The third quarter was positive for U.S. equity investors, as a surging U.S. economy and labor market, in which consumer confidence hit an 18-year high, helped the S&P 500 enjoy a stable and steady uptrend, making new all-time highs near 2930 in September. The Federal Reserve (the Fed) increased rates for the third time this year, with an expected fourth increase coming in December. The Bloomberg Barclays U.S. Treasury Index finished down 1.6% for the 12 months ending September 30 and is only up 0.64% over a three-year period.
Stocks have been the leader in producing gains, though ten-year Treasury yields over 3.0% may begin to make bonds attractive competition. One of the most encouraging statistics is that equity valuations have come down as the year has progressed. The S&P 500’s median P/E ratio hit 27 on January 31st but has now fallen to 24 despite substantial equity market gains. This leads us to believe that real profit and revenue gains have been seen, and no doubt aided, by January’s corporate tax cut.
While much of 2018 has been filled with talk of tariffs and concerns, the picture began to clear by the end of the quarter. An updated version of NAFTA was signed, putting an end to the loudest of tariff concerns. The China tariffs are a different story, however. China’s average tariffs per the WTO are 9.8%, and its trade dispute looks to be a higher stakes game that won’t end soon. The China trade dispute along with the strength of the U.S. dollar is a source of stress on emerging markets, and we believe is one of the biggest risk factors that markets face.
U.S. Equity — Large Caps on the Rise
The U.S. equity portion of the MultiStrategy portfolios ranks a number of U.S. equity styles and factors using Clark Capital’s relative strength-based ranking methodology, and then purchases those ETFs with higher rankings (and avoids those with lower rankings), assembling them into a portfolio that attempts to outperform the Russell 3000.
As the quarter developed, we continued to own large cap growth (SPYG) and momentum (MTUM) stocks, but the rest of our portfolio is slowly becoming more defensive in alignment with our rankings. The S&P 500 has risen into the top half of our rankings, as few ETFs are able to beat it. The pace of growth stocks’ outperformance vs. value has slowed, though growth still made new relative highs in early September. The following were other developments in the portfolio during the quarter:
- Large cap value (SPYV) increased 5.8%, while large cap growth (SPYG) rose 9.2%. Small cap value (IWN) trailed all styles with a 1.67% gain, while small cap growth rose by 5.6%. Momentum stocks gained 8.7%, while minimum volatility increased by 7.8%. The S&P 500 was up 7.7%.
- Small caps enjoyed a strong second quarter and outperformed for much of the third quarter. However, that trend appears to have ended, perhaps due to higher interest rates beginning to have a bite, as small caps disproportionally rely on banks to fund their growth and operations. With small caps showing relative weakness, we see high dividend (HDV) and high quality (QUAL) ETFs rising in our ranking matrix. These ETFs could become buys as October develops.
- The top contributors to the portfolio during the quarter were the SPDR S&P 500 Growth ETF (SPYG) and iShares Russell 2000 Growth ETF (IWO). The top detractors were the iShares Edge MSCI USA Momentum Factor ETF (MTUM) and the iShares Core S&P 500 ETF (IVV).
Fixed Income — High Yield Bonds Enjoy Their Strongest Quarter
The fixed income portion of the MultiStrategy portfolios engages in sector rotation within fixed income, owning High Yield, U.S. Treasuries, or cash equivalents, depending on which sector our model determines has recent relative trends in its favor.
The fixed income portion of MultiStrategy has owned High Yield since the end of February 2016, now a period of over two and a half years. Since our 2016 buy of High Yield, the Bloomberg Barclays High Yield Index is up 30.5%, while the Bloomberg Barclays U.S. Treasury Index is down 1.4%. During the third quarter, the Bloomberg Barclays High Yield Bond Index pulled in a 2.4% gain, while the US Treasury Index declined 0.6%.
High Yield enjoyed its strongest quarter of 2018, as economic and corporate earnings news helped move spreads near their lowest level since 2008. For most of 2018, the portfolio’s preferred defensive vehicle has been cash equivalent vehicles, as cash now outpaces U.S. Treasuries in our models. If we truly are entering a bond bear market where interest rates are often rising, cash could often be the vehicle of choice. Here are some additional developments during the quarter:
- Health Care and Telecomm were the best performing high yield sectors both during the quarter and year-to-date (YTD). All High Yield sectors were also up during the quarter and are up YTD.
- We have noticed that issuance in the High Yield space has fallen as companies have instead preferred to finance via bank loans. This has provided an important bullish reduction in supply to the High Yield markets. However, another consequence of the rise of bank loans is less issuance among weaker CCC High Yield credits. The number of lower-grade CCC bonds in the High Yield Index has fallen 26% in the past two years. Despite the past few years of the High Yield rally, the underlying High Yield Index now actually contains less risky credits.
- In broader corporate America, companies are adding leverage to fund growth and buybacks, which may lead to a higher supply in the High Yield markets. Amazingly, 49% of the U.S. Investment Grade corporates are now BBB, with the next downgrade moving them into the High Yield category.
As we look to 2019, our outlook remains bullish. Most market observers have long voiced worries that this economic expansion was or soon will be the longest on record. However, it’s important to remember that it is also the slowest expansion ever, averaging only 2.3% GDP per annum.
With such a slow rate of expansion, it makes sense that it will take even longer than usual to have the economy’s growth become unsustainable. How long, then, can the economy continue its solid growth? Ned Davis Research notes that the Fed’s balance sheet normalization is still ongoing and will likely be reached in 2021.
Therefore, we believe a few more years of a stable underlying economy could be more likely than many think.
Within equities, we are continually watching for a shift away from Technology, Consumer Discretionary, and growth stocks towards Financials and value stocks. Beyond a normal correction, we have not seen that ship turn. We will continue to monitor style and factor trends and use our relative strength models as a guide.
High Yield credit remains quite strong and continues to hold its own during this period of rising rates. We remain watchful for risks, and our tactical approach allows us to adapt if a defensive market takes hold.
This is not a recommendation to buy or sell a security or to adopt a particular investment strategy. The opinions expressed are those of Clark Capital Investment Management Group and are subject to change without notice. The opinions expressed are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Clark Capital reserves the right to modify its current investment strategies based on changing market dynamics or client needs.
This document may contain certain information that constitutes “forward-looking statements” which can be identified by the use of forward-looking terminology such as “may,” “expect,” “will,” “hope,” “forecast,” “intend,” “target,” “believe,” and/or comparable terminology. No assurance, representation, or warranty is made by any person that any of Clark Capital’s assumptions, expectations, objectives, and/or goals will be achieved. Nothing contained in this document may be relied upon as a guarantee, promise, assurance, or representation as to the future.
The relative strength measure is based on historical information and should not be considered a guaranteed prediction of market activity. It is one of many indicators that may be used to analyze market data for investing purposes. The relative strength measure has certain limitations, such as the results being impacted by an extreme change in a security price.
It should not be assumed that any of the securities transactions, holdings, or sectors discussed were or will be profitable, or that the investment recommendations or decisions Clark Capital makes in the future will be profitable or equal the performance of the securities discussed herein.
There is no guarantee that any of the securities discussed herein will be included in or excluded from an account’s portfolio at the time you receive this report. All recommendations from the last 12 months are available upon request.
Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.
The MultiStrategy benchmark consists of an allocation to the Russell 3000 and an allocation to the BBgBarc US Corporate High Yield. The Russell 3000 Index measures the performance of the 3000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market. The BBgBarc U.S. Corporate High-Yield Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The benchmark for this composite is based upon the approximate allocation of equities and fixed income in the MultiStrategy composite. The Russell 3000 is generally representative of broad based equities. The BBgBarc US Corporate High Yield is generally representative of broad based U.S. fixed income.
Clark Capital Management Group, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Clark Capital and its investment advisory services can be found in its Form ADV Part 2, which is available upon request.