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Portfolio Adjustments

Posted by Jeremy Merchant on Jan 4, 2016 5:27:37 PM
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portfolio_adjustmentsEquity markets were down today following this morning's poor manufacturing reading out of China. The rout in China pressured markets globally and increased volatility. The abrupt termination of relations between Saudi Arabia and Iran added to volatility today. As volatility started to increase in mid-2015, portfolio adjustments to account for these dynamics also increased.

Looking back in late July 2015, valuations became slightly stretched. To account for this, we moved the portfolios to an equity underweight at the end of July. Shortly thereafter and similar to today's market action, economic statistics out of China began to scare the markets to lower valuations. Post the market's reaction to China, we were able to place the portfolios back into a neutral posture almost 28 days later in late August.

After resetting the portfolios back to neutral at the end of August 2015, the S&P 500 once again climbed back above the 2,100 level. During this last climb northward, quarterly earnings from the companies inside of the S&P 500 Index were resetting lower. By early November, our calculations had the market trading at over 19 times 2015 earnings. Similar to late July, we once again reset the portfolios to an equity underweight.


During November's portfolio activity, we executed two adjustments that will probably remain in place in early and mid-2016.

First, within the equity allocation, we introduced a market neutral, uncorrelated allocation. The goal of this exposure is to produce consistent returns with much less volatility than the overall market. We believe seeking uncorrelated positions in relation to the general equity market will be a strong theme for the portfolios in 2016.

Secondly, we began the process of reducing our higher volatility fixed income positions. Through trades in October, November, and again in early December, we greatly reduced volatility within the fixed income allocation. In addition, the money market exposure moved from the standard 2-3% to nearly 10% of the fixed income allocation.

There are a few key reasons we have been aggressively looking for opportunities this year to move the portfolios to a more defensive posture.  First, we see that market leadership is extremely fragmented this year.  For 2015, nearly ALL of the S&P 500 Index calendar year return came from just a few stocks: Facebook Inc., Amazon.com Inc., Netflix Inc. and Google (now a subsidiary of Alphabet Inc.) In fact, this group has become so popular that it is now known by the acronym FANG, for Facebook, Amazon, Netflix and Google. The price-to-earnings ratios on three of those four companies are at incredibly high levels. Facebook has a PE of nearly 40x, Amazon is at 117x and Netflix is at a jaw-dropping 454x. Google remains at a near-normal valuation level of 22x. To put these valuations in context, the historical average PE of the S&P 500 is 15.7x.

Note the extreme disconnect of returns within the S&P 500 Index in the graphic below. This graphic shows how fragmented the market was in 2015. This lack of leadership (fragmented market) is certainly a concern to us and one of the primary reasons our portfolios are defensively postured.


Secondly, we must note that corporate earnings are at peak levels for this cycle. Remember, we overweighted equities for most of 2009-2014 because corporate earnings were improving and we believed that eventually the market would probably track the corporate earnings recovery. Today, we see that 2015 earnings will probably end the year at lower levels than 2014. In the graphic below, we can see the quarterly earnings and compare 2014 to 2015. In 2016, we expect earnings to be somewhere between the 2014 and 2015 level.


While the S&P (through November at least) was outperforming all other equity asset classes for the YTD period, we suspect that market fragmentation will eventually cause the S&P to lag other equity asset classes. Since the S&P 500 Index is a cap-weighted index, we are finding that too much concentration is now in too few names (FANG stocks) and now is probably not the time to chase the S&P 500 Index. In the graphic below, we can see that the last time the S&P 500 Index outperformed all other equity asset classes before 2014 was over 16 years ago in 1998.


Lastly, we note that the credit markets are starting to experience ripple effects from the extended drop in energy prices. Because of this cause-and-effect relationship, we cut our high yield exposure by over 60% in early October. By mid-November we had exited high yield bonds. Looking forward, we hope that energy prices can stabilize by mid to late 2016. When this happens, we expect to re-establish a dedicated energy position within the portfolios. Moreover, we may be able to re-enter high yield bonds by mid-2016 at more attractive levels.

In summary, we are being very cautious with the portfolio construction in early 2016. We are currently running an equity underweight and have over 8-9% cash within our fixed income allocation. In addition, we are increasingly focusing on uncorrelated positions within our existing equity allocation. As noted above, now is NOT the time to chase after the S&P 500 Index. Since the S&P 500 Index is a cap-weighted index, it is abnormally concentrated in the above-referenced stocks which face extreme valuations. 

Rest assured that as we account for market dynamics within our portfolio, we will keep you updated on any proactive adjustments we execute.



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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.

Topics: Investment Updates