The Post-MPT Growth Allocation model has become more conservatively positioned over the past quarter
The largest allocation increase has been US Treasury Bonds.
Gold stocks has seen the largest allocation decrease.
Leveraged positioning in Post-MPT Growth has increased from 18% to 32% (33% is the maximum allowed).
Besides US Treasuries, the strategy is significantly overweighted in financials, utilities, and energy.
Technology, materials, and health care are underweighted.
The model indicates that US economy should continue to grow in 2018, but at a slower pace than in 2017
The model is still strongly invested in stocks.
According to the business cycle approach to equity sector investing, the reduction in technology and gold stock relative holdings and overweights in energy and utilities indicates a move from the mid-cycle to late-cycle in the economy. As we have been expecting, technology has been the best performer over the past five years as corporations and individuals reversed the underinvestment in technology that took place during and in the aftermath of the Great Recession. As is usually the case in the mid-cycle, utilities and materials have underperformed over the past five years.
If we are going into the late-cycle, we should expect materials, health care, energy and utilities to post the strongest results. The model has already overweighted energy and utilities.
The Post-MPT model strongly overweighted materials at the end of the 2002 – 2007 economic expansion. Along with energy, materials have done well historically in the late-cycle as inflationary pressures build and the late-cycle economic expansion helps maintain solid demand. The combination of strongly increasing energy demand and slowdown in Chinese growth may be leading our indicators to favor energy over materials.
Health care may have already seen its best days. Although tied to basic needs, which would usually attract investors looking for stocks that are less economically sensitive in this part of the cycle, health care was a leading sector in 2012 to 2015 due to the continued rollout of the Affordable Care Act (ACA), the Federal Drug Administration speeding up its drug approval timeline, and companies strongly raising prices. All of this took place as the population aged and needed more drugs and services. But between continued attacks on ACA and Medicare reimbursement rates, health care sector revenue growth is likely to slow in the coming years.
The model is allocating to Treasury Bonds against the consensus view
The 10-year Treasury yield is at the top end of the 12-month 2.00% – 2.50% range.
The bond market will question the wisdom of significant decreases in the Federal Reserve balance sheet while increasing Fed Fund rates in a time of moderate to weakening inflation. Core Personal Consumption Expenditures Price Index is the key measure of inflation for the Federal Reserve. This measure has fallen in 2017 from 1.8% to 1.5%, far below their 2.0% target.
The Fed has indicated three 25 bp rises in the Fed Fund rate while the market is pricing in two in 2018. Given the slow-growing economy, the lack of inflation pressure and the additional drag from the balance sheet decreases, we believe the market is likely to be correct with the risk that there may be only one increase this year.
The combination of slow economic growth, modest inflation and a less aggressive Fed will lead to declines in 10-year yields back to the 2.00% to 2.25% area in the coming months benefiting dividend stocks including utilities.
The overweighted equity sectors will have strong, certain demand in 2018
Financials (FAS) has become the highest weighting in the Post-MPT Growth model. The sector outperformed in the fourth quarter as Fed rate hikes and strong loan demand are pushing up revenue growth. Also, regulatory reform is resulting in increased dividend payments and share buybacks that will attract investors in the coming quarters.
Utilities (VPU and UPW) was the only sector with negative returns in the fourth quarter. With real estate and Treasury bond holdings, interest sensitive stocks are over 40% of the model’s risk, currently. There continues to be a never-ending demand for yield that will shield sector returns in a market correction. If our economic and broad market forecasts are realized, the combination of high yields (averaging 3.2%) and rising dividend rates will cause utility stocks to outperform in 2018.
Year-to-date, energy (VDE) was the worst performing sector in 2017. Although West Texas Intermediate oil prices rose from $42 to $60 a barrel in the second half of the year, the decline from $56 at year’s onset was too much for these stocks to overcome. The combination of the global balance of energy supply and demand and central bank’s worldwide accommodative policies should lead to higher oil prices and energy stock prices.