The investment strategy for the 4th quarter and beyond considers many factors. The economy is expected to slow further with numerous land mines that could tip the economy into recession. A weaker economy could actually be good for stocks and bonds as the threat of inflation and higher interest rates will lessen. While a slower economy is anticipated, corporate earnings could show good results relative to expectations for the 3rd quarter that will be reported in mid-October. Well-managed firms will benefit from improving supply chains, lower transportation costs which could produce higher profit margins and cash flow.
We often portion client portfolios into two strategies; fixed income to cover portfolio withdrawals over the next five to seven years and long-term growth. Fixed income strategies continue to focus on core high-grade bonds, with maturities aligned to a client’s cash needs. This strategy has provided peace of mind to clients that their financial needs are positioned for the next five to seven years usually.
The big strategy issue is when do we begin to purchase longer-term bonds? For over a year, the Fidelity Conservative Bond Fund has been our largest holding. This fund yields over 5% and its short-term maturities have protected against losses as long-term interest rates have risen sharply. However, once the economy slows and inflation moderates further, short-term yields will drop. To add higher yields to portfolios, recently we added the Fidelity Floating Rate Bond Fund to some accounts. This fund has a yield of over 6% but it fluctuates with short-term interest rates that have gone up for the past year. Given our relationship with Fidelity, we have an informative advantage as to how the funds are positioned and the ease of trading into or out of a fund quickly.
For the year so far, fixed-income performance has generally avoided the losses experienced in long-term bonds. We are looking for signs that long-term (ten to thirty years) interest rates have peaked. Will that be 4.5%, 5.0% or higher? Signs of a peak is energy but it’s too early to make that conclusion.
Shifting to the growth strategies, it has been a challenging 2023, although still, we have made money. Performance of the SP500 has been dominated by a handful of mega-cap stocks while the average SP500 stock is down for the year to date (See RSP equal weight SP500). Client performance has been in the middle between the SP500 and the equal-weighted SP500 since our portfolios are more diversified. Since peaking in late July, the SP500 has dropped by 6.5% with the majority of the punishment in the past week since the Federal Reserve meeting. With the lower stock prices, much of the risk of higher inflation and slower earnings growth, have been factored into prices.
To briefly review our equity objectives and strategies, the objective is to outperform our benchmark, the SP500, by 1% to 2% over a business cycle of 3-5 years. The strategies to accomplish the objective include many factors that can be summarized into qualitative issues including focused competitive advantages, market structure and corporate citizenship. Financial analysis eyes profit margins, sales growth, and return on invested capital that often results from non-financial characteristics. Financially, we monitor the trends of holding as to their performance relative to the overall market and their sector. Often stock trends are precursors to changing financial performance.
Looking forward, many of the current challenges could be mended during the historically strong 4th quarter. The short-term question is if the SP500 bottoms at current levels or declines to 4200 where there is support. Recently, we have hedged most portfolios by purchasing an ETF that trades inversely in the direction of the NASDAQ composite index. The hedge position will be sold when evidence of a market bottom is in place. Investor sentiment as measured by the put/call ratio is showing high pessimism but could get more extreme.
Equity portfolios are about 80% – 90% invested, thus most portfolios have spare cash to invest. There are a number of secular themes investment holdings are positioned to benefit.
- Innovation leaders
- Natural gas
- Domestic infrastructure/energy efficiency
Core holdings are positioned to benefit from these trends. To briefly review some notable holdings, Carrier Corp ($54.56 CARR) is reshaping their business to focus on New Era air conditioning technology while spinning off their fire security division. Their pending acquisition of Weissman, a private European company and leading provider of heat pumps, could be a major source of revenue growth.
Energy holding have been busy making acquisitions that hurt their stock prices in the short-term but positioned them for enhanced growth long term. Oneok, ($61.85 OKE) acquired Magellan to create the nation’s largest pipeline network transporting natural gas, refined products including jet fuel and crude oil. Similarly, EQT ($39.09 EQT) made two property acquisitions to expand their natural gas reserves. Weak natural gas prices have hurt earnings recently, but drilling efficiency helped to lower costs.
For clients who eye a growing dividend, Garmin quietly continues to innovate with new product introductions across their 5 divisions. Only of analysts have “buy” recommendations on Garmin shares, probably because the analysts who research the company don’t fish and can’t afford an airplane where their products for navigation are industry leaders.
In the technology sector, our theme remains AI leaders. Nvidia ($447.82 NVDA) is the leader of semiconductor chips needed for the highest level of AI. Nvidia’s financial performance has been beyond outstanding. We expect Nvidia’s stock performance to lead tech stocks once the current malaise subsides. Following Nvidia, Microsoft ($3221.80) and Google ($132.51 GOOGL) purchase the high-end chips from Nvidia to run their new AI applications while Arista Networks ($187.80 ANET) transmits data over networks and Palo Alto Networks ($236.77 PANW) protects large technology infrastructure from hackers with new AI products to enhance security.
Deere ($378.39 DE), the leading agriculture provider globally, is advancing autonomous tractors. The stock has not performed well this year after a strong 2022 as investors question if the current cycle for equipment sales has run its course, but the innovation and labor savings may be pushing to the current cycle a long-term trend. Also note, Nvidia is one of Deere’s top suppliers.
During the quarter, we exited two notable holdings. First, Next Era Energy’s shares were reduced, and the final sliver of shares were liquidated recently. The utility sector has been one of the weakest performers this year. Weak performance has correlated to the rise in interest rates. Utilities need capital to invest in future electric production and the cost of capital has gotten a lot more expensive, thus profits may be lower in the future.