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 Tuesday November 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.

S&P 500: A Solid ‘Business’ In A Volatile Time

Even though we advocate tactical asset allocation like our Asset Allocation Composite (AAC), we are also a firm believer in buying and holding stocks or equities of good businesses, provided that their values have a potential to appreciate at a rate above inflation (thus preserving or increasing purchase power at a minimum) and also are less likely to incur significant interim loss. In today’s newsletter, we want to revisit a concept we proposed several years ago on why an index fund such as SPY or VFINX or S&P 500 index fund represents a solid business at the time their price is approaching to some reasonable levels to purchase.

I Bonds Update

Before we go on to our main topic, we want to update on I Bonds that were mentioned in our previous newsletter. At the time of publishing, we estimated that the I bond’s interest rate for the next six months if you purchase after October would be around 6% as the CPI of September was not available by then. We now know that the CPI number of September is 296.808 from this table, so the estimated interest rate would be

0+2*(September2022-March2022)/March2022=0+2*(296.808-287.504)/287.504=0.0647 or 6.47%

The above is based on the estimated fixed rate as 0. Its real value will only be known by November. Many believe that the fixed rate might be higher than 0% (up to 1%?) and thus our best guess would be less than 8%. At any rate, it’s probably still much lower than 9.62% that you’ll get if you buy the I Bond this month.

S&P 500: A Solid business revisited

Recently, many stock prices have declined substantially. In fact some high growth stocks have seen their prices declined by more than 70%. For example, ARKK (ARK Innovation ETF) that invests in many high growth tech stocks has seen its price dropped more than 78% from its all time high (or -62% year to date). S&P 500 also dropped around 20% year to date. 

As we mentioned in our previous newsletters, we estimate that S&P500  price is now reaching a level that’s on par with bonds in terms of its risk premium. Though it’s still not that cheap, but it does get cheaper. So naturally, it’s a good time to start to ponder more on what kinds of businesses one can safely buy and keep for a long term, at least for your strategic portion of the portfolio.

In April 1, 2019: S&P 500 As A Business, we praised that S&P 500 index fund, viewed as a ‘conglomerate’ business, is a very solid business. To recap, it has the following

  • Never lost money in any single year since 1871
  • Has grown its earnings at 6% above inflation annually (or 9%-10% annually in nominal term). This is significant as it not only preserves your purchase power, it also increases your wealth at some non trivial rate (your real purchase power is roughly doubled every 12 years).
  • It’s very unlikely to be bankrupt as the revenue of this ‘business’ represents more than half of the US GDP. So unless the US as a nation experiences a huge upheaval, this is perhaps one of the safest businesses in the world.
  • It’s less affected by many individual companies’ business as it’s so diversified.
  • Its annual rebalance (the index rebalance) means this business is regularly restructured. In fact, such a rebalance has proved to be very effective as it prunes bad business and promotes good businesses.

At any rate, if you want to get a reasonable return without incurring too much risk such as misreading a company’s business prospect (which can be extremely damaging to your investments if you buy into some ‘bad’ stocks in some significant capital allocation), we see S&P 500 index funds like VFINX, SPY or VOO are safe alternatives.

The latest update on this ‘business’:

Its earnings:

The latest 12 trailing month earnings at the end of second quarter was still very high, $192.58 per share. At the moment, S&P index is at 3797, that would translates to earnings yield 5%, higher than 10 year Treasury yield 4.2%. On the other hand, the latest FactSet’s analyst estimate for Q3 this year is a tad higher than $192 (around $200), making the earnings yield still around 5%, not that bad.

However, we want to point out that it’s likely that S&P 500 earnings estimate is still way too high as analysts probably haven’t been able to fully factor in the high interest impact (higher borrowing cost and slower demand). It’s possible that the earnings in the coming quarters might come down dramatically.

Other high quality ‘conglomerate’ funds

There are a few of other funds that are worth mentioning and probably better than or similar to S&P 500. We have discussed iShares MSCI USA Quality Factor ETF QUAL before (see July 15, 2019: Quality Stock Factor ETFs). This ETF selects companies that have had high quality and consistent earnings growth from some large and mid cap stocks. It’s an index fund so its selection is governed by a well formulated mechanical algorithm, free from human emotional and subjective opinions. As most of our readers know, we are a firm believer in well formulated mechanical method. 

Currently, QUAL holds about 128 stocks. It’s diversified enough.

VanEck Morningstar Wide Moat ETF MOAT is another one that we believe worth holding. Strictly speaking, MOAT is not a passive index fund as Morningstar relies on their analysts to assign MOAT rating to a stock. Morningstar defines Moat as follows:

The Morningstar Economic Moat Rating represents a company’s sustainable competitive advantage. A company with an economic moat can fend off competition and earn high returns on capital for many years to come.

Morningstar has identified five sources of moat. Switching costs are those obstacles that keep customers from changing from one product to another. The network effect occurs when the value of a good or service increases for both new and existing users as more people use that good or service. Intangible assets are things such as patents, government licenses, and brand identity that keep competitors at bay. A company with a cost advantage can produce goods or services at a lower cost, allowing them to undercut their competitors or achieve higher profitability. Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry.

A company whose competitive advantages we expect to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with either no advantage or one that we think will quickly dissipate has no moat.

The moat concept for a business or a stock was made famous because it’s one of the key investment tenets for Warren Buffett. Simply put, a business with moat is durable enough to sustain for a long period of profitable time.

Currently, MOAT holds about 48 stocks.

We like MOAT even though Morningstar didn’t explicitly state its underlying formula and its moat rating is likely to be subjective. However, we do believe Morningstar does have an internal process for their analysts to follow in this rating.

The other non-passive (or active) ETF is Capital Group Core Equity ETF (CGUS). Capital Group is well known for its long running mutual funds that can only be accessed by financial advisors. We’ll devote a future newsletter on their active ETFs in more details.

The latest performance: (as of 10/24/2022)

Ticker/Portfolio Name YTD
1Yr AR 3Yr AR 5Yr AR 10Yr AR
QUAL (iShares Edge MSCI USA Quality Factor ETF) -24.1% -20.9% 6.9% 8.3%
MOAT (Market Vectors Mstar Wide Moat ETF) -17.9% -17.3% 8.1% 10.3% 12.4%
CGUS (CGUS) -9.4%
SPY (SPDR S&P 500 ETF) -19.0% -14.8% 10.0% 10.1% 12.2%

Returns since 2/23/2022 when CGUS has data:

So MOAT has done better but all of the ETFs are comparable. On the other hand, for the past 5 years or so, QUAL has done much worse than the others. Notice that to purchase properties like stocks for a long term, you should be glad to scoop up those that have fallen harder, so long as you believe they have similar or better return potentials. 

For those who are more adventurous, you can also read our June 7, 2021: “Good” S&P Sectors to consider to purchase some of those S&P sector funds like healthcare XLV or technology XLK when stocks reach a cheap enough level.

On the other hand, to make things simple, we recommend S&P 500 as it’s very diversified (500 stocks) and actually has been proven to be extremely hard to beat by many other funds! Owning such a diversified and solid ‘conglomerate’ instead of picking some stocks on your own, you should be able to sleep better at night with high likelihood to outperform!

Market overview

As of last Friday, 20% of f S&P 500 companies had reported their Q3 earnings (see FactSet ). The blended earnings growth rate for the S&P 500 is 1.5% which is worse than 2.8% expected on September 30, 2022. So we can see actual earnings are likely to come down more than what analysts have expected. Factors that can seriously affect corporate earnings include the already risen interest rates (that might still take some time to make a full impact) and persistent high inflation. Whether the economy will have a ‘soft landing’, or a slower yet non-recessionary growth with inflation being under control, is anyone’s guess. For the past year, many have consistently under estimated the stickiness of high inflation — it’s actually very understandable as the last high inflation period (80s) was more than 40 years ago. Many so called bond experts and economists haven’t really had real experience in this kind of periods.

It’s very likely markets (stocks and bonds) have reached bottoms in this cycle. However, as always, we don’t rely on forecast and will respond based on our strategies.

As always, we stay the course with our strategies and reiterate the following:

  • 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 preferably much longer given the current high valuation. 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 and preferably many more 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 and now valuation is becoming less hostile. However, it is still not cheap 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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