This past September, we at Astoria Portfolio Advisors argued that investors should tactically de-risk their ETF portfolios going into October. Subsequent to that call, the S&P 500 Index fell 10%, and we witnessed one of the worst sell-offs since the Lehman crisis.
The magnitude and force of the sell-off exceeded our expectations. Put simply, we don’t think the economy is anywhere near as catastrophic as it was 10 years ago.
Going into the end of the year, we now believe that tactically turning bullish offers a good risk/reward for U.S. stocks on a relative basis. Here’s why:
1. U.S. fundamentals remain intact.
The S&P 500 trading at a forward P/E ratio of 15.7 is simply not expensive, in our view. Bull markets don’t die when you have valuations at these levels. Yes, higher interest rates indicate there is competition for stocks, and valuations may be capped in an environment of higher interest rates, but U.S. stocks are significantly more attractive than bonds.
2. Buyback season will accelerate now.
That’s the case because the blackout period is over and corporate earnings season is ending. The third-quarter earnings season in the U.S. will register close to 25% growth in profits and will match the first and second quarters to produce one of the best quarters we have seen in over 10 years.
3. The U.S. midterm elections were a significant overhang for the market and removed some key tail risks.
A split congress may be a better outcome for markets, as it could lead to more constructive conversations with China on trade policy. Returns for Chinese and emerging market equities since Jan. 26 have been weak (the iShares China Large-Cap ETF (FXI) is down 25%, and the iShares MSCI Emerging Markets ETF (EEM) is down 23%).
How To Invest For This Environment
To fund the increase of additional U.S. equities in our Multi-Asset Risk Strategy (MARS) ETF portfolio, we reduced our fixed-income holdings and emerging market equities.
We have been vocally bearish on bonds, and we have been significantly underweight duration throughout 2018. Specifically, we sold our Vanguard Mortgage-Backed Securities ETF (VMBS), which has 100% exposure to bonds rated AAA and a duration of approximately seven years. We are keeping duration as short as possible given an environment of rising inflation and higher interest rates. Remember that the Bloomberg Barclays US Aggregate Bond Index is currently on pace for its worst year since 1994.
We established a position in the WisdomTree US Quality Dividend Growth Fund (DGRW), which complements our other U.S. equity ETFs, as well as our overall factor exposures. DGRW screens for companies with strong return on equity (ROE) and return on assets (ROA), high long-term growth estimates, as well as companies earning enough revenues to meet their dividend payment.
As of Sept. 30, 2018, the WisdomTree U.S. Quality Dividend Growth Index has an ROE of 19.5% and an ROA of 4.6% compared to only 15.6% and 3.6% for the S&P 500 Index. The shareholder yield (a measure of dividend plus buyback yield) for DGRW is 4.51% versus 3.91% for the S&P 500 Index.
For a larger view, please click on the image above.
Sources: WisdomTree, FactSet as of 9/30/2018. Chart shows the WisdomTree U.S. Quality Dividend Growth Index against the S&P 500 Index.
We also reduced our overweight in emerging market equities. We still believe EM stocks serve a place in a globally diversified multi-asset portfolio. The MSCI Emerging Markets index is currently at a 40% discount to the S&P 500, near levels last reached in 2003. At these levels, EM stocks are a value play, and historically value and momentum stocks have exhibited negative correlation.
In all, we own approximately 70% of equities in our MARS ETF Portfolio.
In summary, positioning in U.S. equities is a lot cleaner following the 10% correction and the elimination of key tail risks. There is relatively more upside in U.S. stocks on a short-term tactical basis in the months ahead.
You can reach John Davi at [email protected] or @AstoriaAdvisors. Any ETF holdings shown are for illustrative purposes only and are subject to change at any time. For full disclosure, please refer to our website: www.astoriaadvisors.com/disclaimer.