the party early.

Market Update

I remain optimistic about the stock market over the next few years. However, during the short-term I believe the market will remain somewhat volatile. I have no reason to believe the market will fall back to the recent lows set in February and I think the worst is now behind us.

Considering the absence of strong economic data from the U.S. and the rest of the world, I believe that our market will remain range-bound for the months to come. Success in a range-bound market heavily relies on a sector rotation model. While we missed the first rotation into the ultra-defensive sectors, we are presently right in line with the sectors I believe offer the greatest potential during this next cycle.

Sector and Positions Update

Finance & Banking Sector

The Finance sector is usually a leader coming out of economic slumps. This is why I shifted part of the allocation to the Banking subsector. Banking stocks have a high correlation to the 30-year Treasury yield. And with expectations of rising interest rates, focusing on the Banking subsector gives us a strong opportunity to outperform the broad Finance sector.

The risk with these sectors is that interest rates may stay low. Many economists believe the negative interest rate policies of other countries are having an adverse effect on Treasury yields by keeping our rates artificially low.

As the world economies and stock markets recover, I believe investors will be quick to pull money from bonds to buy equities. This potential move, coupled with the Fed continuing to raise interest rates, is how this sector could easily generate above average returns. In the short-term I will watch to see which direction interest rates are moving. If rates start to fall, I may have to temporarily shift out of this sector.

Technology & Internet Sector

The Internet subsector has a high correlation to the 10-year Treasury. With the expectation that the Fed will raise rates, I believe it offers the greatest potential for above average returns when compared to other Technology sectors.

Health Care & Biotechnology

The Health Care sector is considered a defensive sector and is one of few sectors that did not get much attention in this recent shift to the defensive sectors. Currently, Health Care is one of my top choices to outperform as investors look for undervalued sectors. We have not shifted further assets here due to our exposure to the Biotechnology subsector.

Admittedly, our allocation to the Biotechnology subsector is the reason we outperformed last year and are underperforming this year. It has ties to both the Health Care and Technology sectors. It is classified as a growth sector rather than a defensive sector. What makes Biotechnology interesting is that it has the potential to outperform the Health Care sector by a wide margin.

At the end of March, the Biotechnology sector started to emerge with very strong returns. Any additional shifts from other positions into Health Care will be strictly to the Health Care sector. While the Biotechnology sector can outperform the Health Care sector, we will limit our exposure to the position we have. This is due to the increased volatility associated with Biotechnology stocks.

Small-Caps

Our small-cap allocation is currently allocated to small-cap growth stocks. This sector is down considerably since last year and has just begun to show signs of life. Given that the growth sectors have largely been absent from this recent rebound, it comes as no surprise that small-caps are still underperforming. Like Financials, small-caps are usually a leader coming out of an economic slump. At this time, I do not anticipate any changes to this position.

International & Emerging Markets

On the International front we are fairly diversified in a Small and Mid-Cap International fund with our highest concentration in Europe. Last year, this fund’s outperformance was another reason we did so well. This year, international equities have underperformed their U.S. counterparts. It comes as no surprise that this fund is slightly trailing U.S. Large-Cap equities. As global recession fears wane and global markets rebound, I expect this fund to be a strong performer.

Emerging Markets are very sensitive to the U.S. dollar. When the U.S. dollar appreciates, Emerging Markets equities fall. As a result, this position is down significantly. Fortunately, Emerging Markets only hold a small weighting in the higher risk portfolios.
The U.S. dollar declined in March after rumors of a secret meeting at the G-20 meeting in China. Allegedly, top nations agreed to let the dollar fall hoping to stabilize international equity markets and raise commodity prices. Since the G-20 meeting, Emerging Markets have rebounded, but they still have a long way to get back to even. Should the dollar begin a long trend downward, this position could significantly outperform.

Bonds

In the middle of 2015, we took a hedged position on long-term bonds in anticipation of the Fed raising interest rates. The move paid off last year as long-term rates rose. Going into the correction in early 2016 where interest rates dropped caused this fund to underperform.

Interest rates are currently range bound. There are still a large portion of long positions on bonds (long positions keep interest rates down) which has the 30-year Treasury yield sitting at about 2.6% per year. This is hardly a return to get excited about. Should long-term rates begin to appreciate, this fund is designed to rapidly capitalize on that.

Based on my research, there is some downsize risk to holding this position in the short-term. However, that risk is fairly minimal. Should interest rates rise over the long-term, the upside potential of this position is rather high. Last month a couple mutual fund managers announced they were going to exit their Treasury positions in anticipation of further interest rate hikes and improving economic data. This news validates our position.

For the moment, we will hold this position. There appears to be upward pressure on long-term interest rates. Should interest rates drop further, we may temporarily need to shift out.

The duration on the remaining bond positions has been dropped to the lowest possible amount in order to minimize losses due to rising interest rates.

Portfolio Summary

Even though the portfolios are lagging by a couple of percent where I’d like them to be, I believe there is a tremendous amount of upside potential. This year, U.S. Large-Cap equities and Long-term bonds have been the strong performers. Md-Caps, Small-Caps, International, Emerging Markets, High Yield Bonds and Emerging Markets bonds have all underperformed.

Portfolios like ours that are fully diversified should be underperforming based on the fact that so many asset classes have yet to join this rebound. The reason we outperform when the market is strong is because our portfolios have growth sectors as part of the model. This is why I believe that as the economy rebounds, our returns will strongly rebound too. And if interest rates do rise, we are well allocated to capitalize on that trend.

Thank you for the opportunity and trust you place in me to manage your money. I appreciate having you as my client and all of the referrals! If you have any questions, please feel free to call or e-mail my office.