iSectors Post-MPT Growth Update – September 2015

Posted on: 09/08/2015

The September rebalancing of the iSectors Post-MPT Growth Allocation resulted in a major downward shift in the portfolios risk.  The amount of leverage dropped from 29% in August to 2%. It has been over two years since Post-MPT Growth’s portfolio leverage has been this low.

Currently, the model’s allocation is suggesting a neutral view toward the equity markets. As such, we believe it would be helpful to review where we are in the economic cycle. Following a strong rebound in the economy after a recession, growth will typically go through a time of moderation. After the early 1980s and early 2000s recessions, growth spiked one to two years after the recession then moderated for a number of years (see chart below).  The recovery from the 1990s recession did not fit this pattern too well, due to outsized spending on technology (internet and Y2K related issues) at the cycle’s end.

In this recovery, we had a mini-spike in real Gross Domestic Product during the 3rd quarter of 2010 when the only year-over-year numbers increased greater than 3%, but no large rises after the recession. Since then, we have only been able to achieve moderate expansions of 1% to 3%.

The yield curve is now off of its post-recession highs, but is still far from zero.  This leads us to believe that we are still in the middle of the economic recovery.

iSectors Post-MPT Growth Update

A reliable recession indicator is the shape of the US Treasury yield curve.  As the chart below indicates, the 10 year Treasury yield minus 1 year Treasury yield always becomes negative before going into a recession.  In essence the market decides that the tightening that is taking place on the short end of the yield curve is so strong, that economic growth will decelerate. Therefore, the Fed will need to reverse course and ease interest rates in coming periods.  This leads to lower longer-term rates than short rates.

Currently, the yield curve is off of its post-recession highs but is still far above zero.  This leads us to believe that we are still in the middle of the economic recovery.

iSectors Post-MPT Growth Update

It is not unusual to have one or more 10% corrections in this part of the cycle.

Mid-Bull Market Number of Corrections
2012 to date 3
2003 to 2006 1
1993 to 1997 2
1983 to 1986 1

Source:  Yardeni Research

Since 1980, the average 10% correction has lasted four months before the bull market resumes.  The two summer corrections in this period have averaged a little over two months in duration.  Therefore, the iSectors Post-MPT model is probably correct in reducing risk for the time being.  But we should not be surprised if the model becomes bullish again before year-end.

Turning to sector allocations, technology has become relatively more overweighted in recent months.  Technology revenues tend to accelerate in this area of the market cycles due to increased corporate spending.  Many companies had to spend a few years keeping costs low to repair their balance sheets and increase earnings after the recession.  This led to below trend technology spending.  The need to replace outdated equipment and software to increase productivity is so strong that companies will raise technology budgets in coming years.  Also, consumers are reacting positively to new product introductions by Apple and Microsoft which will boost the whole technology sector.

Although still overweighted, our health care allocations have decreased.  Even though the demographics continue to favor the sector and acquisition activity is strong due to cash-filled balance sheets, health care stocks are becoming well priced.  We are happy to begin taking profits in this sector.

Our long-term Treasury holdings have reduced some of the volatility in the portfolio.  We maintain this allocation and continue to be comfortable that the Fed will raise interest rates at a slower pace than expected by the markets.  Even if 30-year Treasury yields don’t go back to the recent lows of 2.73%, we do not expect a significant rise in interest rates in the coming months.

Finally, we are comfortable with no investments in basic materials and utilities.  Basic material stocks are being hurt by slowing global economic growth, which may continue for some time.  Although utilities are a beneficiary of current low interest rates due to their heavy borrowing demand, the sector’s low profit margin and slow revenue growth will cause stock market investors to emphasize other market areas.

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