Why I might NOT WANT to beat the index NOW

This year has been another good year for the S&P, with a year-to-date total return of 9.9% (as of 6/28/17). Investors are asking, “How have I done versus the index?” thinking predominantly of return and not risk. Very few investors are asking, “How am I protected against the next recession.” The memory of 2008, or 2000 to 2002, or 1973 to 1974, etc. is fading. A recent survey conducted by GoBankingRates found 68% of respondents said their portfolio strategy “DOES NOT ACCOUNT FOR THE POSSIBILITY OF A RECESSION.” The old saying comes to mind, “If you fail to plan, then you plan to fail.”

What could make 68% of investors behave irrationally, giving no thought to the possibility of a recession given how many recessions they’ve had to endure?” We believe there are a couple of factors, one of them being the consistent returns earned in the stock market since 2009. As the saying goes, “Time heals all wounds.” Now that investors have SEEN the recovery, they BELIEVE the stock market will just continue to go up. Unfortunately, this is an emotional response and investing for the future based upon the past has a history producing of poor results. A second factor is many investors seem to believe “This time it is different.” The fund flows into passive equity index funds (ETFs) seem to suggest these investors believe their chosen index fund is providing enough diversification that they will not get harmed; they believe this time it will be different because this time they own the index.

We want to address these two beliefs. With respect to the market’s history, it’s important to know that we are MUCH NEARER a MARKET HIGH than a market low. We of course know this; it seems we can’t go more than a week or two without hearing in the news about new market highs. However, for many investors, hearing about new highs is triggering their “Greed Response,” where they “NEED TO BEAT THE INDEX.” Perhaps it would be more prudent if it were triggering their “Fear Response,” and their reaction were that it’s been a great ride since 2009, and it would be wise to protect their gains over the last 8 years, rather than risk giving it all back. Using Warren Buffet’s words, “Be fearful when others are greedy, and be greedy when others are fearful.” Returning the mantra of “Buy low and sell high,” now would be a more appropriate time to reduce portfolio risk than 2009 was, even at the price of underperforming the index.

The next issue we want to address is the apparent belief that “This time it’s different.” We would contend passive index investing may not provide as much protection as some would like to believe. By looking under the hood of the S&P 500, we identified where the returns this year have come from. We found that the technology sector alone provided 49.5% of the S&P’s total year-to-date return. More interestingly, we found that only 5 companies in the S&P 500’s technology sector (Apple, Microsoft, Facebook, Google, and NVIDIA) accounted for 56.3% of the technology sector’s performance. In other words, while investors have owned the S&P 500 to get a diversified return stream, they really have received a very focused return stream where 1% of the S&P 500’s companies have provided 28% of its gain.

Further, “Market Cap Weighted Indexes (like the S&P)” are programmed to buy high and sell low. Why? Because “Market Cap Weighted” means that as a company gets more expensive, it becomes a bigger weight in the index. If you would have bought the S&P 500 in 1990, when “Technology” was considered no big deal, you would have bought a 6% exposure to the Technology Sector. And if you would have bought the S&P 500 in 1999 at the peak of the tech bubble, you would have bought a 29.2% exposure to the Technology Sector. From 1990 to 1999, the S&P 500 Technology sector enjoyed one of the highest growth rates the markets have ever seen, growing at over 1200% for the decade. From 2000 to 2010 however, the S&P 500 Technology Sector returned to investors a -46% rate of return. Clearly, we would have wanted to reverse our weighting in Technology such that we would have owned 29% in 1990 and 6% in 1999. This asymmetric return profile is why so many investors experienced what we now call the “Lost Decade (2000 to 2009),” where the total return on the S&P 500 was less than 0%.

Now we turn to what we’re doing to prepare portfolios for a possible recession. Historically speaking, we would have used investment grade or government debt (bonds). However, in today’s ultra-low rate environment, it is difficult to find high quality bonds that will keep up with inflation, let alone outperform inflation. So what do we do now?

We look to other investment classes that can provide a higher income stream than investment grade debt (high dividend paying stocks, MLPs, preferred stock, etc.). We also begin to contemplate carrying higher levels of cash. If a portfolio needs to produce a 5% rate of return to support its distribution rate, combining a portfolio yield of 3% with a cash position of 6% ensures the portfolio can meet its distribution demand for 3 years without the need to touch principal. We also know U.S. stocks have achieved positive returns 82.9% of the time over a rolling three-year period. What this means to investors is that if they needed to sell any stocks to meet distributions demands, there is an 82.9% chance they would do it at a gain, or in other words, they would have bought low and sold high 82.9% of the time. We believe this outcome justifies the nominal reduction in return because of an elevated position in cash.

We also introduce non-correlating asset classes that tend to perform well when recessions come. Reducing the correlation of portfolio investments increases the probability that we will be able to sell assets at a gain if the need should arise within or after the 3 year period we’ve covered with income and cash on hand.

Please call or email us with any questions or concerns.

 


 

© Fortem Financial 2017. All rights reserved. Data Sources: News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources such as government agencies, corporate press releases, or trade organizations. Market Data: Based on reported data in WSJ Market Data Center (indexes); U.S. Treasury (Treasury Yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The opinions expressed are solely those of the author, and do not represent those of Fortem Financial, LLC or any of its affiliates. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. Carefully consider investment objectives, risk factors and charges and expenses before investing.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighed index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.

Categories: Monthly Market Commentary

The first half of 2017 is in the books and we think the second half should be as good or better for markets around the globe…

Markets were mixed last week as the Financials sector rallied while Technology lagged. On Wednesday, several banks announced dividend increases and share buybacks; the decisions followed the Federal Reserve’s determination that, for the first time in seven years, all of the banks subject to its Comprehensive Capital Analysis and Review (CCAR), the so-called “stress test,” had passed. Higher yields on Treasury bonds further supported the favorable outlook for financial companies. The technology-heavy NASDAQ underperformed as investors, in weighing the sector’s attractive growth prospects against strong year-to-date gains, may contemplate rotating into other areas.

Source: Pacific Global Investment Management Company

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

 

 

Market Week

Small cap stocks, which have trailed large and mid caps thus far this year, may be a potential destination for these funds. Meanwhile, economic data remain generally supportive. The final estimate for first quarter GDP was increased to +1.4%, driven by a higher estimate for consumer spending; measures of consumer confidence are near 13-year highs. Still, the economy remains on a slow growth trajectory as durable goods orders declined and inflation eased. After oil prices fell into bear market territory last week, the sector recovered as overwhelmingly negative investor sentiment subsided. A slight increase in crude oil inventories was more than offset by reductions in supplies of refined products, including gasoline and distillates.

The results for the first half of the year are in: the S&P 500® Index and the Dow Jones Industrial Average posted their best performance in four years while the NASDAQ posted its best result since 2009; Technology and Health Care stocks enjoyed the strongest gains while the Energy sector was a notable laggard. Importantly, though, the market continued to advance despite the decline in oil prices during the second quarter. Moreover, and in contrast to recent years, the markets enter the second half of 2017 without the pall of Greek debt crises or Brexit weighing on sentiment. The relative calm should enable investors to focus on the health of the global economy and corporate profits.

Attention will now shift to the upcoming second quarter earnings season as companies provide updated outlooks for the remainder of the year. With the downturn in oil prices, companies in the Energy sector will be in focus; investors will look for updates on the current environment as well as managements’ expectations for near-term and longer-term activity. Overall, companies in the S&P 500® Index are expected to grow sales by 4.7% and earnings per share by 6.5%; the technology sector is forecast to lead earnings growth at 10.3%, followed by financials at 6.2%. The continued expansion in corporate profits, in combination with an improving global economic outlook, should sustain the market’s positive bias over the second half of the year.

 

 

Last Week's Headlines

  1. The final report on the first-quarter gross domestic product showed growth improved marginally, but it is still relatively weak compared to the fourth quarter. The GDP increased at an annual rate of 1.4% in the first quarter of 2017, according to the third and final estimate released by the Bureau of Economic Analysis. The second estimate released in May estimated the GDP growing at a rate of 1.2%. In the fourth quarter of 2016, the GDP increased 2.1%. The deceleration in the GDP in the first quarter reflected a downturn in private inventory investment, a deceleration in personal consumption expenditures (consumer spending), and a downturn in state and local government spending that were partly offset by an upturn in exports, an acceleration in nonresidential (business) fixed investment, and a deceleration in imports. Gross domestic income grew 1.0% in the first quarter, in contrast to a decrease of 1.4% in the fourth quarter.
  2. Consumers did more saving than spending in May, according to the Bureau of Economic Analysis. Personal income increased $67.1 billion, or 0.4%, in May, while disposable (after-tax) income jumped $71.7 billion, or 0.5%. However, personal consumption expenditures (consumer spending) rose a scant $7.3 billion, or 0.1%. The increase wasn't attributable to wages and salaries (+0.1%), but reflected increases in dividend income, personal income transfers (generally to savings, which rose 0.4%), and proprietors' income. Core prices, less food and energy, increased 0.1% and are up a marginal 1.4% year-on-year. While this report is not necessarily negative, it is in line with other economic indicators, which show inflation in particular, and the economy in general, slowed in May.
  3. The manufacturing sector may be weakening after new orders for long-lasting goods fell for the second consecutive month. New orders for durable goods fell $2.5 billion, or 1.1%, in May, following a 0.9% decrease in April. The drop in new orders is the largest monthly decrease in 6 months. Excluding transportation, new orders increased a marginal 0.1% for the month. Shipments of manufactured durable goods in May, up following two consecutive monthly decreases, increased $1.8 billion, or 0.8%, to $234.9 billion. Unfilled orders for manufactured durable goods in May, down following two consecutive monthly increases, decreased $2.3 billion, or 0.2%, to $1,120.1 billion. Inventories of manufactured durable goods in May, up 10 of the last 11 months, increased $0.7 billion, or 0.2%, to $395.4 billion.
  4. An uptick in consumer exports helped narrow the trade deficit in May, according to the Census Bureau. The international trade deficit was $65.9 billion in May, down $1.2 billion from $67.1 billion in April. Exports of goods for May were $127.1 billion, $0.5 billion more than April exports. Imports of goods for May were $193.0 billion, $0.8 billion less than April imports.
  5. The Conference Board Consumer Confidence Index®, which had fallen in May, increased somewhat in June. The index rose to 118.9 for June, up from May's 117.6 reading. Consumers remained upbeat about current economic conditions, but were less enthusiastic about the short-term outlook, as the Expectations Index declined from 102.3 in May to 100.6 in June.
  6. Respondents in the University of Michigan's Surveys of Consumers seemed to follow consumers' sentiments from The Conference Board's report. The Index of Consumer Sentiment dropped in June to 95.1 from 97.1 in May. Consumers viewed current economic conditions favorably, as that index increased from 111.7 to 112.5. However, the Index of Consumer Expectations decreased from 87.7 to 83.9 — an indication that consumers aren't too sure about the future of the economy.
  7. In the week ended June 24, the advance figure for seasonally adjusted initial claims was 244,000, an increase of 2,000 from the previous week's revised level. The previous week's level was revised up by 1,000 from 241,000 to 242,000. The advance seasonally adjusted insured unemployment rate remained 1.4% for the week ended June 17, unchanged from the previous week's unrevised rate. During the week ended June 17, there were 1,948,000 receiving unemployment insurance, an increase of 6,000 from the previous week's revised level. The previous week's level was revised down by 2,000 from 1,944,000 to 1,942,000.

 

 

Eye on the Week Ahead

Trading should be slower during the holiday-shortened week. The June employment report is released at week's end. The unemployment rate has fallen over the past few months, but so has the number of new hires. Wage inflation has been moderate at best and isn't expected to pick up steam any time soon.

 


 

Fortem Financial 2016. All rights reserved. Data Sources: News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources such as government agencies, corporate press releases, or trade organizations. Market Data: Based on reported data in WSJ Market Data Center (indexes); U.S. Treasury (Treasury Yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The opinions expressed are solely those of the author, and do not represent those of Fortem Financial, LLC or any of its affiliates. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. Carefully consider investment objectives, risk factors and charges and expenses before investing.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighed index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.

Markets still firm and climbing the wall of worries, but Energy continues its selloff...

Stocks were flat-to-higher last week in relatively quiet trading as investors looked ahead to second quarter earnings season. A rebound in technology stocks drove the NASDAQ to outperform while the energy sector underperformed (more on this in our Market Week commentary). The release of the Senate’s draft version of an Obamacare repeal and replacement bill dominated headlines. Early criticism by Senate Republicans suggests that the proposed legislation may not garner sufficient support to pass. For now, investors are not yet imputing any outcome in health care reform.

Source: Pacific Global Investment Management Company

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

 

 

Market Week

On Thursday, the Federal Reserve performed its annual Comprehensive Capital Analysis and Review (CCAR), also known as the bank “stress test.” All 34 of the largest U.S. banks passed the examination; one test, a “severely adverse” scenario, featured a global recession with U.S. unemployment rates jumping to 10% and distressed commercial real estate market conditions. The positive results evidence the improved condition, post-financial crisis, of the country’s largest banks. The significant progress raises the possibility that the Fed may relax some of its capital rules; the upshot would be increased lending activity, especially to potential borrowers that had been neglected due to the strict capital requirements.

Energy stocks fell as oil prices declined for a fifth consecutive week; Brent crude oil, the international benchmark, has retreated more than 15% since OPEC’s agreement in May to extend production cuts. Investors are concerned by increased output from Nigeria and Libya (both of which are exempt from the OPEC deal), and a growing number of active drilling rigs in the U.S. Yet, the Energy Information Administration’s weekly inventory report showed that U.S. stockpiles, while still elevated, are receding. And, Iran’s oil minister stated that OPEC is contemplating deeper cuts to reduce the global inventory overhang. The reality is that, due to labor and equipment shortages, many of the recently-drilled shale wells are unlikely to be brought online in the near-term. These drilled-but-uncompleted wells (DUCs, in industry parlance) hit an all-time high in May. The current economics of shale oil point to a break-even price range of $40 to $60 per barrel; and, in contrast to prior years, most shale producers have not locked in higher prices for their production. Thus, as oil prices are near the low end of the break-even range, we anticipate that companies will respond by curtailing activity until prices recover. Indeed, oil prices themselves may be the catalyst to bringing supply into balance.

Source: Pacific Global Investment Management Company

 

 

Last Week's Headlines

  1. The housing sector may have shown signs of improvement in May, as existing home sales climbed 1.1% for the month — 2.7% above a year ago. Total housing inventory rose 2.1%, which helped increase the number of sales. However, inventories remain low, which is driving up prices. The median existing-home price in May was $252,800, which is the highest median price on record and is up 5.8% from a year ago. Unsold inventory is at a 4.2-month supply at the current sales pace, which is down from 4.7 months this time last year.
  2. At an annual rate of 610,000, sales of new single-family homes in May were 2.9% above their revised April rate, and 8.9% above the May 2016 estimate. The median sales price of new houses sold in May 2017 was $345,800. The average sales price was $406,400. The seasonally adjusted estimate of new houses for sale at the end of May was 268,000. This represents a supply of 5.3 months at the current sales rate — unchanged from April.
  3. In the week ended June 17, the advance figure for seasonally adjusted initial claims was 241,000, an increase of 3,000 from the previous week's revised level. The previous week's level was revised up by 1,000 from 237,000 to 238,000. The advance seasonally adjusted insured unemployment rate was 1.4% for the week ended June 10, unchanged from the previous week's unrevised rate. The advance number for seasonally adjusted insured unemployment during the week ended June 10 was 1,944,000, an increase of 8,000 from the previous week's revised level. The previous week's level was revised up 1,000 from 1,935,000 to 1,936,000.

 

 

Eye on the Week Ahead

The final week of the month and second quarter offers a last look at the rate of economic growth with the release of the final report for the first-quarter GDP. Inflation is slowing, a trend that is expected to carry over to consumer income and spending as detailed in this week's May report on personal income and outlays.

 


 

Fortem Financial 2016. All rights reserved. Data Sources: News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources such as government agencies, corporate press releases, or trade organizations. Market Data: Based on reported data in WSJ Market Data Center (indexes); U.S. Treasury (Treasury Yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. The opinions expressed are solely those of the author, and do not represent those of Fortem Financial, LLC or any of its affiliates. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. Carefully consider investment objectives, risk factors and charges and expenses before investing.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighed index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.

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