2018 Investment Strategy Review

Stock and bond market performance has been more volatile in 2018.  After an amazing run in 2017 stocks have become more sensitive to interest rate hikes and potential disruptions in global trade because of ongoing trade negotiations by the Trump administration.

Bonds too have seen an increase in volatility as the Federal Reserve increases the Fed Funds rate and sell bonds from their balance sheet.

The start of the year was extremely volatile for both asset classes but over the last month U.S. stocks and bonds have settled down.  Other asset classes are still struggling.  Emerging market bonds are down over 4% and emerging market stocks have declined nearly 10% according to statistics from ETFReplay.com.

Over the years I have tracked the performance of 4 classical investment strategies from pillars in the industry. Here is a quick look at how they are doing so far in 2018.

Note:  This data is historical and does not reflect actual account performance.  Please see the performance disclosure below for additional detail.  The benchmark for each strategy is the iShares Moderate Growth ETF (AOM).  It is important to remember the CAGR (Compound Annual Growth Rate) for all these strategies are only  using approximately 6 months of data.  Year-To-Date (YTD) performance and volatility is provide below each summary.

We start with our baseline “Classic” Strategy Year-To-Date (YTD) performance.  This strategy is considered a blue-chip approach to investing by several well respected investors.  This mix of investments represents 60% U.S. stocks and 40% U.S. Bonds.

YTD:  Classic Return:  2.8% vs. AOM Return 0.0%     Volatility:  9.7% vs. AOM Volatility 6.0%

Next, we will look at the YTD performance 3-asset class strategy we call the “Cycle” strategy.  This strategy holds 5 investments from 3 asset classes.  It is the lowest volatility strategy I manage.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Cycle Return:  0.6% vs. AOM Return 0.0%    Volatility:  5.5% vs. AOM Volatility 6.0%

Adding more asset class, next we feature a “risk parity” strategy YTD performance.  In this approach 7 asset classes are weighted based on their volatility (or risk) with lower volatility investments receiving a higher weight.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Risk-Parity Return:  -1.7% vs. AOM Return 0.0%    Volatility:  4.1% vs. AOM Volatility 6.0%

Finally, the most diversified of the bunch, the 10-asset strategy YTD performance.  This approach invests equally in 10 asset classes.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Ten Asset Return:  -0.4% vs. AOM Return 0.0%    Volatility:  5.8% vs. AOM Volatility 6.0%

It is clear 2018 has not favored highly diversified strategies.  Those strategies that focus on U.S. stocks have performed better.

For a real shocker, here is how 10 select industry groups I incorporate into my strategies have performed YTD.  This is an all stock selection, so the benchmark has been changed to the S&P 500 (SPY).

YTD:  Industry Group Stocks Return:  16.3% vs. SPY Return 5.6%    Volatility*:  19.5% vs. SPY Volatility 16.1%

*Note the significant increase in volatility associated with the portfolio of Industry Groups.  That is the trade-off for exposure to high-growth areas of the economy.

We don’t know what the future holds but as we embark on a new generation of product and service innovation, along with stronger economic performance in the U.S., I have been guiding clients to overweight U.S. stocks and incorporate industry groups from areas of the economy expected to grow faster than the general economy.  It has been working well and has the potential to add value for years to come.  In addition, I can include industry group exposure to any of the strategies above where risk-management characteristics should generally reduce volatility.

All the statistics provided by ETFReplay.com.

Past performance does not guarantee future results.  Investments and the income derived from them fluctuate both up and down.  Investments at Dightman Capital are subject to risks including loss of principal.  No specific investment recommendations have been made to any person or entity in this written material.  This presentation is for informational purposes only and is neither an offer to sell or buy any securities.  Benchmarks or other measures of relative market performance over a specified time period are provided for informational purposes only.  Dightman Capital does not manage any strategy toward a specific benchmark index.   A variety of sources we consider reliable have provided information for this presentation, but we do not represent that the information is accurate or complete.  Dightman Capital Group does not provide tax advice to its clients.  Conduct your own research or engage an investment professional before making any investment decision.  Investors are encouraged to discuss any potential investment with their tax advisors.  The material provided herein is for informational purposes only.  Data Sources:  IDC, Dightman Capital.

Uncorrelated Assets Still Terrific

One of the strategies I developed for my investment management services is closely related to what has been called the “All Season” or “Permanent” portfolio.  The idea behind this type of investment approach is to deliver a low volatility, reasonable rate of return that can weather any type of market environment: bear market, inflationary, stagflation, etc.  This investment approach has been featured by many different successful investors including Ray Dalio, Cliff Asness, & Harry Browne.  I studied their work and developed my own version.

What make the approach work is using high volatility but low correlated investments.  Take gold for example.  It’s long-term rate of return is mediocre, especially given its high volatility.  What can make gold glimmer, however, is its historically uncorrelated nature.

I recently heard a popular investment newsletter podcast suggest this approach has not worked since 2009.  The shows presenters claimed that correlations have risen, and the strategy has not been performing as expected.  I was surprised by the claim because it has been performing exactly as expected, both as a stand-alone strategy and also as a multi-model approach.

Just to be sure, however, I tested correlations from pre-2009 through 2018 and found very little evidence correlations have risen.  I am not sure if they were mis-informed or just trying to sell more newsletter but I though it was a disservice to highlight “All Season” and “Permanent” portfolio creators and then suggest the approaches don’t work anymore.  So let me be clear, my version of the “All-Season” and “Permanent” portfolio continues to deliver low correlations between asset classes.

Here is a look at the matrix I created comparing correlation of the four asset classes in my approach.

ETFReplay, Dightman Capital, July 6th, 2018

My strategy has not experienced a high degree of correlation and the numbers above suggest the environment has not been one of high correlation.

It is important to understand correlations change.  In my test I looked at 60-day correlations, that is, the price movements between the two assets over rolling 60-day periods going back about 12 years.  As you can see from the examples below, correlations change a lot during short periods, which is a good reminder why a long-term investment perspective is needed.  Perhaps the newsletter writer in the podcast happen to peak at the numbers during a period where correlations moved higher.  As graphics below illustrate, correlations between gold and stocks , for example, do bounce around.

 

 

 

 

 

 

 

 

 

 

If we extend the rolling period to 120-day, we see correlations smoothed considerably.

 

 

 

 

 

 

 

 

 

 

I refer to my strategy as the Cycle Strategy. It is one of the most conservative investment strategies I manage and compared to an all stock benchmark like the S&P 500, is has experienced an incredibly low correlation of +0.36% over the last few years.  Meaning, approximately 2/3 of the time the strategy does not move in the same direction as the S&P 500. The maximum draw down is approximately ½ the S&P 500 while also capturing approximately ½ the return.  (Statistics courtesy of ETFReplay.com, Last 36 months through July 11, 2018)  I am also able to provide the same data going back to 2009, which looks terrific.

 

 

 

 

Three of the four asset classes in this strategy can be extremely volatile at times.  Yet, more often then not they experience their volatility at different times.  Therefore, as a group they can be less volatile.

Trade Negotiations & LIBOR Spike

Another round of volatility hit stocks this week, but current support levels remain, and volume has been tamer. The Nasdaq 100’s outperformance YTD remains intact suggesting tech investors are still committed to the sector.

It’s one thing to see stocks under pressure but the recent spike in LIBOR (the rate banks lend to each other overnight) was my focus this week. Fortunately, the banking system remains stable and the rise in LIBOR appears to be the result of an increase in demand from short-term U.S. government funding needs for deficit spending and U.S. corporations pulling offshore money from corporate bonds and putting it into cash for spending. While the spike in LIBOR signals caution, banks impacted by the higher rate are not flashing other warning signs.

For those familiar with the TED Spread, the difference between interest rates on Eurodollar Contracts and T-bills, we are still well below levels that signaled problems in the banking sector back in 2008.

On balance the market is evaluating several concurrent events; higher interest rates, chronic deficit spending and trade policy adjustments are center stage. The economy and corporate sales/earnings are in good shape, so the bias remains to the upside. If a nasty trade war does break out, then we could see more downside pressure on stocks and the economy; we are a long way from that environment and it will be interesting to see how far President Trump will push the Chinese. They have far more to lose then we do in a trade war, but I don’t think the president wants to derail the overall growth environment in the U.S.

There is no such thing as “free trade”. What President Trump is trying to do with trade overall is reduce the concessions we provide our global partners (and reduce outright theft). The goal of spreading wealth via trade rules is a noble one, but the principles that make our country the success it is are free for the adopting too.

You may have heard, today the Dropbox IPO started trading and delivered a gained of 35%. An active IPO market is a sign this market may have more upside. Leading stocks are also holding up well, which is promising.

So far markets are correcting for trade uncertainties following interest rate concerns earlier this year. As uncomfortable as it can be, it’s a healthy process and should allow stocks to resume their uptrend once trade matters are resolved.

Stocks Finally Correct, What’s Next?

After an outstanding 15-month stock market advance, last week stocks experienced a significant pullback.  The S&P 500 declined 3.9% but all three major U.S. stock indexes remain in positive territory so far in 2018.  After outstanding performance in 2017, U.S. stocks started 2018 on an even more accelerated run with the Dow Jones Industrial Average gaining 7.6% during January, before last week’s pullback.  The stock market rally needed to slow down.

In terms of earnings, Factset reports as of February 2nd approximately 50% of the companies in the S&P 500 have reported actual results for Q4-2017.  Of those, 75% are reporting actual earnings-per-share above estimates compared to the five-year average.  In terms of sales, 80% are reporting actual sales above estimates; the sales and earnings health of U.S. publicly traded companies appears to be good.

The likelihood of additional interest rate hikes in 2018 may have been the trigger for last week’s stock market correction.  Jerome Powell is the new Fed Chair and futures markets are expecting another 75-basis point increase in Fed Funds in 2018, which would bring the rate to around 2%, still below the historical average.  Investors also saw declines in bond prices last week as the 10-year Treasury yield shot up to 2.92%.

The continued improvement in economic numbers along with the overall optimism and rapid pace of innovation currently underway could suggest we are a long way from interest rates causing a sustained decline in the stock market.

Don’t be surprised if stocks are up big on Monday.  We could see more selling but a lot of cash remains on the sidelines and some investors have been looking for an opportunity to enter this market; one of the reasons stocks have not given much ground since President Trump ushered in a new set of economic policies aimed at broad sustained economic growth.

I have said this before and I will repeat it here.  We could very well see the the Dow at 30,000, the Nasdaq at 10,000 and the S&P 500 at 5,000 before we see the next bear market.  For those that do not understand how this could be, let me remind you; stocks went nowhere for 14 years from 2000 – 2013.  In the four or so years since the S&P finally regained a new all-time high in 2013, the stock market spent 18 months in a trading range between 2015-16, as the U.S. teetered on the verge of falling into a recession.

We have a combination of conditions that are conducive to a continued market rally:

  • Low Interest Rates
  • Positive Economic Policy
  • An Innovation Renaissance

Unlike prior market cycles, this one may not last as long as those previously for a couple reasons.  First, this expansion comes on the heels of a recovery that started 8 years earlier.  Second, a tremendous amount of debt was created in the U.S. and globally as the primary policy for recovering from a debt crisis.  If you are shaking your head, you should be.  Eventually we will pay a price for policy mistakes used to address the 2008 financial crisis.  Until then it is a race between economic growth and debt growth.  The next crisis could very well come from a country needing to restructure their debt.

In terms of interest rates, it appears we have some breathing room.  The 10-year Treasury yield remains well below levels of the last 20+ years.

In terms of short-term rates, if the Fed Funds rate were to rise above 3% the economy should be doing exceedingly well.  However, government debt funding is more sensitive to short-term rates, so policy makers are likely to take funding costs into consideration as they move rates higher.  Fortunately, other broad economic factors appear to be holding inflation in check which should allow The Fed to keep short-term funding rates at or below normal levels.

Until The Fed has turn up interest rates to a point of slowing the economy, the stock market is likely to continue rallying…there are amazing investment opportunities in the next generation of biotechnology, materials, software, and much, much more.  It is truly an exciting time to be an investor which is another reason I believe more money will find its way into the stock market over the coming years.

Please let me know if you are interested in learning more about investment opportunities from innovations in finance, travel, technology and more in a risk-managed, proactive approach.

Stock Index Performance Calculations, Stockcharts.com

Yield data from Stockcharts.com, Investors Business Daily.

Equifax Breach & Securing Your Personal Information

By now you have likely heard about the data breach at Equifax.  We have been here before…numerous times in the recent past consumers have been notified of a massive data breach of personal information at well-known companies.  If you have not done so already, here is where you can check to see if your data was impacted by the Equifax breach.  equifaxsecurity2017.com

The best way to protect yourself is to monitor your own personal information and be on the lookout for identity theft. Here are additional options to consider.

  • Fraud alerts: Your first step should be to establish fraud alerts with the three major credit reporting agencies. This will alert you if someone tries to apply for credit in your name. You can also set up fraud alerts for your credit and debit cards.
  • Credit freezes: A credit freeze will lock your credit files so that only companies you already do business with will have access to them. This means that if a thief shows up at a faraway bank and tries to apply for credit in your name using your address and Social Security number, the bank won’t be able to access your credit report. (However, a credit freeze won’t prevent a thief from making changes to your existing accounts.) Initially, consumers who tried to set up credit freezes with Equifax discovered they had to pay for it, but after a public thrashing Equifax announced that it would waive all fees for the next 30 days (starting September 12) for consumers who want to freeze their Equifax credit files.6Before freezing your credit reports, though, it’s wise to check them first. Also keep in mind that if you want to apply for credit with a new financial institution in the future, or you are opening a new bank account, applying for a job, renting an apartment, or buying insurance, you will need to unlock or “thaw” the credit freeze.
  • Credit reports: You can obtain a free copy of your credit report from each of the major credit agencies once every 12 months by requesting the reports at annualcreditreport.com or by calling toll-free 877-322-8228. Because the Equifax breach could have long-term consequences, it’s a good idea to start checking your report as part of your regular financial routine for the next few years.
  • Bank and credit card statements: Review your financial statements regularly and look for any transaction that seems amiss. Take advantage of any alert features so that you are notified when suspicious activity is detected. Your vigilance is an essential tool in fighting identity theft.

At the end of the day the best person to protect your identity is you.  If you are not already, it is a good idea to start monitoring your financial accounts and credit file on a regular basis.

Debt-Laden Companies? #FakeNews?

The following commentary is from Brian Wesbury, Chief Economist at First Trust, an innovative exchange traded fund (ETF) provider I use in some of my investment strategies.  I have found much of Brian’s commentary over the year to be helpful,  so I am sharing his most recent “Wesbury’s Comments”.  I hope you find it helpful too – Brian Dightman

Debt-Laden Companies? #FakeNews?

Remember the weak May payroll report – just 138,000?  Didn’t think so.  But, back then, that first report on May was reported as a massive economic slowdown that should stop the Fed from further rate hikes.

But the weak May number was due to a calendar quirk that led to an undercount of college kids getting summer jobs.  Payrolls jumped 222,000 in June, were revised up for May and, now, the two month average is 187,000.  That’s exactly the same as the average in the past twelve months and almost exactly the same as the 189,000 average in the past seven years.  In other words, the negative story from a month ago was misleading.

So, guess what?  The Pouting Pundits of Pessimism are pivoting!  It’s not jobs anymore, now it is “high debt levels among nonfinancial corporations.”  They say this happens near the very end of an economic expansion, so brace yourself.

It is true that nonfinancial US corporation debt is at a record high of $18.9 trillion.  It’s also true this debt is the highest ever relative to GDP.  But these companies don’t pay their debt with GDP.  They hold debt against assets and incomes.

Since 1980, nonfinancial corporate debt has averaged 44.9% of total assets (financial assets, real estate, equipment, inventories, and intellectual property).  Right now, these debts total 44.5% of assets, or slightly less than average.  The record was 50.6 in 1993.  Think about that, 1993 was right at the beginning of the longest economic expansion in US history.

Some say that the value of corporate financial assets is inflated by financial alchemy.  So, let’s take financial assets, which include record amounts of cash, out of the equation.

Before we do that, please realize that the financial assets of nonfinancial companies exceed total debts by $1.4 trillion, a record gap.  But let’s look at ratios without them, anyway.  The debt-to-nonfinancial asset ratio is at 85%.  This is right in the middle of the past 25-year range – roughly 74% to 95%.

Debt relative to the market value of these companies has averaged 82.2% since 1980 and currently stands at 80.0%.  If you calculate net worth using historical costs for their nonfinancial assets (instead of market value), the debt-to-net worth ratio is 121%, but has averaged 128% since 1980, 125% since 1990, and 119% since 2000.  Again, nothing abnormal.

What about interest payments?  The most recent data show that interest and miscellaneous payments are 11.2% of these companies’ profits versus an average of 13.2% since 1980, 12.2% since 1990, and 11.6% since 2000.  What happens if interest rates keep rising?  Less than you think.  Only 28% of the debt is short-term versus an average of 44% in the 1980s, 41% in the 1990s, and 33% in the 2000s.

None of this means the economy is safe forever.  Another recession is inevitable.  It’s just not coming anytime soon.  In the meantime, beware of stories that take one simple measure – like corporate leverage – and spin it pessimistically.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

Approved for public use.  Thanks and have a great week!

Giving Thanks

give-thanksThank you for the opportunity to dialog with you throughout the year about investing and financial planning topics.  I will continue to provide information I believe you will find relevant and timely.