Portfolio Balancing Act

Back in April I wrote a blog post titled Portfolio Management Decision-Making that highlighted the difficulty in developing an effective risk-managed portfolio of investments to meet client goals.  On the one hand, it could be a very simplistic approach with just two holdings:  the S&P 500 for the equity piece and the Bloomberg U.S Aggregate Bond Index for the fixed income piece.  But, we all know that the investment universe is much more complex than that and is made up of a multitude of different sectors and sub-sectors.

Many investment managers provide “model” investment portfolios that attempt to target risk profiles by adjusting the sector and sub-sector weightings of equities and fixed income.  A typical model portfolio can be comprised of 60% equities and 40% fixed income with some diversifying allocations to other sub-sectors.

The main difference between any of these models is the allocation to the equity and fixed income sub-sectors.  The equity sub-sectors most often seen are small- and mid-cap equities, international developed and emerging market equities, and growth or value style.  In the fixed income space it is common to see high yield bonds, corporate bonds, and emerging market bond sectors.  Needless to say, the allocations to the sub-sectors are the factor most driving investment performance.

I took a look at a few of the large investment model providers:  State Street, Vanguard, and WisdomTree (see table below).  They each provide long-term strategic model portfolios comprised of equity and fixed income sectors.  I analyzed two specific strategies:  the 60% equity / 40% fixed income growth strategy and the 80% equity / 20% fixed income aggressive strategy.

As seen below, none of the models consistently beat their naïve benchmarks (iShares Core Growth for the 60%/40% strategy and iShares Core Aggressive for the 80%/20%).  Though all of the models target the overall equity/fixed income allocation, it is the underlying sector allocation that drives the difference.  In these cases, sometimes they win (green highlight) and sometimes they lose (no highlight)!

D&A model portfolios are most usually customized for each client depending upon their specific unique preferences.  Model portfolios offer frameworks, but customization is key to achieving client goals.  Most accounts are made up of some core holdings in the S&P 500 and Core bonds, but most usually over 50% is allocated to diversifying positions.  Also, some weighting is often given to thematic or other positions in the investment factor, technology, or other sub-sector.

As I said in that April blog post,

There are literally an infinite number of combinations of equities and fixed income to create a portfolio with similar levels of risk, so SOMEONE needs to make an investment decision and invest in SOMETHING!  That is my job, as an investment adviser, to use my experience and knowledge of the markets to understand client objectives and goals to create an appropriate diversified portfolio with a target level of risk.

Winning with Diversifiers: A 2024 Market Breakdown

What has worked in 2024?  The S&P 500 has reached many new all-time highs this year being up +23.7% YTD through October16, but what else has performed well to help diversified portfolios beat their bogies?  I write a lot about the use of diversifiers in portfolios, so let’s take a look.

We talk a lot about small- and mid-cap equities as a way to diversify away from the mega-cap tech companies that make up a large part of the S&P 500.  YTD those asset classes still lag the S&P 500, but they are making up ground since mid-July (see table below for ETFs that could be held by a typical D&A client account).  For example, small- (SCHA) and mid-cap (SCHM) equities are up +5.7% and +6.7%, respectively, over the past 3-months compared to the S&P 500 (IVV) that is up +5.7%.  Likewise, equities with momentum (MTUM) and minimum volatility (USMV) factors have performed relatively better being up +8.7% and +7.9%, respectively.  Also, emerging market equities (SCHE, +7.4%) have started to join the party with some outsized returns helped with some stimulus we have seen in China.

We have seen the same phenomenon occur in the fixed income space with diversifying sub-sectors in fixed income outperforming core fixed income.  For example, over the past three months, core fixed income (SCHZ, +2.6%) has lagged other major fixed income diversifiers like investment grade corporate bonds (LQD, +3.8%), high yield bonds (HYG, +3.7%), emerging market bonds (EMB, +4.9%), and preferred stocks (PFF, +6.7%).  This relationship held fairly strongly on a YTD basis, as well!

This recent relative outperformance in diversifiers is helping D&A portfolios move strongly against their benchmarks on a recent and longer term basis.  Most D&A portfolios focus on core asset classes like the S&P 500 and U.S. aggregate bonds, but a good allocation away from those core holdings should allow those portfolios to outperform over time.  D&A will continue to manage portfolios with a focus on “long-term strategic asset allocation as the main driver of portfolio returns and diversification amongst asset classes as the primary means of managing risk.”

Cautious Optimism to Record Highs

Two weeks ago, when I wrote my blog post on the 2024 Q3  review titled “Stimulus, Stocks and a September Surge”, I was careful to not be too zealous with my assessment of the economy and the markets.

I opened that blog post with these thoughts:

Easing inflation, mostly stable employment, good economic growth, and an accommodative Fed are all bullish indicators for a stock market to perform well and that is what we saw during 2024 Q3

And closed it with this thought:

If you asked us what we think the market will do we would say “Beats Me!”, but most client accounts would have some exposures to the asset classes that are leading the markets at most any time. 

So, it goes without saying that I am pleased that the markets have delivered on expectations carrying forward the momentum from Q3.  The S&P 500 (IVV) has now reached another all-time high yesterday with a 2024 year-to-date return of +24.2%; on top of a 2023 YTD return of +26.3%!  Also, we are starting to see some good broadening of strength in the other diversifying asset classes that I always talk about including small/mid-cap equities, some factor exposure, and international and emerging markets.  Plus, fixed income has mostly behaved and has not been too much of a drag while smoothing performance.

As I have reported, most client accounts have been overweighted to equities during 2024 and fixed income has been managed to a shorter duration to reduce interest rate risk.  Clients have reaped the benefits of these strategies.  D&A is a long term investor and we target investment portfolio strategies to help clients achieve their goals.  We avoid behavioral bias, do not try to time the market, and stay-the-course as long as conditions warrant it. 

Stimulus, Stocks and a September Surge

Easing inflation, mostly stable employment, good economic growth, and an accommodative Fed are all bullish indicators for a stock market to perform well and that is what we saw during 2024 Q3; fittingly, with the S&P 500 reaching an all-time high at quarter-end!  Based on easing inflationary measures, the Fed initiated its well-anticipated Fed Funds rate cut on September 20, 2024.  Though the 50 basis point cut was larger than expected, the Fed assured markets that the large cut was simply a move away from the previous restrictive monetary conditions and was not indicative of any anticipated crisis; further cuts likely would be more moderate.

As expected, the markets rallied on the news and recovered nicely from a mild sell-off during late-July/early-August.  Separately, China announced robust stimulus measures into its economy in mid-September prompting a large rally in that and other emerging markets.

Notably, the Fed actions had an impact on the broader markets as we saw most diversifying asset classes rally and overtake the S&P 500 during Q3, though still lagging over the YTD horizon (see table below).  During Q3, the S&P 500 (IVV, +5.8%) still had a robust return but was surpassed by its diversifying brethren small- (SCHA) and mid-cap (SCHM) equities with 8.9% and 7.2% returns, respectively.  High dividend equities, represented by iShares Select Dividend ETF (DVY, +12.9%) rallied, too, demonstrating more broadening of the rally.  International (SCHF, +7.0%) and emerging market equities (SCHE, +9.9%) followed suit with outsized returns.

Fixed income, on cue from the Fed actions, generated good returns during Q3 as short rates eased and credit spreads narrowed with recession fears melting away.  Core bonds (SCHZ, +5.3%) and high yield bonds (HYG, +5.7%) buoyed as shorter bonds (SLQD, +3.4%) kept pace.

Most of my blog posts during Q3 had a bullish bias and we are happy that markets have responded positively to economic trends per my July 26 blog post, Small Caps Rising?:

If you asked us what we think the market will do we would say “Beats Me!”, but most client accounts would have some exposures to the asset classes that are leading the markets at most any time. 

Buckets, Benchmarks and Risk

I had lunch with an old friend recently and the conversation led, inevitably, to money!  As an investment adviser and Chartered Financial Analyst (CFA) holder, I usually find myself chit-chatting about investment management and retirement planning.  Some of the topics we focused on included:  how much is too much cash, how to determine a personal risk profile, and how to determine an appropriate personalized investment strategy.  Following below, I will summarize how I addressed these conversation points.

How much is too much cash? 

Readers of this blog post will know that most investment decisions are driven by the specific goals and needs of the client, so there is never one single right answer for every individual.  For example, if you are young, gainfully employed, and with a largish nest egg your needs for cash are very different (quite low need) than if you are elderly, in poor health, with only modest savings (quite large need).

Aside from “emergency fund” cash that most people should have equal to about 3-months of living expenses, I like to think about cash needs using the “bucket” approach.  Sometimes it is useful to think about your investment portfolio by putting your investments into buckets consistent with your time frames.  For example, if you think you will need $50k of cash each year over the next 5 years, put $250k of short term investments into your “conservative” bucket.  The balance of your investable assets can be allocated to risky assets as your “aspirational” bucket; maybe a blend of stocks and bonds for years 5-10 and then mostly risky stocks for 10+ years out.

How do we determine our risk profile?

A lot of times we throw the term “risk” around thinking people know what we are talking about.  For example, I will often quote numbers related to the “standard deviation” of return that reflect a statistical measure of risk.  When I say an investment has a risk of 17%, I mean that historically that investment has a high probability of being either up or down by 17% over any given year.  Another measure of risk is “drawdown” risk; the risk that reflects how far down an investment fell over a recent time horizon.  It is important to recognize that “loss” described here does not reflect “unrecoverable” loss, but loss simply due to market volatility.

For example, the S&P 500 has had the most phenomenal recent 15-year return profile since the dot-com craze producing an avg. annual compound rate of return of +14% with a “risk” of 17.3% with a -33.9% drawdown.  The 17% risk might not mean too much to an investor, but the -33.9% drawdown should strike a chord.  Imagine having $1 million one day and then seeing it is down $339k!

For clients with large investment portfolios and a long time horizon, sometimes they can “afford” to tolerate the drawdown risk since they have plenty of capacity and time to recover from the risk.  And, if they have used the “bucket” approach highlighted above and have a cash cushion, they have an extra bit of security.  For investors, with smaller portfolios and a shorter time horizon, exposure to risky assets should be curtailed.

How to determine an appropriate personalized investment strategy?

All clients of D&A have an investment benchmark that I manage against.  No benchmark is perfect since no benchmark can capture the nuances of how an investment portfolio is built to support the goals of a client.  Instead, I use the benchmarks as a rough guide on where we are headed.

For example, I like to use the iShares core allocation exchange-traded funds (ETFs) as benchmarks for many of our client accounts.  These ETFs target a long-term strategic asset allocation of stocks and bonds from conservative to aggressive allocations.

As a starting point, these benchmark ETFs have good core positions but are mostly naïve and do not include any dynamic aspects of the financial markets like investment and style factors on the equity side and high yield or short term bonds on the fixed income side.  And certainly, they include no client customization.  

Most D&A client accounts vary by a wide margin to the benchmarks due to these additional investment aspects.  Factoring in client-specific factors such as time horizon, quantum of wealth, tax considerations, life situation, and other things ultimately gets us to where we need to be.

Now What? Redux!

Back in January, I posted a blog titled “Now What? A Futurist View” dealing with long term market views. Some of those thoughts remain very relevant as the market has reached new heights back in July and taken dips down most recently.

I encourage a re-read of this blog to understand the potential for new technologies to transform the global economy. Specifically, Cathie Wood (of infamous tech fame) proffered this dynamic view of the future:

In it, she focuses on her identification of “five innovation platforms” that are evolving at the same time: artificial Intelligence (AI), robotics, energy storage, blockchain, and multiomic sequencing. The growth potential “reminds us of Amazon, 20-25% compound growth over 20-25 years” that potentially could be “sustained forever”.

The time frame for changes like this are indeterminate and market volatility is sure to accompany the construction and destruction of economic realities. As I said back in January:

D&A believes in long-term strategic investing to help investors achieve their goals consistent with their time horizon, risk tolerance and special considerations.  The views of Cathie Wood are compatible with our philosophy as we both have a long term time horizon.  A fully diversified exposure to US and global equities will allow investors to capitalize on this view without adverse idiosyncratic risk exposure.

A Balanced Growth Strategy

The S&P 500 index, represented by the iShares Core S&P 500 ETF (IVV), consists of the 500 largest stocks in the U.S. and broadly reflects the sectors and businesses within the U.S. economy. These stocks exhibit different characteristics, often referred to as "styles." The two primary styles are "growth" and "value," with a combination of the two known as "blend." Growth stocks typically have higher price/earnings ratios, justified by their larger expected earnings growth rates. In contrast, value stocks usually have lower growth rates but more stable earnings.

Over the past decade, growth stocks have significantly outperformed value stocks. Growth stocks, as represented by the iShares S&P 500 Growth ETF (IVW), returned +14.76%, while value stocks, represented by the iShares S&P 500 Value ETF (IVE), returned +9.17%. The broader S&P 500 (IVV) returned +12.82% during this period. Much of the recent outperformance in growth has been driven by mega-cap tech companies like Nvidia, Microsoft, Apple, and others.

How does D&A manage this relationship within the context of client goals and risk profiles? There are several ways to capture the excess returns from the growth style, including buying individual stocks, active mutual funds, or passive ETFs. At D&A, we generally favor passive ETFs as a way to gain diversified exposure to this style.

Some active mutual funds have performed exceptionally well in the growth space. For example, the T. Rowe Price Blue Chip Growth Fund (TBCIX) achieved a 1-year price return of +31.45%, slightly outperforming the passive growth ETF (IVW), which returned +29.93% (see chart below). During the same period, the value style continued to lag growth, with a +17.76% return, and the core S&P 500 (IVV) returned +24.09%.

So, why doesn’t D&A exclusively invest in the T. Rowe Price Blue Chip Growth Fund? The answer lies in risk management. Upon closer examination, this mutual fund excels in up markets, with an upside capture of 106%, similar to the growth ETF. However, it has a concerning downside capture of 128% compared to the growth ETF's 117%, and a maximum drawdown of -39.61% compared to -30.49% for the growth ETF. In essence, when the market rises, this mutual fund provides 106% of the index's return, but when the market falls, it captures 128% of the loss. While this could balance out over time, the higher short-term volatility doesn't seem like a favorable tradeoff for clients with anything less than a very long-term investment horizon.

At D&A, we start almost every client portfolio with a core holding in the S&P 500 passive ETF. By its nature, the S&P 500 includes exposure to the growth style. We then assess the client's risk profile and allocate an appropriate portion to a growth style ETF to overweight growth in client accounts. Additionally, most client portfolios already include an allocation to a passive ETF targeting the momentum factor, which in today's market is also overweight in growth.  As a result, most client portfolios have a double overallocation to the growth style.

Why ETFs?

Most people are familiar with the mutual fund structure.  These are “pooled” funds of diversified investments managed by investment professionals and regulated by the Securities and Exchange Commission (SEC).  Investors buy shares in the mutual funds and share in the investment performance; both up and down.  At the end of each day, all holdings in the fund are valued and a “net asset value” (NAV) is calculated and used for all activity in the fund that took place that day.

Exchange-traded funds (ETFs) are just like mutual funds except they are traded on an “exchange” just like regular stocks.  ETFs also have a net asset value except it is calculated continuously during the day allowing the ETF to be traded all day long.  But, the ETF does not necessarily trade at the NAV but usually trades at bid/ask prices that are a bit higher/lower than the NAV to compensate the exchange.

ETFs have several advantages over mutual funds.  Most importantly, the ability to trade during the day is a major advantage for risk management purposes.  For example, let’s say you had a portfolio of mutual funds and you wanted to rebalance to a different strategy.  In this case you would sell the mutual fund on the night before and would not have the proceeds to reinvest until the next day!  There are ways to minimize this risk, but this structure still exposes the investor to basis risk because the markets could move overnight and you would be forced to reinvest at a higher price than expected.

Another major advantage is the broad selection of passive diversified ETFs that track major indices, thus eliminating behavioral bias and active management that could hurt performance.

Also, because of the mechanism used to create/redeem ETF shares, most ETFs avoid the need to pay capital gains distributions; a major benefit for investors in taxable accounts.  Another benefit is the generally lower investment expenses compared to mutual funds, though this benefit is slowly disappearing due to competitive pressures.

The major disadvantage of ETFs is the aforementioned bid/ask structure.  For ETFs with low volume or other unique characteristics, the bid/ask spread could be very large thus costing the investor a high “implicit” fee on transactions.

D&A favors ETFs for most client accounts because of the benefits indicated above; especially the risk management aspect and the ability to invest in a broad selection of passive diversified ETFs to help target investment strategies tailored for our clients.  Also, because D&A usually invests only in the most liquid ETFS and trades relatively infrequently, the potential for higher bid/ask expenses is reduced.  And finally, the generally lower investment expenses embedded in ETFs is an advantage for our clients.

Small Caps Rising?

On July 13 I wrote a blog post titled “Small Caps’ Big Week”, and I applauded that brief trend as long overdue.  The big story this week, so far, is more of the same, per the CNBC graphic below.

As I have been reporting for a while, it’s been a tough run for small and mid cap equities over the most recent 10+ years, but maybe we are starting to see the beginning of a long term trend similar to the 2001-2010 period when small cap regularly led large cap?  In fact, historically over a very long time horizon from 1926-2023, small cap equities returned +11.8% compared to +10.3% for large cap equities (Morningstar).

I am a follower of Tom Lee, outspoken bull from FundStrat, who recently commented on CNBC on the merits of the small cap space.  He covered many of the virtues of small cap including the Russell 2000 having a relatively low P/E of 11 and faster earnings growth. From a technical standpoint he highlighted a historical perspective that 10 out of the past 11 days the Russell 2000 has moved more than 1% and the 9 times that it did that since 1979 the average 12-month gain was +40%!

Some of the other rationales for his bullishness include a political perspective, which in my mind is highly suspect because the election is still three months away, where the market is projecting a Trump presidency that will benefit M&A, deregulation and regional banks that would benefit small cap stocks.

From our website, the “D&A investment philosophy centers on long-term strategic asset allocation as the main driver of portfolio returns and diversification amongst asset classes as the primary means of managing risk.”

If you asked us what we think the market will do we would say “Beats Me!”, but most client accounts would have some exposures to the asset classes that are leading the markets at most any time.  Client accounts have benefitted from exposure to large cap equities during their great historical run and we expect that client accounts will benefit again as other asset classes take over market leadership.  The challenge is to know when the lead changes, and that is very difficult to do except by luck.

Small Caps' Big Week

As readers of this blog post are well aware, I have been bemoaning the tribulations of small cap stocks for the past few years.  Performance of this major asset class that we use a diversifier has lagged and been mostly dismal against its large cap brethren recently.  For example, the large cap S&P 500 (IVV) is up an annualized +10.4% return over the past 3 years while small cap (SCHA) is flat at 0.0%!

So, it is with great joy that I report that small cap stocks had a great week (see picture below)!  Last week, small caps made a big leap forward with a robust +5.2% return versus a +0.9% return for the S&P 500. Likewise, mid cap stocks popped, too, with a +3.7% weekly return.

We have seen this before, of course, when I last trumpeted some hope for small caps back in the fourth quarter of 2023.  At that time, both small and mid cap stocks led the S&P 500 for that brief period of time.  That rally was short lived, however, as its momentum lagged into this year; until last week!  Before its rally last week, small cap continued to struggle with a YTD return of 0.0% against +17.5% for the S&P 500; that is not a typo!

In addition to significant allocations to large cap stocks, D&A has consistently held moderate allocations to small and mid cap stocks for most client accounts as a means to diversify risk away from increasing client exposure to the mega cap tech behemoths like Microsoft, Apple, Nvidia, etc.  This strategy has caused a drag on performance for those accounts, but the idea, of course, is to hold complementary asset classes that “zig” when the others “zag”.  We have certainly seen that recently, but so far mainly in one direction!

So, the question is why now?  What is the impetus for this shift and the feeling of a “broadening” of performance into the small cap space?  Some market commentators say it is the growing prospect of a Fed rate cut in September.  Others say it is merely a rotation into small caps after mega cap tech stocks have moved too far and too fast leading to rotational profit-taking. Regardless of the cause, D&A will “stay the course” keeping client accounts broadly diversified in order to smooth the risk profile and performance over the long term.

Nvidia: 10x Tech Titan

I hardly ever write blog posts about individual stocks (see my DISCLAIMERS below!)  However, the astounding performance of Nvidia (NVDA) over the last two years has been absolutely amazing and is certainly worth an update.  From its recent trough on October 14, 2022 as the Fed tightening cycle was heating up through Friday, the stock is up more than 10x (split-adjusted price of $125.8 / $11.2 = 1,022%) per chart below!

 During its ascent, there were daily blips where the stock was down as much as -10%, but it countered that with nice rebounds.  Its daily standard deviation of return was +/-3.5%, meaning there was a very high probability that the stock could go up/down by 3.5% in any one day.

 What makes this performance even more astounding is that this is not some penny stock with limited coverage going from $0.25 to $2.50.  Nvidia is a large cap stock with billions in gross revenue and a large following of institutional and retail analysts and ownership. 

 I last wrote about Nvidia in February 2024 when it was only amazing!  At that time, I highlighted its situation as follows:

This tech company, in the old days simply known for its high-performance graphics cards for gaming and video, found itself in an almost amazing business situation.  Perhaps serendipitously, Nvidia found itself with a chip architecture and design that made it perfectly suited for a multitude of new applications other than gaming!

The new applications started with crypto and crypto mining… then, it migrated to self-driving cars, other devices and robotics needing video recognition.  And now, the beginning of the AI revolution finds Nvidia with another large product niche that makes its chips highly in demand.

Combine this product demand with the very scalable manufacturing process of computer chips and you come up with drivers of both top line and bottom line growth.  Sort of analogous to a drug maker who finds out that its one drug cures not only headaches, but many other maladies – all while production is hugely scalable!!

 Since then, it has continued its upward trajectory with higher revenue, earnings and market share.  The company has already disclosed product plans for the future, thus building up anticipation for new chips with better capabilities and energy efficiency.  The reported 85% market share is a built-in market for its proprietary next-generation chips and services.

Plus, given its astounding growth, new additional technical market factors come into play.  For example, Nvidia went from the third to the second largest holding in the $72 billion SPDR Select Technology ETF (XLK) with a 20% allocation.  So, 20% of every new dollar invested in that popular ETF will be invested in NVDA; a built-in market demand for that stock as new money flows into technology.  Likewise, NVDA has a 14% weighting in the $77 billion Vanguard Information Technology ETF (VGT), a 14% weighting in the $20 billion iShares U.S. Technology ETF (IYW), and a 20% weighting in the $20 billion VanEck Semiconductor ETF, not to mention its 6.5% weighting in the $500 billion iShares Core S&P 500 ETF (IVV) and others.

As a Chartered Financial Analyst (CFA) charterholder, I am well aware of the methods used to estimate equity values of companies.  However, I am also well aware that pure fundamental and technical analysis does not guarantee that a stock will be anywhere near what an analysis could indicate.  But, if someone wanted to write a story about a stock that had the best prospects for continued growth and return potential, then Nvidia might be IT!

This report is for informational purposes only.  The information, data, and analyses contained herein include confidential and proprietary information and other information from third parties.  The information provided is believed to be accurate, but the accuracy and completeness of the information is not guaranteed.  Past performance is not indicative of future performance.  This report is not an offer or a solicitation of an offer to buy or sell any security.

2024 Q2 Market Update

The U.S. economy has defied all fears of recession and over blown inflation since the Fed tightening cycle that began in March 2022.  In fact, Fed Chairman Jerome Powell coyly remarked in response to a “stagflation” comment on May 1 that he has not seen the “stag-“ or the “-flation” that would cause him concern.

The capital markets have agreed with this belief as U.S. markets continue to show pockets of strength and many new all-time highs in Q2, led once again by mega-cap tech stocks in the S&P 500 (IVV) with a robust YTD performance of +15.3%.  Though it is tempting to call this “irrational exuberance”, in most cases earnings growth has met/exceeded expectations validating the price strength of the large cap companies in that index.

However, many U.S. capital market sub-indices continue to lag the S&P 500 and produced negative performance during Q2.  Per the table below, small and mid caps (SCHA and SCHM) lag the most in Q2 (but still positive YTD) with high-quality dividend (DVY) struggling to stay even.

We are happy to finally see emerging market equities (SCHE) push forward due to some new strength in China and Taiwan and lead the broad capital markets during 2024 Q2 with a return of +5.3%, though still lagging the U.S. on a YTD basis. Lastly, fixed income, in the final throes of the Fed’s tightening cycle, are still seeking a firm ground from which to build.  Core bonds (SCHZ) are flat on the year, with shorter bonds (SLQD) and high yield bonds (HYG) a bit better.

My 2024 Q2 blog posts focused on three major themes:  investment strategy, portfolio diversification, and economic indicators.  Each of these themes is expressed in my role as an investment adviser per my blog post, Portfolio Management Decision-Making:

There are literally an infinite number of combinations of equities and fixed income to create a portfolio with similar levels of risk, so SOMEONE needs to make an investment decision and invest in SOMETHING!  That is my job, as an investment adviser, to use my experience and knowledge of the markets to understand client objectives and goals to create an appropriate diversified portfolio with a target level of risk.

My 5-year Blog-A-Thon!

I started writing weekly blog posts way back in late 2018!  I target one every week, but sometimes it’s every two weeks.  I write them because it’s a way for me to focus and summarize my thoughts on the markets and to express what I think is important.  It is also a way for me to let my clients know that I am always thinking of them!

As you may be aware, I have been playing around with the artificial intelligence utility called ChatGPT to see if it has any direct business uses for D&A.  Right now, it is mostly a fun toy to play around with but I don’t doubt that one day its power will make it invaluable for all aspects of business and society. 

One of the major uses of ChatGPT is to analyze and summarize large blocks of text and data.  It can also “write” blog posts on selected topics, but I have not used it for this purpose and will continue to write my own original blog posts.  However, one good use of this ChatGPT functionality is to help me analyze all 260 blog posts I have written over the past 5 years to help me summarize the main themes I have covered. 

Per the table below, I think it did a good job summarizing my focus over the last 5 years!  I am happy to report that the lion’s share of the thoughts expressed from my blog posts centered on market analysis and investment strategies (50%) since that is where I strive to provide the highest level of service to our clients. The second tier of focus dealt with specific asset classes (20%) and then retirement planning (15%) with the remainder dealing with behavioral finance and other topics.

Occasionally, I will write blog posts pertaining to a specific client concern or situation (anonymously, of course!)  So, if there are any unmet needs for clarification on certain strategies I have employed or if anyone simply would like to read my thoughts on a certain topic, please reach out and I will work on it for you.  Thanks!

Federer, Forehands and Finance!

My daughter lives in Hanover, NH and is a big tennis fan, as am I.  We were thrilled to learn that Dartmouth University invited tennis star Roger Federer to speak at their commencement on June 9 this year!  He focused his talk on “tennis lessons” that made me think about how playing tennis and investing have many parallels.

Certainly, both involve strategy, planning, adaptability plus a bit of luck!  In tennis, you need to anticipate your opponent’s moves and plan your shots accordingly.  Similarly, in investing you must anticipate market trends and make strategic decisions about where to allocate resources.

Both also demand continuous learning and adaptability.  In tennis you constantly refine your skills and adapt to different playing styles.  Hitting a strong inside-out crosscourt forehand to your opponent’s weaker backhand is a path to probable success.  Likewise, in investing you need to stay informed about market changes and be ready to adjust your strategies.  When the Fed telegraphs a dovish interest rate forecast, it is best to modify strategy accordingly.

Also, patience and discipline are crucial in both areas.  In tennis, staying calm and composed helps you make better decisions on the court.  Don’t rush that put-away volley, or you might hit it out or into the net!  In investing, maintaining a disciplined approach can help you navigate market volatility and avoid impulsive decisions.  Don’t chase that high-flying investment theme unless there is a strong case supporting it.

And finally, luck is also a factor in tennis and investing!  There are many unpredictable aspects to tennis like “net cords” where the ball just trickles over the net, gusty wind conditions, or bad ball bounces.  In investing, sometimes the markets move in unpredictable ways that are either to your detriment or benefit.   The timing of cash flows into the market could also be a positive or negative factor depending on when you entered the markets.  Also, unexpected economic or geopolitical events can significantly impact market returns.

While luck can influence outcomes in both tennis and investing, skill and preparation often mitigate its impact.  Both in tennis and investing, a well-prepared investor is better prepared to capitalize on lucky breaks and to recover from unlucky events.  Just like having a diverse selection of shots and skills in tennis helps your game, likewise diversification in investing helps mitigate risk.

And Still Champ!

The facts cannot be overstated!  The S&P 500 (IVV), as a broad-based stock index of the largest companies in the U.S., reached new all-time highs last week and has continued its phenomenal run of outperformance over the past 15 years!  Amongst the major asset classes like small- and mid-cap U.S. equities and international developed and emerging market equities and others, not one has beat that index at best return AND lowest risk!

Per the chart below, we can see that the S&P 500 (IVV, the green line) had tracked close to the other major indices until pulling away starting in 2021 where other broad indices lagged. Amazingly, it has achieved its pack-leading compound annual growth rate of +14.4% per year with the lowest volatility amongst its group at 17.3%.

Numbers like these have led some to question the value of diversification. Simply put, owning anything other than the S&P 500 in a broadly diversified global portfolio has hurt performance. However, it's important to remember that no one could have forecasted this impressive streak of outperformance, and there was still a high degree of risk, albeit less than other competing asset classes.

 Over the last several quarters D&A has committed more client assets to the S&P 500, depending upon the client portfolio objectives, while also keeping bonds duration shorter than the benchmark and has thus reaped some benefits.  However, the remaining allocations to some diversifying positions have been a drag thus far this year.  Like I said in my most recent blog post, Strategic Insights for Market Success, we are patient long term investors and are committed to our outlook:

 “The U.S. growth picture remains robust and is broadening globally, with parts of Emerging Markets showing promise. Central bankers expect inflation to decline gradually, with no signs of widespread acceleration. We continue to favor the momentum and other factors and are sticking with small- and mid-cap as market breadth has started to gain traction.

In conclusion, while the S&P 500's performance has been exceptional, it's crucial to maintain a balanced perspective and consider long-term strategic investments to navigate future market conditions successfully.

Strategic Insights for Market Success

As a dedicated investment advisor at D&A, my primary focus is to ensure that our strategic and tactical positioning remains sound for our client portfolios. This requires extensive research and analysis of current market conditions. Over the past several quarters, our strategy has included overweighting equities, enhancing the quality of our equity positions, and maintaining a shorter duration in fixed income relative to core benchmarks. However, the dynamic nature of the markets necessitates continuous evaluation to determine if adjustments are needed.

Recently, I took part in a Northern Trust webinar titled "What’s the Market Missing?" which provided valuable data and insights influencing my current views. Here are some key takeaways:

Real Wage Growth and Consumer Spending:

Real wage growth in the U.S. is on the rise, likely supporting consumer spending going forward. However, high interest rates have increased the interest burden, especially for lower-income groups. This mixed impact on disposable income warrants close monitoring.

Inflation and Interest Rates:

Inflation remains a challenge for the U.S. economy, though it has been steadily declining. Notably, "core services ex-housing" inflation is on an uptick, attracting the Fed's attention.  With U.S. equity valuations elevated but within normalized bands, the "higher for longer" interest rate scenario could be a key determinant of future market moves.

Volatility:

Volatility has been unusually low, with recent averages well below the historical norm of 20%. Historically, volatility spikes can lead to asymmetric returns—markets tend to be more volatile on the downside than on the upside. Factors like value and momentum, which prefer volatility, have shown mixed performance. Since 2022, momentum has been the best-performing factor. We should be cautious, as volatility is unlikely to remain at these depressed levels for long.

Current Tactical Views and Recommendations

Currently, we maintain an overweight position in stocks over bonds.  The U.S. growth picture remains robust and is broadening globally, with parts of Emerging Markets showing promise. Central bankers expect inflation to decline gradually, with no signs of widespread acceleration. We continue to favor the momentum and other factors and are sticking with small- and mid-cap as market breadth has started to gain traction.

In the fixed income space, we continue our shorter duration bogey and underweight in investment grade bonds and overweight in high-yield bonds, aligning with the strong growth outlook. This positioning also hedges against the risk of being wrong about the inflation trajectory, especially given the negative correlation between stocks and bonds observed in Q1.

Conclusion

Our investment philosophy hinges on thorough market analysis and strategic adjustments based on emerging data. The insights from the Northern Trust webinar reinforce our current positioning but also highlight areas for vigilance, such as volatility and inflation dynamics. By staying informed and adaptable, we aim to continue delivering strong, risk-adjusted returns for our clients.

In the words of Jerry Seinfeld

I wrote a blog post on May 8 titled "Here's a TIP" that dealt with inflation and D&A strategies.  It was a bit dry and some of you may not have read it!  So, in hoping that I could make the topic more engaging, I asked our new artificial intelligence (AI) friend CHATGPT to re-write it in the words of Jerry Seinfeld! Take a read below!  I think you will find it entertaining since it capture the essence of what I was saying with a bit of comic spin:

So, let's talk about inflation. You know, that sneaky little thing that makes your dollar bill feel more like a coupon? Yeah, that one. People always say, "Hey, if you want to hedge against inflation, buy gold, buy commodities, buy equities." But you know what else they say? They say, "Hey, don't forget about TIPS!" No, not those little nuggets of wisdom your grandma gives you. I'm talking about Treasury Inflation-Protected Securities.

These things are like regular bonds, but with a twist. They're issued by the U.S. Treasury, so you know they're legit. And instead of just sitting there collecting dust, their returns are adjusted to keep up with inflation. Pretty neat, huh? But here's the kicker: Turns out, they haven't been the superhero we thought they were in the fight against inflation.

I mean, just look at the numbers! TIPS had some good years, sure, but when inflation peaked in 2022, they took a nosedive. Down 12.3% while inflation was up 8.0%? Ouch! It's like trying to fight fire with a water pistol.

And why did they flop? Well, it's all about the math. Low coupon rates, interest rate hikes – it's enough to make your head spin. Core bonds had it rough too, barely scraping by with a -0.1% average annual return. Talk about a close call!

Meanwhile, traditional inflation hedges like gold, equities, and commodities were out there flexing their muscles. They left TIPS in the dust, along with CPI (that's inflation, folks) and their dreams of being the inflation-fighting hero.

But hey, it's not all doom and gloom. There's a silver lining in this cloudy financial forecast. Turns out, diversification is the name of the game. Short-term bonds, high yield bonds, bank loans – they all held their own against inflation, and then some.

So, what's the plan now? Well, Dattilio & Ash aren't exactly rushing to buy TIPS anytime soon. But with interest rates on the rise, they might just become the belle of the ball. And as for gold? Well, hindsight's 20/20, my friends.

Instead, they're doubling down on core equities. Because let's face it, big companies know how to hustle. They're raking in those earnings despite the inflationary storm brewing. And sure, other equity diversifiers like REITs and international stocks might be struggling, but hey, a little diversification never hurt anybody.

So there you have it, folks. Inflation might be giving us all a run for our money, but with a little strategy and a lot of diversification, we'll come out on top. After all, it's not about how hard you fall, it's about how high you bounce back. And in the world of finance, that's the name of the game.

Here's a TIP!

Aside from the traditional inflation hedges like gold, commodities and equities, Treasury Inflation-Protected Securities (“TIPS) usually come to mind.  These securities are bonds issued by the U.S Treasury and are fully guaranteed.  They are different from regular bonds in that the total return earned from income and principal is adjusted to reflect inflation over the time to maturity.  How have TIPS done over the past few inflationary years in their role as an inflation hedge?

As we all know, the capital markets have all been up and down over the past five years.  What we may not have realized is that TIPS (TIP) have not been too effective an inflation hedge.  From the table below you can easily see that TIPS had a few good years and a few bad years; the bad years coming exactly when inflation peaked in 2022; actually DOWN -12.3% when inflation was up +8.0%!

The reasons for the underperformance have a lot to do with bond math and the low coupon rates that existed prior to interest rate increases that started in 2022.  That same phenomenon impacted core bonds (AGG) in a similar manner causing its average annual return over the entire 5.3-year period to be only -0.1%!  Over that longer time horizon TIPS did outperform core bonds, but not by much and certainly not enough to warrant an inflation hedge badge!

Also from the chart above, you can see that traditional inflation hedges like gold (GLD), core equities (IVV), and commodities (GSG) all handily beat TIPS and CPI (inflation) over that horizon. Interestingly, it is important to note that diversification in the fixed income universe paid off handsomely during this difficult period.

Aside from long term investment grade bonds (LQD) that have struggled in the face of higher rates, other fixed income sectors proved to be good diversifiers to help hedge inflation risk by outperforming core bonds.  Short-term investment grade bonds (SLQD), high yield bonds (HYG), and bank loans (BKLN) all outperformed TIPS and managed to stay close or beat inflation.  Some of that outperformance is due to a shorter bond duration and historically narrow credit spreads.

Dattilio & Ash has not been a buyer of TIPS during the prior market cycle. Higher rate levels today, however, may make TIPS a more interesting investment thesis going forward.  Gold, on the other hand, with 20/20 hindsight could have been a viable investment option over the past few years.  D&A had not been an investor in commodities due to their higher level of risk. 

Instead, we have focused mostly on core equities and shorter duration fixed income sectors and have consistently had total fixed income duration shorter than that of core bonds.  Shorter duration fixed income has less interest rate sensitivity and will outperform longer duration bonds when rates are rising in a Fed tightening cycle.

Core equities have been a good place to be as large stable companies are able to increase earnings due to inflationary pressures and D&A has been increasing allocations to this sector over the past several quarters.  Other equity diversifiers, like small- and mid-cap equities, real estate investment trusts (REITs) and international and emerging market equities continue to struggle to keep pace with core equities but we continue to hold for diversification purposes.

Video Blog - Market Views: A Long-term Strategic Assessment of the Capital Markets

In this 6-minute video blog post I highlight what the markets have done recently and over the past 10-years and discuss the relationships of risk and return of a few of the major asset classes.  I then integrate those thoughts into how we manage investment for clients.

Portfolio Management Decision-Making

I have written a lot about risk over the years and how it can influence portfolio management and market participant behavior.  For example, in 2022 many investors feared the developing market weakness and they “ran for the hills” by selling equities and buying bank CDs; thus, locking in losses and missing the huge recovery and new all-time highs in the broad equity markets.

Managing risk through portfolio management is as much an art as it is a science.  For a globally diversified portfolio and a given set of constraints, there are numerous approaches we could follow and many analytical tools (such as Portfolio Visualizer) we can use to help guide us with this task.  Let’s look at a few strategies that we could employ for a typical client.

Let’s assume you are a client with a long-term time horizon to retirement and want to maximize return as an aggressive investor with the capacity to accept a large amount of risk (20% standard deviation of returns).  Intuitively, we can guess that the target aggressive portfolio would be heavily weighted to equities with no fixed income allocation.  But, what exactly would this portfolio look like and what does the 20% standard deviation of return translate to?

Using the Portfolio Visualizer model, we can model expected results and get an idea of the details underlying these assumptions.  As you would expect, this aggressive model portfolio would generate large losses when the equity markets go down with a maximum drawdown of -30.16% but would generate a modeled expected return of +13.63% over a 10-year horizon (See table/chart below).  This portfolio targets the most aggressive sectors of the equity markets and is minimally diversified to help maximize returns; something a typical investor might not be comfortable with.   

Let’s say, however, that you are a bit risk-averse and instead want to target a lower moderate risk portfolio with a 10% standard deviation of return.  In that case, your fixed income allocation goes up from 0% to 26% and your maximum drawdown goes to only -16.13% with a modeled expected return of +9.37%. Interestingly, this modeled portfolio maintains a relatively large equity weighting, but this time it is allocated to the least risky equity sectors.

If you are somewhere in the middle, we can target a 12% risk and target a growth portfolio that results in a 10% fixed income allocation that generates a modeled return of +11.14%.  Again, this modeled portfolio targets the least risky equity sectors in lieu of a larger fixed income allocation to help reduce portfolio risk.

So, what does this all mean?  Models, after all, are only “models” and can only be used as a guide.  Quant investors, meaning those asset managers who rely on quantitative models to manage their portfolio, do NOT beat the market with any regularity over time so we know that models alone are NOT the solution.

There are literally an infinite number of combinations of equities and fixed income to create a portfolio with similar levels of risk, so SOMEONE needs to make an investment decision and invest in SOMETHING!  That is my job, as an investment adviser, to use my experience and knowledge of the markets to understand client objectives and goals to create an appropriate diversified portfolio with a target level of risk.