This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based TOPS ETF Portfolios.
I developed an idea several years ago regarding portfolio management decisions. Whenever we are making a portfolio change, I ask my team the following question: “Are we running from something, to something, or both?”
As portfolio managers, we have the mandate to invest 100% of assets in the portfolio. Therefore, we live in a zero-sum world. If we decide an asset class is undesirable and a candidate for reduction, we must invest that percentage into something else.
After 18 years of managing professional assets for thousands of investors and some of the country’s largest financial institutions, I can tell you it is rare when things line up such that we can simultaneously run “from something” and “to something” with the same strong conviction.
This reality is fundamental to the job and very true today. Currently, we hear a lot of investors wanting to run “from something” without something they would like to run “to.”
Investors are concerned primarily with stock valuations, low interest rates and the upcoming election. But where should they run “to”?
We believe a well-diversified portfolio, using four buckets, is a prudent game plan for many investors. Further, the four buckets help frame the conversation and outline the decision clearly.
A unique development in this report, readers will notice large cap growth U.S. stocks have their own bucket. If I had foreseen 10 years ago that large cap growth U.S. stocks would deserve their own bucket in 2020, I’d likely be writing this article from my helicopter instead of my office.
As I discuss the current landscape, I aim to outline why large cap growth U.S. stocks deserve their own bucket, and a new bucket (bucket 4) should be added.
The 4 buckets:
BUCKET 1 - Large Cap Growth U.S. Stocks
BUCKET 2 - Other Stocks (including large value, SMID, international and nontraditional)
BUCKET 3 - Bonds & Cash
BUCKET 4 - Hedged equity
BUCKET 1 - Large Cap Growth U.S. Stocks
Lewis Hamilton recently logged his 90th Formula 1 racing victory, which places him one win shy of Michael Schumacher’s record 91 victories. Like Jack Nicklaus’ 18 professional major victories and John Wooden’s 10 championships at UCLA, including seven in a row, these type of reigns of dominance are legendary.
There’s an argument to be made that large cap growth U.S. stocks should be included in the group of luminaries with Hamilton, Schumacher, Nicklaus and Wooden. Large cap growth U.S. stocks have simply elevated to a different atmosphere over the last 10 years. Along with the nearly 30% YTD outperformance over large cap value U.S. stocks through Sept. 11, 2020, growth stocks have dominated for a decade.
Source: Bloomberg, 8/1/2010 – 8/1/2020
As we know, a few major players have helped to drive this outperformance. Due to sheer dominance, the FAANGM stocks (Facebook, Apple, Amazon, Netflix, Google and Microsoft) now make up about 25% of the S&P 500.
(Use our stock finder tool to find an ETF’s allocation to a certain stock.)
All these victories have pushed valuations to historically rich levels.
Our team measures valuations monthly by eight different metrics for seven major asset classes. We then take the monthly values for the last 20 years and rank them in percentiles. Currently, large cap growth U.S. stocks are near the 100th percentile in valuations for every one of those metrics, with the lowest being the 90th percentile.
BUCKET 2 - Other Stocks (including large value, SMID, international and nontraditional)
It’s often said you either have it or you don’t. As such, we have grouped all other traded stocks (other than large growth) into bucket 2. While they’re definitive asset classes, there’s a clear gap between this group and large growth stocks.
There are obviously nuances to each of these asset classes, such as the makeup of value stocks and the impact of COVID on REITs. A similarity we see, though, is valuations are historically more attractive for the asset classes in bucket 2.
For example, in our 20-year study, small cap and mid cap U.S. stocks sit in the bottom quartile for price to book ratio. That’s just one example, but the theme permeates our analysis.
Given valuations, and other relevant factors, these assets in bucket 2 should react differently to current concerns than large cap growth stocks.
BUCKET 3 - Bonds & Cash
Interest rates and inflation are near historic lows. Every day we get asked, how can I earn something on my cash?
It’s a question without a good answer. Many will give an answer, though the answer will likely be a version of robbing Peter to pay Paul.
We’ve developed a strategy to balance risk in fixed income, allowing us to maintain exposure for the benefits this bucket provides.
Despite the low rates, we feel bonds and cash continue to have a valuable position in a well-diversified portfolio. No other bucket can provide the principal protection of bonds in panic markets and diversification benefits.
BUCKET 4 - Hedged Equity
Using options on U.S.-traded ETFs, investors now have the opportunity for efficient and transparent downside protection in major equity markets. With the overall growth of ETFs, the ETF options marketplace has significantly matured over the last 20 years. As of Q2 2020, the notional open interest of options on the four reference ETFs used in our TOPS Global Equity 15% Target Floor Index (SPY, IWM, EFA, and EEM) reached approximately $900 billion.
Another tool in the marketplace that can be used to hedge equity exposure is liquid index futures.
These tools represent a fourth bucket, which can be used to provide market participation with downside protection. This asset class is still developing, but some solutions we provide in this area include:
TOPS Global Equity 15% Target Floor Index
TOPS US Equity 15% Target Floor Index
TOPS Managed Risk Balanced ETF Portfolio
TOPS Managed Risk Moderate Growth ETF Portfolio
TOPS Managed Risk Growth ETF Portfolio.
Addressing Key Concerns for Investors
Some key concerns affecting investors currently include:
Heightened stock valuations: Are we in a bubble?
Will the presidential election swing markets severely?
How should we allocate in a low interest rate environment?
As an example, with our four-bucket framework, we can more easily evaluate these three concerns and make portfolio decisions.
Heightened Stock Valuations: Are We In A Bubble?
The COVID pandemic was the definition of a black swan scenario. While most stocks haven’t fully regained their March levels, positive returns from the trough reflect the makings of a V-shaped recovery for equities.
Often confused by investors, the stock market and economy are not 100% correlated. Investors see the pain the economy is suffering. COVID has proven to be less of a problem for the stock market than the economy in the short term, however.
Driving factors for strong stock recovery include S&P 500 concentration in sectors that are COVID protected, the perpetual nature of stock ownership benefiting from low interest rates and flush liquidity.
As discussed above, the recovery has pushed valuations on large cap U.S. growth stocks historically high. These heightened valuations have raised fear that a bubble could exist in stocks.
Despite the hefty valuations, we believe there’s relatively balanced risk of heightened valuations and opportunity for continued leadership of large cap growth stocks.
Only time will tell how things play out, but we believe long-term investors can’t afford to take an allocation bet against large cap growth stocks. Valuations were historically high five years ago, and growth stocks have only pushed to new highs since.
If a bubble exists, it doesn’t appear the Federal Reserve would do the popping. The Fed has been “all in” at the poker table since the crisis started.
Its recent policy change regarding inflation targets and full employment treatment supports the premise it will continue to be “all in,” at least for the foreseeable future. Fed support bodes well for growth stocks.
Will The Presidential Election Swing Markets Severely?
It’s no secret the upcoming election is monumental. The White House, about one-third of the Senate, and the House of Representatives are all on the ballot. The two presidential candidates have stark differences in policy perspectives, especially with respect to taxes.
While there are many reasons to doubt the polls, it is never a waste of time to think about what tax policy would look like with different administrations, and how that would affect the economy and markets.
If Biden wins, but the GOP retains the Senate (right now, Republicans have 53 seats), the answer is likely very little change.
What many investors are focused on is a scenario where Biden wins and the Democrats take the Senate, called the “blue wave.” In that scenario, the Democrats could use the special budget process on Capitol Hill to raise taxes permanently (meaning no natural sunset) with a simple majority, like President Clinton did in 1993.
The biggest focus for investors is Biden’s proposal to raise the corporate tax rate to 28% from 21%. A 7% increase in corporate tax rates should have a direct impact on earnings; thus, it would impact valuations and stock prices.
The concern is the increase in corporate tax rates could cause a significant pullback for stocks.
We are still two months away from the election and much can happen. Likewise, regardless of the winner, it’s not a sure thing what the winner will do and how quickly he will do it.
As portfolio managers, we’re focused on analyzing the potential impact of a blue wave or a victory by the incumbents on stocks, and preparing to manage the risk of either scenario.
How Should We Allocate In A Low Interest Rate Environment?
As a result of low rates, several have investors asked:
Should I hold bonds at all?
Is 70/30 the new 60/40?
Historically, low interest rates have left investors with little yield and heightened duration risk. If we run “from” bonds, should we run “to” stocks? Some would say yes.
For the first time since 1959, the yield on S&P 500 stocks is higher than yields on 10-year U.S. Treasuries (Barclays and S&P). This is not because the S&P 500 yields have skyrocketed. Rates are low, changing the risk versus reward payoff for stock ownership versus bonds.
But what about those hefty valuations on large cap growth stocks and issues facing stocks overall?
While adding equity exposure makes sense to some, it doesn’t come without risk. Our assumptions for our well-diversified fixed income portfolios still put equity risk far above that of bonds.
4 Buckets As The Game Plan
We need to allocate 100% of the portfolio, and we think the solution should include all four buckets.
The S&P 500 closed Sept. 11 at 3341. A recent article in Barron’s, titled “Wall Street Strategists Say There Are Few Gains Ahead for the S&P 500: Here’s What Else They Expect,” provided a consensus estimate year-end target of 3492. Likewise, the article highlights consensus predictions of 3800 to 3850 for 2021, and consensus S&P 500 earnings estimates of $128 for 2020 and $161 for 2021.
If the strategists are correct, investors will want to be in stocks to reach their goals. To play this market, we can look to the four buckets for the most prudent game plan.
Is bucket 1 overvalued and out of steam? Maybe. However, there’s also a substantial probability that bucket 1 continues to do well, justifying appropriate exposure.
Is it finally the time for bucket 2 to lead? Valuations would foreshadow outperformance for bucket 2 in the next full cycle, providing a nice portfolio balance to exposure in bucket 1. Many of the institutional partners we work with have higher expected returns on bucket 2, given these valuations.
Should we get rid of bonds? For most investors, we think the answer is no. The paycheck (interest rates) for holding bucket 3 is low; however, bonds remain a quality diversifier and “flight to quality” asset. We would encourage investors to think hard before increasing naked stock exposure significantly simply to run “from” bonds.
The secret sauce going forward may be in bucket 4. Bucket 4 is a unique and innovative way to allow investors to increase equity exposure, while maintaining a floor in value. We believe bucket 4 will become an essential tool of portfolio management. Our TOPS Equity Target Floor Indexes are designed as the leading tool for this type of offering.
Bucket 4 can be used to replace some bond exposure, complement a well-diversified balanced portfolio or equitize cash that was sitting on the sidelines for fear of significant downturns.
As we look at the four buckets, we see different stories. Given these concerns, and others we see in the market, we feel the best plan of action is to combine our 4 buckets into cohesive portfolios.
Vince Lombardi once said, “The measure of who we are is what we do with what we have.”
The three concerns above are real, as are many others we face as investors. Of the tools available, the four buckets above are key tools for us.
We remain steadfast in providing appropriate risk-adjusted returns for our investors over multiple investment cycles, including this one. By using the four buckets and understanding the benefits and drawbacks of each, we feel we can best manage through the current market environment.
ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5 billion in ETFs for retail and institutional clients in multiple investment products. Email: firstname.lastname@example.org; phone: 800-765-5201.
Valmark Advisers, Inc. (“Valmark”) is a federally registered investment adviser located in Akron, Ohio. Valmark and its representatives are in compliance with the current registration and notice filing requirements imposed upon federally covered investment advisers by those states in which Valmark maintains clients. For registration or additional information about Valmark, including its services and fees, a copy of our Form ADV is available upon request by contacting Valmark at 1-800-765-5201.
This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal.
Diversification cannot assure gains or protect against losses.
Past performance is no guarantee of future results. Information contained herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Indexes are unmanaged and cannot be directly invested in.
Source: Bloomberg for historic price and return references.
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