March 14, 2022: Quality Sectors Prevail

Mar 15, 2022 | Feature, Newsletter

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Friday April 1, 2022. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Quality Sectors Prevail

Since we started our newsletters in 2011, this is the very first time this newsletter author feels a persistent downward pressure in both financial markets and economies. For the past three months or so, there was always some substantial market turbulence every time we started to write a newsletter. We have no doubt that our readers are feeling the same. 

In this newsletter, we would like to remind our readers of a very important phenomenon in investing: quality matters. We will review a portfolio based on ‘good’ S&P sectors and see how it’s doing right now. We then proceed to discuss current market situations in some details. 

Quality matters: “good” S&P sectors

By now, quite some speculative investors should have felt heat in their investments. For example, ARK Innovation ETF (ARKK), a proxy to high flying growth stocks, has literally lost two third of its value from its peak set last February. Compared with broad market indexes, it doesn’t seem to be that much stellar anymore, in fact, it underperformed Nasdaq 100 index ETF (QQQ) since its inception in 2014:

Of course, it’s not fair to just look at returns in a 7 plus year time frame. In general, as we have argued numerous times in the newsletters, we think 20 years or more is a more realistic time frame. Nevertheless, one can see that at the moment, even for the original ARKK investors, it’s actually inferior to just simply holding QQQ. Not only QQQ returned better, it incurred much smaller volatility. 

This leads to a theme we have iterated several times in the past: quality matters. Specifically, we would like to revisit a portfolio we mentioned in a previous newsletter June 7, 2021: “Good” S&P Sectors. In that newsletter, we mentioned that companies in S&P 500 11 sectors have very different earnings growth quality and growth.

Let’s first look at the latest earnings picture for these sectors: 

Courtesy of Yardeni Research Inc.

In that newsletter, we further identified four ‘good’ sectors: consumer staples, health care, information technology and real estate (to a less extent, we also mentioned utilities that have slower earnings growth). The above charts show that companies in these ‘good’ sectors enjoy more stable earnings (income) and exhibit better growth. Another important property is that the prices of these sectors exhibit higher stability or consistency. In a word, not all sectors are equal. 

It follows that if one would only choose these ‘good’ sector funds as investment candidates to construct a portfolio, one might be able to outperform a general index such as S&P 500. This is especially true for a momentum based portfolio as these sector ETFs often are more consistent and thus more trendy. 

“Good” S&P sector based portfolio excels in current environment

The following shows the updated returns for the portfolios mentioned in June 7, 2021: “Good” S&P Sectors.

Portfolio Performance Comparison (as of 3/14/2022):
Ticker/Portfolio Name YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR 15Yr AR
P Composite Momentum Scoring SP Good Sectors -12.3% 15.7% 15.7% 14.2% 14.5% 13.3%
P SP Good Sector Equal Weight -11.5% 12.2% 15.7% 13.8% 13.7% 10.7%
SPY (SPDR S&P 500 ETF) -11.6% 8.9% 16.9% 14.2% 14.1% 9.8%

Return charts since 6/9/2000:

See details here >>

In the above, P Composite Momentum Scoring SP Good Sectors is a portfolio that utilizes our composite momentum algorithm on the four sector funds (XLP, XLV, XLK and IYR — we use IYR because of its longer history. In a real portfolio, we would suggest to replace IYR with Vanguard REIT index ETF VNQ that has much lower expense cost ratio). The portfolio selects top 2 performing ETFs from the four candidate funds every month. It can select an intermediate term Treasury ETF if the algorithm determines that markets are in a downtrend. 

P SP Good Sector Equal Weight is just a portfolio that invests equally in the four ETFs and it’s rebalances annually. 

Observations:

  • The good sector momentum portfolio has done way better than SPY, both in terms of returns and risk (measured by maximum loss from a peak to a subsequent trough). Even though before the current weakness, it had underperformed in the past 3, 5 and 10 years. In the past one year, it started to do better than SPY. 
  • Even the equal weight good sector portfolio has done better than SPY in a long term such as 15 years or since 2000. This again validates our intuition that simply confining ourselves to quality companies can yield better results for both a momentum or a buy and hold portfolio. 
  • One can use the good sector portfolio as a substitute for US stocks. For example, one can invest in the funds chosen in this portfolio instead whenever a US index fund such as VFINX is chosen in portfolio like P Composite Momentum Scoring Global Risk Assets or P Composite Momentum Market VFINX that are listed on Advanced Strategies. 

The significance of only investing in quality sectors or companies originates from the fact that because of their higher quality earnings, the prices of these sector ETFs are more consistent and trendy. One can apply this to high quality factors, as illustrated by the outstanding performance of P Composite Momentum Scoring Factor ETFs listed on Advanced Strategies. We will discuss this in a future newsletter. 

Market Overview

As of this writing, we are seeing stocks are retesting their recent lows. Although it might seem like that all stocks other than energy have gone down a lot, in reality, we see that utilities, consumer staples and healthcare still have positive trend scores (see sector trend table on 360° Market Overview). The current market downturn hasn’t reached a maximum pain level as these defensive sectors are still somewhat strong:

The other important factor is that the yield curve (the spread between 10 year and 2 year Treasury yields) is about 0.28%, approaching to 0. This, along with the expected GDP growth by the Atlanta Fed next quarter (currently 0.5%) hovering around 0 is flashing a potential recession signal (not yet but getting closer). 

Another new development that can significantly affect world economy is the recent Covid shutdown in China: the two most important economic centers, Shanghai and Shenzhen, are now partially shutdown because of the recent resurgence of Covid in those areas. If the shutdown is prolonged, it can severely restraint supply chains and that will in turn exacerbate current inflation pressure in the US and other countries. We believe that this factor hasn’t been fully factored in markets. 

At the moment, we still see few economic indicators that are indicating deceleration. We are monitoring these indicators closely. 

In fixed income (bonds), it’s basically everything other than inflation-protected bonds now has negative price trend scores (see again 360° Market Overview). 

To summarize, we believe the coming weeks are important and we will see a clearer picture on market trends.

In this volatile situation, we want to emphasize that it’s crucial to free one’s from day to day market behavior and look at investing in the long term. We also advocate the following practice:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation has dropped somewhat. However, it is still very high by historical standard. For the moment, we believe it’s prudent to be extra cautious. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.  

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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