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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