Does Your Investment Portfolio Need First Aid?

By Michelle Connell, CFA | 7 min read

After reaching a year-to-date return of almost 20 percent, the equity markets have been down significantly the last six trading days—almost six percent. Is it possible we have gone into correction mode? If so, should you be doing anything to mitigate the risk to your portfolio?

Why we were due for a pullback.

There have been a lot of assumptions embedded into the market. Valuations were stretched. Before this pullback, growth stocks were up over 26 percent and and their price/earnings ratios were stretched 23 times earnings.  A significant part of growth in earnings per share has come from share repurchases, not just increases in sales or profit margin expansion. Add this to the fact that growth is slowing significantly. The estimate for GDP growth for 2019 is 2.9 percent. Going forward it’s expected to be in the 1.6 to 1.8 percent range.  The market may have just gotten ahead of itself.

What was the catalyst for the last week’s pullback?

When Federal Reserve Chairman Powell lowered the Fed funds rate last week, the bond market responded in a way that signaled that there is a much higher risk of a US recession than was believed before his announcement. Next, the Chinese government devalued the yuan to fall below its seven-to-one ratio, with the US dollar for the first time in a decade. A weaker currency could soften the tariff blow the United States has dealt China. The markets were basically given a one-two punch from both of these and responded by selling off almost three percent on Monday, August 5th.

POSSIBLE AREAS FOR TRIAGE FOR CONTINUED BLEEDING

1. FANMAG names: A large percentage of the price appreciation of growth stocks has been concentrated in the FANMAG stocks: Facebook, Apple, Netflix, Microsoft, Amazon and Google. While these stocks, which trade on  the NASDAQ, have recently corrected to some degree, there may still be more to give back. Note that these stocks are widely owned by Exchange Traded Funds (ETFs) and are typically hit hard during corrections. Trimming of these names may still be in order. 

2. Equities with a growth orientation: As previously explained in the section above titled “why we are due for a pull-back,” growth stocks stocks have become expensive as the environment for domestic and global growth has slowed. Large cap growth stocks have increased 534 percent since the market low in March 2009. Also, the price-to-earnings ratio on these names is slightly more expensive than their 20-year average.  

While the FANMAG stocks have made up a very large portion of large cap growth’s return, the overall investment class may still too heavily weighted in your portfolio and therefore, deserve consideration of a reduction.

3. Possible bond trims: Remember that the bond allocation to a portfolio is meant to produce income and provide protection. The purpose of bonds is typically NOT capital appreciation. During last December’s sell-off, the riskier bonds-such as high-yield and emerging market debt took a beating. Now, there appears to be another exodus from these two types of bonds. Last week, high yield ETFs experienced large outflows. In the past eleven weeks, emerging market bond funds have experienced outflows as well.  

As noted in Investopedia: “While there is almost always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond.

Low buying interest in a particular bond issue can lead to substantial price volatility and possibly have an adverse impact on a bondholder’s total return (upon sale).”

Also, consider the fact that the yield on cash right now is 2.3 percent as compared to the Barclays Agg Index yield of 2.6 percent.  Bond holders are not getting compensated for owning a bond portfolio with duration and credit risk.

POSSIBLE AREAS OF CHANGE TO INVESTMENT ALLOCATION

Value Stocks: As has been the case for the past ten years, growth stocks usually sparkle in bull markets. However, value shares tend to shine in down markets. At least that was the case for the bear markets between 1970 and 2006. 

Over the (very) long-term—value stocks from July 1926 through May 2018—value stocks traded on U.S. stock markets outpaced growth stocks by an annualized 3.9 percentage points.

Finally, many active value managers are adept at managing the downside. For all these reasons, it may be time to add or initiate a position in value stocks.

HEDGE STRATEGIES

Hedging is accomplished using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another investment. As explained by Investopedia, “If the investment you are hedging against makes money, you will have typically reduced the profit you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss.”

As the stock market has become more expensive, more hedged equity strategies have become available to retail clients. Strategies can include loss mitigation or enhancing income. If a portfolio needs to generate a certain percentage of income in our current world of reduced interest rates, these strategies can be helpful.

Active management: Remember it’s not what you make, it’s what you keep. This is may be even more critical now as domestic stock market returns are expected to only be five to six percent for the next ten years. Good active managers can add to portfolio performance over time—especially by losing you less when the market corrects. Thus, look for managers with strong downside risk management. With bonds only expected to return three percent, active management is just as critical.  Contrary to the popular press, there are investment managers that beat the market over an investment cycle.  Just remember that all managers have down years and underperform their benchmark at some point.

Alternative assets: An alternative investment is a financial asset that would not be considered a traditional investment (i.e. stocks or bonds). Alternative assets are used to decrease the risk of a portfolio, enhance income or increase total returns. Alternative investments can include private equity or venture capital, private debt, hedge funds, managed futures, art and antiques, commodities and derivatives contracts.

Many types of alternative investments are only open to accredited investors and typically are tied up or can not be liquidated for a certain period of time. For these reasons, these investments in these have only been available to Institutional investors (i.e. pensions, foundations and endowments).These investments are now accessible to retail investors in the form of limited partnerships or mutual funds.

Keep in mind higher return always comes with higher risk. For alternative investments these risks can be in the form of illiquidity, business and concentration risk and lower transparency. A high level of due diligence—initial and on-going—is required.

Cash: There is nothing wrong with hanging out in an asset class that is making a positive 2.3 percent. Cash has two positive things going for it. One: it’s not going to go anywhere. Two: it may pay to have some dry powder as things get cheap.  Also, remember to have enough liquidity available (cash and money market balances) to cover your obligations or possible emergencies.

Take this market pull-back as an opportunity to provide a check-up for your investment portfolio. There may be positions that need to be cut back or trimmed, or there may be things that could be added. Whether your goal is increasing income, capital preservation or capital appreciation, and analysis and possible rebalancing could enhance the long-term health of your portfolio.

For a complimentary assessment on the health of your portfolio, contact Portia Capital Management today. Click here to send us a message.

About the Author
Michelle Connell, CFA is the President and Owner of Portia Capital Management, LLC and one of the highest-rated finance professors in the United States, currently serving as an adjunct professor at The University of Texas. For her clients, Ms. Connell crafts personalized solutions that include conventional products as well as rare access to alternative assets, including private equity, private debt and real estate, and allows investment portfolio creation with greater downside protection and more consistent returns.    

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