Market Update and Model Portfolio Reviews 2/28/2018
For the month of February, investment grade domestic bonds* were down -0.95% and down -2.09% on the year. On January 26, large cap domestic equities were up as much as 7.55% for the year, before giving back -10.1% from the prior high to the February 8 market close (see chart to follow). Month over month, large cap domestic equities finished down -3.69% and were up positively on the year by 1.83%. All but one of the 11 sectors in the S&P 500 finished negative, which was the Information Technology Sector, up 0.10%. Utilities have continued their slump into this month; they are off by -3.86% , and -12.53% over the trailing three months given the accelerated rising rate environment coinciding with the time period. Other sectors hurt by rising interest rates, albeit by a lesser degree, have been Real Estate and Consumer Staples. While there are other attributable causes that have impacted the performance of Consumer Staples, rising rates has played a role. The energy sector has suffered over the last three months due to both rising rates and, more recently in the month of February, falling energy prices when measured by Brent Crude and WTI (West Texas Intermediate) prices. Fear of inflation due to fiscal stimulus, leading to continued monetary policy tightening causing fear of rising rates are all playing roles in what we continue to refer to as late cycle behavior (exacerbated by poorly timed fiscal stimulus - in our opinion).
Last month, we stated: “We are seeing indicators that are consistent with late business cycle behavior, which we believe indicates that we may be approaching a market correction. We look at indicators that have historically coincided with full business cycles.” Just a few days later, we experienced our first correction in approximately 2.5 years when measuring Large Cap Domestic Equities**. This is not an opportunity to pat ourselves on the back, as we are not implying that we knew this was going to happen right after our comments. We will look at this correction in further detail below (or on the following pages).
Month over month, the strategies outperformed their benchmarks (except for the Ultra Aggressive strategy). With our equity benchmark positive on the year and bond benchmark negative on the year, the YTD performance reflects our relative strong performance in managing interest rate risk in our more conservative portfolios and under performance in our higher risk/reward portfolios. Our largest performance detractor allocation this month was our allocation to a low volatility strategy within Large Cap Equities. Long duration (treasury coupon strips) continued to drag performance lower at a time when we would generally benefit the most to this exposure (risk off environment). We will elaborate further on this short term spurious correlation, driven by fiscal policy issues and not mechanical portfolio issues. Our other self-labeled safe haven exposures that benefited on the month were the Long Yen to Dollar currency exposure and a closed end fund exposure, focused to Non-Agency Mortgage Backed Securities. Exposure to investment grade floating rate securities performed positively as short term (and long term) rates shifted higher. Preferred stock exposures were positive on the month, off a bounce to the tough start to the year for preferred stocks.
DISCLOSURE (Click links for sources. If in print, sources available upon request). Calculations & Definitions available upon request. Measured by the Barclays US Aggregate Bond Index* - Morningstar. S&P 500 Total Return Index** See “Model Disclosure” page for important disclosures and information – Period Measured 12/31/2017 – 2/28/2018. Model Performance presented net of highest advisory fee.
What happened in February?
What drove the correction in large cap domestic equities and selloff across broad based asset classes from January 26 to February 8, 2018? Why did traditional and non traditional diversifying asset classes let even the most diversified investors down? An overbought market coupled with, in our opinion, poorly timed fiscal policy announcements drove these short term correlations higher than their long term averages. Specifically, the long Yen to Dollar fared well against most other large currency pairings in relation to the S&P 500 Index. In qualification of this point, the period above is a short period to draw conclusions on, but the math is still the same. Correlation is a commonly referenced measurement for building portfolio diversification. The idea is that it may help you decide if historical returns have been driven by similar factors or differentiating factors. Correlations change over time; they are not static. To illustrate, we use five widely recognized ETFs (Exchange Trade Funds) as proxies for asset class returns over this period. Traditional safe haven trades, like Gold and Long Yen to Dollar, did not provide for the type of protection one would have expected. Correlations broke down over this short period, although we believe most of the data when looked at qualitatively could be concluded as spurious correlation. The shift in rates moving upward were off the back of inflation concerns, starting in December of 2017 and continuing through late February 2018. The Yen to Dollar currency exposure was effectively flat during this short period measured above, but was up approximately 3% on the year by January 26. January 26 coincides with the high before the correction started where it stayed flat during the correction, and finally ended the month of February up nearly 5.5% for the year. If we use December 6, 2017 as a starting point through February 21, 2018, the rate on the ten-year Treasury bond went up as much as 25% (and hence why nearly all traditional long bonds suffered). Although seemingly correlated over the short window, outside factors demonstrate that the short term correlation was distraction from reality. It’s easy to conclude that there was no diversification benefit over this period, when in fact there were other catalysts that drove this casual causation to occur. As a refresher, correlation can range from - 1.00 (perfectly negatively correlated) to + 1.00 (perfectly positively correlated). It does not measure by how much assets should move relative to the other asset (loosely speaking correlation tells you how accurate beta is). Correlation for this short period of time using the proxies (using end of day pricing) above were as follows: SPY to SPY = 1 (perfectly positive correlation to itself), SPY to FXY = 0.21 SPY to AGG = 0.82, SPY to GLD = 0.83, SPY to LQD = 0.92.
Views and opinions are of Alternative Capitalis, LLC and are not intended as investment advice. Period measured 1/26/2018 – 2/8/2018. The data used to calculate performance was obtained from sources deemed reliable and then organized and presented by Alternative Capitalis, LLC.
Monthly Winning Streak Ended
The S&P 500 Total Return Index went 15 months with positive returns month over month before suffering a monthly loss in February. This is longer than any other run in the past 20 years on a total return basis. The last correction started July 20, 2015 and did not fully recover until April 18, 2016. This most recent correction of -10.1%, starting on January 26, has yet to prove if we will see an even further pull back or recovery from the prior highs on January 26. Some charts can only be viewed through the rear view mirror. A moving average on a total return basis at least shows resistance levels were met, given that the S&P 500 TR Index did not break through this level in February. This is a technical way of looking at the chart. Generally, a breakthrough of the 200 day moving average price trend (line) may lead market participants to believe that more bad news lies ahead, although this is not always the case.
Period measured over 7/20/2015 to 2/28/2018 for the S&P 500 Total Return Index. Views and opinions are of Alternative Capitalis, LLC and are not intended as investment advice.
Is the Glass Half Full or Ready to Overflow?
Last month we discussed areas we monitor for broad based views on the economic cycle. One area that we discussed was output capacity. A basic way to understand full output capacity in the economy is to imagine filling a glass of water to the brim, at which point any additional water would cause an overflow and a waste of water. Please know that this is a very loose example, but regardless of your background, we all know what happens when you keeping pouring water when the glass is full. When an economy reaches full capacity through full employment and full productivity (and there is not someone there to drink the water fast enough) then the risk of overheating (overflowing) has been met. In our loose example of a glass of water compared to the economy, this most recent round of fiscal stimulus (passage of tax reform) turns the water pitcher into a garden hose. Let’s remember how we found our footing after the last recession; recovery was driven by an unprecedented amount of monetary stimulus through multiple rounds of quantitative easing. The world would have looked different today had those measures not been taken. The scary thought was if we unwound as quickly as we wound up the Fed’s balance sheet (as stated over previous monthly updates, this was far from a likely reality). In fact, the public was provided with a policy from the Federal Reserve that outlined, to the penny (over the short run), how Treasury securities would roll off their balance sheet in a controlled fashion. Policies are subject to change, but we found relief this past month with the new Fed Chairman Jerome Powell indicated in his first open hearing with Congress that they would continue to follow the predictable path of the Federal Reserve’s balance sheet reduction process currently in place. This provided relative closure on our two stated concerns back in our October 2017 monthly update, for risks to shocks in the Treasury term premium model we presented. “1) with a new Fed Chair replacing Janet Yellen comes the opportunity to change course of the FOMC reinvestment policy; and 2) as we highlighted last month, larger than expected public deficit increases through Tax Reform would likely put additional supply of public debt (Treasuries) leading to added inflationary pressures and drive yields higher to offset fiscal stimulus.” In summary, and as expected, the fiscal stimulus shifted rates higher over inflation fears. This concern was answered with the passage of the new tax reform at the end of 2017. Shortly after Powell’s remarks, we saw a slow down in what has been a capitulated bond market selloff to date.
Like a full glass of water, business operating profit margins can only go so high to drive EPS growth forward. Said differently, operating margins can only go as high as 100%, although in practice this would mean that no expenses would occur, which for obvious reasons is not the case. Profit margins will improve, all else equal, with the lower corporate tax rates coming in 2019. In our view, however, all else is not equal, as higher interest rates do come at a cost (on average) to profit margins. Top line growth (sales growth) seems unstoppable in a narrow view of time, but the reality is that even the world champion hot dog eater can only consume so much before reaching full capacity. High stock and bond valuations have been justified by many due to low interest rates. With fear of inflation pressing rates higher and the reality that there will be exclusions on what used to be expensed for tax purposes, these justifications for high valuations appear to be conflicted. These conflicts will make it more difficult to maintain sustained revenue growth and sustained operating profit margin growth off the back of fiscal stimulus this late in a market cycle. More simply put, our marginal propensity to consume items at all levels of wealth initially rises, peaks and falls as we continue to get more of something.
DISCLOSURE (Click links for sources. If in print, sources available upon request). Calculations & Definitions available upon request. Views and opinions are of Alternative Capitalis, LLC and are not intended as investment advice.
Timing Still Matters - The Lost Decade
The ten year period of 2000-2009 was a tough decade for domestic equities. If you invested $100,000 in a diversified domestic equity portfolio(1) for the decade of 2000-2009, your investment would only have been worth $97,980(1), representing loss of $2,020. Total Inflation over that same time period was over 25%(2). In real dollar terms (inflation adjusted) your investment would only be worth $73,485. We use this chart to highlight why we stick to our philosophy of taking risk off the table as we enter into the late stages of an economic cycle. This is an example of ten years in opportunity cost lost. What do the next ten years look like?
Period measured 12/31/1999 to 12/31/2009. Views and opinions are of Alternative Capitalis, LLC and are not intended as investment advice. It is not possible to directly invest in the Russell 3000 Total Market Index.
2.US. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPIAUCSL, November 30, 2016.
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Alternative Capitalis, LLC is a registered investment adviser. Information presented herein is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Model Performance Disclosure: The performance shown represents only the results of Alternative Capitalis, LLC’s model portfolios for the relevant time period and do not represent the results of actual trading of investor assets. Model portfolio performance is the result of the application of the Alternative Capitalis, LLC’s proprietary investment process. Model performance has inherent limitations. The results are theoretical and do not reflect any investor’s actual experience with owning, trading or managing an actual investment account. Thus, the performance shown does not reflect the impact that material economic and market factors had or might have had on decision making if actual investor money had been managed. Model portfolio performance is shown net of the model advisory fee of 1%, the highest fee charged by Alternative Capitalis, LLC. Model portfolio performance is shown net of the sample trading costs based on our Custodian’s, TD Ameritrade Institutional, trading costs. Performance does not reflect the deduction of other fees or expenses, including but not limited to brokerage fees, custodial fees and fees and expenses charged by mutual funds and other investment companies. Performance results shown include the reinvestment of dividends and interest on cash balances where applicable. The data used to calculate the model performance was obtained from sources deemed reliable and then organized and presented by Alternative Capitalis, LLC. The performance calculations have not been audited by any third party. Actual performance of client portfolios may differ materially due to the timing related to additional client deposits or withdrawals and the actual deployment and investment of a client portfolio, the reinvestment of dividends, the length of time various positions are held, the client’s objectives and restrictions, and fees and expenses incurred by any specific individual portfolio. The performance calculations are based on a hypothetical investment of $100,000 for both the model and benchmarks presented. On July 23, 2018, we corrected previously reported month end performance reports to account for transactions costs (trading fees) related to rebalancing model portfolios. The month end reports effected ranged from 2-28-2018 to 5-31-2018. Prior reports accounted for transaction costs related to trading fees. The four reports have been corrected and updated on Alternative Capitalis, LLC website (www.altcapitalis.com). 2-28-2018 had the largest variance in incorrect performance reported with an average of 9 BPs (“basis points”) (0.09% or 9/100 of 1.00%) of overstated positive performance in the models and ranged as high as 15 BPs to as low as 2 BPs. A comparison chart of the variances in reported performance can be provided upon request. Benchmarks: The performance results shown are compared to the performance of the performance of a blended ETF (exchange-traded-fund) portfolio comprised of the following two ETF’s symbols, SPY & AGG, are described below. The benchmarks used are investable ETFs and their performance calculation is inclusive of the highest fee charged to a client(s) account, 1.00% annually. This will reduce the total return of the investable benchmark by the annualized rate of 1.00%. The ETF symbol SPY (SPDR® S&P 500® ETF Trust) which seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index (the "Index"). Visit for more information about the ETF. The S&P 500® Index results do not reflect fees and expenses and you typically cannot invest in an index. The ETF symbol AGG (iShares Core U.S. Aggregate Bond ETF). The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market. (the "Index"). Visit for more information about the ETF. The index composed of the total U.S. investment-grade bond market results do not reflect fees and expenses and you typically cannot invest in an index. The benchmark is blended representing a weighting of a percentage (%) to SPY and percentage (%) to AGG based on the respective model weights below. Unless otherwise indicated, the benchmarks are not rebalanced to maintain their original weighting over the period measured. Instead, they are comprised of the starting allocation and will shift given the prevailing market environment over the period measured. Return Comparison: To benchmark the results, the ETF (exchange-traded-fund) symbol SPY (SPDR® S&P 500® ETF Trust) which seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index (the "Index"). The S&P 500 was chosen as it is generally well recognized as an indicator or representation of the stock market in general and includes a cross section of equity holdings. In addition, the ETF symbol AGG was chosen as a benchmark. The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market. The total U.S. investment-grade bond market was chosen as it is generally well recognized as an indicator or representation of the bond market in general and includes a cross section of debt holdings. For each respective model benchmark the performance measurement weightings are as follows to SPY / AGG %: 20/80, 30/70, 40/60, 50/50, 60/40, 70/30, 80/20, 90/10 % respectively for Ultra Conservative, Conservative, Moderate, Balanced, Growth & Income, Growth, Aggressive, Ultra Aggressive. OPTIONS TRADING RISK DISCLOSURE: Options Trading – Both the purchase and writing (selling) of options contracts –involves a significant degree of risk not suitable for all investors. Investors should carefully consider the inherent risks and financial obligations associated with options trading as further detailed in the Options Clearing Corporate booklet “Characteristics and Risks of Standardized Options.”
The results do not represent actual trading and actual results may significantly differ from the theoretical results presented.