How long will this upward move in stocks last? It’s a constant and valid concern, especially considering how well the markets have done for years. What will end the rally?
We are currently dealing with elevated valuation and sentiment levels, historically low volatility, rising interest rates, reversal of quantitative easing, terrorism, natural disasters, political uncertainty, and more. It is impossible to know what concern will finally “stick” and be the material cause for a correction. Sometimes markets just simply get exhausted to the upside. However, as there are always market concerns, being on the right side of the trend is more important. The current trend and economic indicators remain supportive of further stock outperformance. The market quite literally climbs a continual wall of worry. We will keep monitoring our models for indications of risk, but for now the weight of the evidence remains bullish.
If I had to pick my primary concern, it would be the potential effects from the Fed’s reversal of quantitative easing. The Fed’s quantitative easing actions (i.e. bond asset purchases) have provided tremendous liquidity to the markets. How long the markets will be able to move higher in the face of this withdrawal remains to be seen. There is usually a lag time for Fed actions to be felt in the economy and markets. As the Fed is starting slow, it may be some time before what is now being dubbed quantitative tightening (QT) has a material effect. We will watch the process with great interest.
On the constructive side, economic data continues to be positive globally. According to our indicators, recession is still not in the cards anytime soon. U.S. economic growth grew at 3.1% in the second quarter, which was slightly higher than expected. Manufacturing activity is the highest in 13 years and service-sector activity is the highest in 12 years. While stocks are expensive right now, they are not at extremes. Corporate profit growth remains positive and is offsetting the slow pace of rising interest rates. While interest rates are rising they are still extremely low on a historical scale. The prospect of fiscal policy being passed is still supporting the markets due to the potential economic shot in the arm it could provide.
Another positive is that we are heading into what is seasonally the best time of year for stocks. Additionally, the majority of global markets are trading above their moving averages, suggesting that momentum continues to support further gains.
Before this quarter, one of our concerns was that the breadth of the market advance was not very wide — only a few sectors and stocks were making up the bulk of the advance. However, last quarter alleviated some of these worries as the first half laggards such as small caps, energy, and value stocks rallied nicely. The final weeks of the quarter saw a rotation back into many of the “Trump trade” stocks.
Last quarter was good for the stocks in our Top Flight portfolio, which was up 6.3% for the quarter compared to 4.5% for the S&P 500 Index. Our stock portfolio is broken down into two segments and is currently comprised of 30 holdings of 2% each (60% total). The first is a fundamental based approach that focuses on stocks with the least downside risk. These stocks gained about 6.4% on average for the quarter. The second segment is a momentum or trend-based approach. The small cap segment of this approach was up about 11.2% and the large/mid-cap segment was up about 9.8% for the quarter. The best performers came from the auto parts industry with BorgWarner and Lear both up around 20% and 18% respectively for the quarter. Other good performers were building material companies such as Owens-Corning and Continental Building. Vertex Pharmaceuticals performed nicely after positive data on its cystic fibrosis drug. We also saw continued good performance from our aerospace and defense holdings of L3 Technologies, Northrop Grumman, Lockheed Martin, and Booz Allen Hamilton. Many of the small and mid-cap names did particularly well in September, accounting for much of the gain for the quarter.
Top Flight also includes two ETF based strategies. One strategy is based on a seasonality approach that rotates among various sectors and industries. It is comprised of three to five positions of 5% each. This strategy has been an underperformer this year and is only up about 2%. It was dragged down in the first half of the year by energy and retail exposure. While seasonality has been disappointing this year, it has been a good performer in prior years, sometimes attributable for the bulk of the gains in Top Flight. We still have confidence in this approach. The other ETF strategy is a single ETF momentum-based strategy, which is about 10 percent of the portfolio. This segment has had a single holding all year so far, the PowerShares QQQ, which is heavily weighted in technology. It is up about 22.5% for the year.
We are still grinding along in the Managed Income portfolio. Due to the low yields and the risk of extremely high prices, we are still keeping our powder dry. We are getting similar returns as the benchmark (for a lot less risk) and we are not locked into today’s low rates. Most broad-based bond funds or conservative portfolios are comprised of various mixes of longer-dated bonds. As interest rates rise, the losses on those bonds will offset the meager yields offered. Most fixed income funds or portfolios are sitting on a pile of future potential losses. There is no avoiding the dilemma, and even if interest rates didn’t rise they would be stuck with their current low yields. Therefore, we have minimized our exposure to longer-dated bonds. We believe our portfolio to be more conservatively positioned. We still prefer shorter maturity bonds, and as interest rates have risen their yields have improved. Short maturity bonds allow us to increase our yields as interest rates rise without getting hit with capital losses. While we know it is hard to accept low returns, it is better than reaching for yield and taking bigger risks like so many investors are doing. Don’t succumb to the desperation many are giving in to! Yield chasing can be hazardous to your financial health. It’s better to get a lower, more stable return than to put too much at risk.
Disclaimer: 1. Investment performance reflects time-weighted, size-weighted geometric composite returns of actual client accounts. 2. Investment returns are net of all management fees and transaction costs, and reflect the reinvestment of all dividends and distributions. 3. The S&P Index is a market-value weighted index comprised of 500 stocks selected for market size, liquidity, and industry group representation The Barclays Aggregate Bond Index is a benchmark index made up of the Barclays Government/Corporate Bond Index. 4. Benchmarks are used for comparative purposes only. The Paragon Top Flight Portfolio is not designed to track the S&P Index and will have results different from the benchmark. The Paragon Managed Income Portfolio is not designed to track the Barclays Bond Aggregate Index. 5. Past performance is no guarantee of future results. Investments in securities involve the risk of loss. Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.