Dividend Growth Portfolio 2nd Quarter 2018 Letter to Investors

At the halfway point, 2018 is shaping up to be a good year for us. The first quarter was rough. In addition to the correction that dinged virtually all long-only portfolio managers, rising bond yields punished some of our more rate-sensitive positions, particularly REITs and MLPs. Though as yield fears subsided in the second quarter, the Dividend Growth portfolio recouped nearly all of its losses and entered the third quarter with strong momentum.

Through June 30, the portfolio returned 0.39% before management fees and -0.36 after all fees and expenses. Encouragingly, the returns for the second quarter were 7.92% gross of management fees and 7.17% net of all fees and expenses. [Returns figures compiled by Interactive Brokers and represent the real returns of a portfolio managed with firm capital. Returns realized by individual investor may vary based on account size and other factors. Past performance is no guarantee of future results.]

By comparison, through June 30, the S&P 500 index was up 1.67% through June 30 and up 2.93% in the second quarter.

So, while 2018 got off to a rough start, our portfolio has significant momentum behind it as we enter the second half. Our positions in energy — most notably midstream oil and gas pipelines — in real estate and in private equity managers have been the strongest contributors to returns. Our positions in European and emerging market equities have been the biggest drag on returns.

As a portfolio with a strong income mandate, the Dividend Growth portfolio is naturally going to have more interest-rate sensitivity than a broad market index such as the S&P 500. When yields are rising – as they were in the first quarter – this presents a risk. But when yields are stable or falling – as they were in the second quarter – it presents an opportunity.

The question we now face is this: What are interest rates likely to do in the second half of the year?

Ultimately, I expect that the path taken by interest rates will depend on two factors: inflation expectations and fears stemming from the nascent trade war.

I’ll address inflation expectations first. The unemployment rate has been hovering around the 4% mark for all of 2018. Traditionally, many economists have considered a 5% unemployment rate to be “full employment,” as there will always be some segment of the population that is either between jobs or not reasonably employable. Also, there are new would-be workers that come out of the woodwork (students, stay-at-home mothers, bored retirees, etc.) when the labor market gets sufficiently tight as it is today.

At 4%, we are significantly below “full employment,” which has led many economists to expect an uptick in inflation. Thus far, however, inflation has remained muted. PCE inflation (the rate used by the Federal Reserve in its decision making) has been running near or slightly above the Fed’s targeted 2% rate over the past six months, but it is not trending higher, or at least not yet.

If you’ve followed my research for any length of time, you know my view of inflation and the tools used to measure it. I don’t believe it is realistic to expect inflation at the levels seen in previous expansions due the demographic changes affecting the country. America’s Baby Boomers as a generation are well past the peak spending years of the early 50s. In fact, the front end of the generation is already several years into retirement.

The Boomers have been the economic engine of this country for over 40 years. As they retire, the borrow and spend less, taking aggregate demand out of the economy.

This isn’t purely academic. It’s been happening in Japan for over 20 years. Japan’s reported unemployment rate, at 2.8%, is even lower than ours. And Japan’s deficit spending and central bank stimulus absolutely dwarf those of America if you adjust for the relative sizes of the two economies. Yet Japan hasn’t had significant, sustained inflation since the early 1990s… when Bill Clinton was still the governor of Arkansas.

At the same time, automation technology and artificial intelligence is already eliminating jobs. Walk into a McDonalds today. You can order at a kiosk and never actually speak to a human employee.

At the higher end, Goldman Sachs reported a year ago that half of its investment banking tasks could viably be automated away.

While there are clearly exceptions in certain high-skilled jobs, the fact is that labor gets replaced by cheap technology as soon as it gets too expensive. It’s hard to imagine sustained inflation in this kind of environment.

Of course, this doesn’t mean that Mr. Market won’t decide to fret about it in the second half and send yields higher again. But I would consider any short-term weakness on higher bond yields to be a buying opportunity.

This leaves the fear of an economic slowdown. Right now, the economic numbers look healthy and there is no immediate sign of recession on the horizon. But unemployment tends to reach its lowest points near the end of the expansion. Furthermore, the Fed is aggressively raising rates, which is flattening the yield curve. A flat or inverted yield curve is a sign of economic distress and usually precedes a recession.

United States Treasury Yield Curve

Does any of this mean a recession is “due” tomorrow? No, of course not. But it does suggest that we are late in the economic cycle, at a point when value sectors and higher-yielding sectors tend to outperform.

So, while I may make a few minor portfolio adjustments in the third quarter, I believe we are very well positioned at the half.

Looking forward to a strong finish to 2018,

Charles Lewis Sizemore, CFA

 

Dividend Growth Portfolio 1st Quarter 2018 Letter to Investors

The first quarter of 2018 was not kind to value and income investors. Long-term bond yields started rising in the second half of last year, and that trend accelerated in January. For the quarter, the Dividend Growth portfolio lost 7.36% vs. a loss of 1.22% on the S&P 500. [Data as of 3/30/2018 as reported by Interactive Brokers. Past performance is not a guarantee of future results.]

Remember, as bond yields rise, bond prices fall, as do the prices of bond proxies such as utilities, REITs and other high-yielding stocks.

At the same time, the great “Trump Rally” that kicked off after the 2016 election reached a frenetic climax in December and January. The proverbial wall of worry that has characterized the “most hated bull market in history” since 2009 crumbled and was replaced by the fear of missing out, or “FOMO” in traderspeak.

The combination of a surge in bond yields and a sudden preference for high-risk/high-return speculation over slow-and-steady investment caused most income-focused sectors to underperform in January.

And then February happened. Volatility returned with a vengeance, dragging virtually everything down, growth and value alike. So, in effect, value and income sectors enjoyed none of the benefits of the January rally, yet still took a beating along with the broader market in February and March.

SectorBenchmarkQtr. Return
Large-Cap GrowthS&P 500 Growth1.58%
Large-Cap StocksS&P 500-1.22%
InternationalMSCI EAFE Index-2.19%
UtilitiesS&P 500 Utilities-3.30%
Large-Cap ValueS&P 500 Value-4.16%
Real Estate Investment TrustsS&P U.S. REIT Index-9.16%
Master Limited PartnershipsAlerian MLP Index-11.22

It’s striking to see the differences between sectors. Even after the selloff in the leading growth stocks — the “FAANGs” of Facebook, Amazon, Apple, Netflix and Google — the S&P 500 Growth Index still managed to finish the quarter with a 1.58% gain.

Meanwhile, the S&P 500 Value Index — which is a reasonable proxy for Sizemore Capital’s Dividend Growth Portfolio — was down 4.16%.

It actually gets worse from there. REITs and MLPs — two sectors in which Sizemore Capital had significant exposure at various times during the quarter — were down 9.16% and a staggering 11.22%, respectively.

Suffice it to say, if your mandate calls for investing in income-oriented sectors, 2018 has been a rough year.

I do, however, expect that to change. While I consider it very possible that we see a bona fide bear market this year, I expect investors to rotate out of the growth darlings that have led for years and into cheap, high-yielding value sectors that have been all but abandoned.

Why a Bear Market is a Real Possibility

They don’t ring a bell at the top. But often times, there are anecdotal clues that a market is topping.

As a case in point , my most conservative client — a gentleman so risk averse that even the possibility of a 10% peak-to-trough loss was anathema to him — informed me in January that he would be closing his accounts with me because I refused to aggressively buy tech stocks and Bitcoin on his behalf.

He wasn’t alone. Again, anecdotally, I noticed that several clients that had been extremely conservative since the 2009 bottom suddenly seemed to embrace risk in the second half of last year. The fear of missing out — FOMO — had its grip on them.

This is the first time I’ve seen FOMO in the wild since roughly 2006. I was working in Tampa at the time, and the Tampa Bay area happened to be one of the centers of the housing bubble. I recall watching a coworker buy a house she couldn’t quite afford because she was afraid that if she waited, prices would quickly get out of her reach. She and her husband bought the house as the market was topping, and it was a major financial setback for them.

It may be in bad taste to recount personal anecdotes like these, but I do for an important reason. I want to avoid falling into the same mental trap.

Today, the market is expensive by historical standards. The cyclically-adjusted price/earnings ratio — or CAPE — is sitting at levels first seen in the late stages of the 1990s tech bubble.

Meanwhile, we are now nearly a decade into an uninterrupted economic expansion, and we’re effectively fighting the Fed. Chairman Jerome Powell has made it very clear that he intends to raise interest rates fairly aggressively to nip any potential inflation in the bud.

None of this guarantees that the current stock correction will slide into a bear market. (The same basic conditions were true in the 1998 correction, and stocks went on to rally hard for another two years.)

But it does tell me that caution is warranted, and that now — more than ever — we should stick with financially-strong value and dividend stocks. In a turbulent market, I expect to see investors seek shelter in “boring” value stocks offering a consistent payout. In a market in which capital gains no longer appear to be the “sure thing” they were a year ago, a stable stream of dividend income is attractive.

Will Value Get Its Mojo Back?

Growth utterly destroyed value last quarter. But this is really just a continuation of the trend of the past five years.

Consider the five-year performance of the iShares S&P Value ETF (IVE) and the iShares S&P 500 Growth (IVW). Growth’s returns have literally doubled value’s, with most of the outperformance happening in 2017.

Growth massively outperformed value in the last five years of the 1990s. But this is by no means “normal” or something that should be expected to continue indefinitely. Consider the performance of the same two ETFs in the five years leading up to the 2008 meltdown.

Value stock returns didn’t quite  double their growth peers. But they outperformed by a solid 40%, and that’s not too shabby.

This by no means guarantees that value stocks will outperform or that the specific value stocks Sizemore Capital owns will outperform. But if the market regime really has shifted — and I believe that it has — then the “FAANGs” story is over. Investors will be searching for a new narrative, and I believe that value and income stocks will be a big part of that story.

In the first week of the second quarter, I moved to a moderately defensive posture, shifting about 20% of the portfolio to cash. This gives us plenty of dry powder to put to work once this correction or bear market runs its course. But if I’m wrong, and this is yet another buyable dip, then we still have substantial skin in the game.

And whether the market goes up, down or sideways, we’ll continue to collect a high and rising stream of dividend income.

Looking to a better second quarter,

Charles Lewis Sizemore, CFA

ETF Flow Portfolio 1st Quarter Letter to Investors

The ETF Flow Portfolio met its first real challenge in the first quarter of 2018, and I’m proud to say it passed with flying colors. The portfolio returned 2.99% for the quarter compared to a loss of 1.2% for the S&P 500. (Returns were net of trading costs but gross of management fees, which may vary by account size. As always, past performance no guarantee of future results.)

But what excites me the most isn’t the outperformance. It’s the fact that the outperformance was achieved by successfully side-stepping the major drawdowns in February and March. The S&P 500 was down 3.9% in February and 2.7% in March on a price basis. By comparison, ETF Flow was down 0.06% in February and up 0.46% in March.

By using its short-term momentum indicators, ETF Flow rotated into defensive positions and spent most of February and March in bonds and cash equivalents.

The stock market has arguably been the greatest wealth-creating machine in all of human history, and it allows passive investors to own a little piece of the world’s greatest companies. But that doesn’t mean that buying and holding an index fund is the best strategy at all times. Market valuations swing like slow-motion pendulums, gradually moving from underpriced to overpriced and back to underpriced again. Unfortunately, after nearly a decade of uninterrupted bull market, stock prices have swung towards being overvalued again. The cyclically-adjusted price/earnings ratio (“CAPE”), among other valuation metrics, suggests that stocks are priced to deliver flat or negative returns over the next decade.

At the same time, stocks investors are effectively fighting the Fed, as Chairman Jerome Powell is committed to gradually raising short-term rates and winding down the Fed’s balance sheet, which was inflated by years of quantitative easing.

Meanwhile, GDP growth and employment both look exceptionally strong at the moment, particularly compared to recent years. But these are lagging indicators that tend to be at their highest near the end of the economic cycle.

None of this is to say that expensive stocks can’t get more expensive or that the stock current correction is guaranteed to slide into a full-blown bear market. But it does suggest that it is prudent to maintain a nimbler trading strategy or, at the very least, to diversify into complementary, noncorrelated strategies. And this is precisely the role that ETF Flow successfully filled during this correction and the role that I expect it to fill going forward.

Looking forward to a strong 2018,

Charles Lewis Sizemore, CFA

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