Dear fellow investor,
The stock market roared higher in August, driving strong performance across the full range of Private Client portfolios. SMI’s equity-focused strategies turned in particularly strong gains, with Stock Upgrading outperforming the market with a gain of +9% and Sector Rotation posting a stunning +18.6% return. Bonds, which have had a great year overall in 2020, finally took a breather in August, retreating a bit. But even there, Bond Upgrading was able to limit losses significantly. Overall, August was a great month for PC investors. Here’s the breakdown.
Dynamic Asset Allocation
There was one change to DAA for September. The recommended categories/ETFs are:
- Gold — GLD
- U.S. Stocks — SPY
- Foreign Stocks – EFA
Change for September:
- Sold BLV (Bonds)
- Bought EFA (Foreign Stocks)
This month we reversed DAA’s end-of-January trade, when we exited Foreign Stocks in favor of Long- Term Bonds. That was a great move: long-term bonds were arguably the best place to ride out the bear market while foreign stocks got hit hard. Even after the extended rebound from the lows, BLV gained +8.1% from where we bought it at the end of January, while EFA fell -2.4%.
Of course, the picture changes as we move to the more recent past, which is why we made this change for September. Looking back at just August’s performance, Foreign Stocks were up +4.7%. More importantly, long-term bonds fell -4.1% as interest rates turned modestly higher. Last week's speech by Fed Chairman Jerome Powell was widely interpreted as a significant change, indicating that the Fed is willing to let longer-term interest rates rise as they pursue a goal of higher inflation. Long-term yields did, in fact, move higher in response (which pushes prices on those bonds lower).
I'm not convinced that long-term rates are heading much higher in the near-term, as it seems likely that softer economic recovery data coming in over the next several months will keep a lid on rising yields. But the key aspects of the recent change in bond yields as they pertain to DAA are:
1. The trend in foreign stocks has strengthened sufficiently in recent months to overtake the weakening momentum of long-term bonds;
2. There's a structural story in the market now that is supportive of higher long-term yields, which would be bad for long-term bond values.
From DAA's perspective, this month’s change is 100% about the first of those two factors — the momentum scores say it's time to make the switch. But it is interesting that the second factor triggered last week, just days before DAA reversed this trade from eight months ago. Swapping these two asset classes worked out well then, and we hope it will be similarly beneficial this time around.
A few notes on gold
Gold finally took a breather after its red-hot ascent in recent months, finishing August with a slight -0.3% drop. For context, gold gained +10.8% in July, and was up another +13.1% from April through June. Put those together and gold had gained over +25% in the four months leading up to August. That’s unsustainable and not healthy for a long-term bull market. Healthy bull markets include pullbacks and corrections, which is what we consider August's price action in gold to have been.
Gold has been an incredible holding for DAA investors since it was added at the end of January. We believe it remains strongly positioned to succeed in the current financial/political environment, characterized as it is by massive Federal Government stimulus and the recent Fed pivot toward openly ignoring inflation in commodities and other tangible assets.
In August, we used the weakness in gold to shift a small portion of Private Client gold positions out of GLD and into two gold mining company indexes. Gold mining companies went through a brutal bear market from 2011-2018, which significantly streamlined their operations, cleaned up their balance sheets, and has most miners still trading at incredibly attractive valuations despite significant gains from their lows. Low energy prices, which are a major component in mining costs, mean that the profit margins of miners have exploded higher along with the rising gold price.
Given the extremely bright big picture set up for gold and the current strength of the gold miners, we believe the risk/reward tradeoff is tilted strongly in favor of shifting a small portion of our gold holdings to the miners.
There were no changes to the Stock Upgrading portfolio for September.
While Upgrading obviously missed out on some gains by staying partially in cash as long as it did, one benefit we’re seeing is that Upgrading is now invested in the strongest funds. That was evident in August as the portfolio raced to a +9% gain, well ahead of the +7.2% increase in the S&P 500 and the +6.5% return on a blended index (just-the-Basics) portfolio.
There was no change to Sector Rotation for September.
"When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational." – George Soros
Many SMI investors may consider old George to be on the naughty list for his political views, but he is one of the most successful hedge fund managers of all time. That makes his quote from 2009 interesting as we witness what could be a bubble in tech stocks inflating.
This has clear implications for Sector Rotation, which profited from another huge month of gains in tech this month. SR's official recommendation, Ark Innovation ETF (ARKK), was up a blistering +18.6% in August.
This is thrilling, and scary, at the same time. When we rotated into ARKK a month ago, I noted the back- tested experience of SR in 1999, which was the last period of comparable tech frenzy. You may remember that tech bubble ended in tears in a brutal -80% selloff from 2000-2002. But before getting to that selloff, SR would have booked by far its most successful trade ever. Even after giving back nearly a third of its value in the two months before SR pivoted out, that final tech trade would have gained +250%!
So while we're nervous about how and when this ends, we're also riding the momentum wave for now, knowing these episodes can extend longer than most people expect. Needless to say, risk management is crucial here, which is why SR is a limited allocation in most PC portfolios.
There was no change to the Bond Upgrading lineup for September. Bond Investing 101 states that when bond yields rise, their prices fall. That’s what happened in August as yields finally bumped higher. This was a bigger deal for bonds of longer duration, the type we owned in DAA. At the shorter end of the spectrum, losses were relatively mild, and for Bond Upgrading they were milder still. While Vanguard’s Total Bond Market Fund slid -0.9% and the Bloomberg Barclays Aggregate Bond Index dropped -0.8%, Bond Upgrading was off just -0.15%. Better upside performance and downside protection is a good combination, explaining why Bond Upgrading leads the Aggregate Index by a +8.9% to +6.9% margin through the first eight months of 2020.
The rotation within our blended Private Client portfolios in August was another great illustration of why we coach investors to view their portfolios holistically rather than focusing on the performance of each specific component. DAA and Bond Upgrading, which have co-starred through most of 2020 with year- to-date gains of +13.1% and +8.9% respectively, finally took a step back this month. But right on schedule, Stock Upgrading and Sector Rotation surged forward, keeping the overall trend of our portfolios moving higher.
We appreciate each of you and the opportunity you’ve given us to walk alongside you on this investing journey. Please let us know if you have any questions or if there’s any way we can be of assistance.
Senior Portfolio Manager