Lighten up and lock in some profits Lighten up and lock in some profits December 6 2018

Lighten up and lock in some profits

We expect a powerful Q4 rally that will drive equities to record highs.
Published June 28 2018
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Bottom Line The investment professionals who comprise Federated’s PRISM asset allocation committee decided to lock in some profits by reducing their equity overweight in their moderate growth model portfolio from 8% to 5%, adding the proceeds to cash. 

The S&P 500 rallied by more than 9% over a 10-week period (from 2,553 on April 2 to 2,791 on June13), largely driven by excellent first-quarter profits, in which earnings per share rose by 25% year-over-year (y/y).  But companies won’t start to report what we believe will be very solid second-quarter results (up an estimated 20% y/y) for another three weeks or so in mid-July.  Importantly, amidst this earnings vacuum, we’re now concerned that second-quarter management guidance will be soft, as companies share our worries about the global tariff and trade war situation, the risk of a monetary policy error by the Federal Reserve, the ongoing immigration mess, sharply rising oil prices hurting consumer spending, and the Blue Wave reclaiming Congress in the mid-term elections. 

So with stocks bumping into overhead resistance for the third time in five months and a host of headwinds ahead of us, stocks appear to be setting up for a 5-8% correction over the summer.  As a result, we thought it prudent to lock in some profits now and create a store of dry powder, which we hope to deploy at better prices later this year.  We still expect a powerful fourth-quarter and 2019 rally that will eventually drive equities to record highs.  Think of today’s move, then, as strictly short term and tactical, as we continue to believe in the solid, longer-term fundamental underpinnings provided by strong economic and corporate profit growth. 

Wall of Worry There are a host of issues upsetting investors at this time:

  • Federal Reserve’s leadership and policy transition is progressing smoothly, as new Fed Chair Jay Powell has already orchestrated two quarter-point rate hikes this year, with at least a third hike to follow later this year.  But investors worry that Powell may hike too quickly, pushing the economy into recession.
  • Trump-inspired global trade wars and the imposition of tariffs could hurt economic growth.  But with the annual U.S. trade deficit at 3% of GDP, if President Trump’s unconventional negotiating tactics generate even modest improvement, then he could boost economic growth here at home, juicing federal revenue generation, reducing the deficit and strengthening jobs and wages.
  • Immigration is a hot-button mess at present, with no clear consensus on how to improve border security, reconnect separated families with young children, create a much-needed path to citizenship for DACA, and help to augment cyclical lows in domestic fertility rates with immigrant workers.
  • Geopolitical risks include Italy’s political instability, which is out of our control, and nuclear concerns surrounding North Korea and Iran, which are very much in our control.
  • Flattening yield curve as a recession signal.  But the curve has not yet inverted, and we do not see any signs of recession on the horizon for at least two more years.  Historically, once the yield curve does invert, we are typically 20 months away from the start of the recession, during which time the S&P 500 has rallied by an average of 11%.
  • Democratic Blue Wave looks less likely to happen in the November mid-term elections, due to Trump’s rising poll numbers and improving generic ballots for Republicans, who are now favored to hold onto the Senate.
  • Crude oil prices as measured by West Texas Intermediate soared 74% over the past year, from a trough of $42 per barrel in June 2017 to its recent peak of $73 in May 2018, as OPEC production cuts of 1.8 million barrels per day and strong global economic growth helped to bring supply and demand back into balance.  Retail gas prices rose by a third over this same period of time, from $2.23 per gallon to $2.97.  A penny increase at the pumps cuts $1 billion from discretionary consumption, so that’s a potential GDP hit of 0.37% and counting. 
  • Feared inflation spike appears to be more of a gradual grind higher, with the core PCE up by 1.8% in each of March and April, which is still below the Fed’s oft-stated 2.0% target.  But May is expected to tick up to 1.9%.

What we did today in PRISM:

  • Domestic large-cap growth – reduce 1%, taking a 1% overweight back down to neutral at a 13% allocation
  • Domestic large-cap value – reduce 1%, taking a 4% overweight down to a 3% overweight at an 18% allocation
  • Domestic small-cap growth – reduce 1%, taking a 1% overweight back down to neutral at a 3% allocation
  • Cash – add 3%, taking a 1% underweight back up to a 2% overweight at a 4% allocation

Where should investors hide this summer in a defensive rotation?

  • Cash
  • Benchmark 10-year Treasury yields rose from 2% last Labor Day to 3.1% in mid-May, but have since declined to 2.83% over the past six weeks in a flight-to-safety rally, a recent trend that could continue to a range of 2.55% to 2.70%.
  • Domestic small-cap stocks have outperformed large caps by nearly 8% over the past five months, a trend that should continue due to stronger U.S. economic growth, a tighter Fed, a stronger dollar, fears of tariffs and trade wars, Trump‘s tax cuts and stronger mergers and acquisitions activity from repatriation.
  • Domestic large-cap income-oriented value funds have underperformed large-cap growth by 27% over the past 18 months, as Treasury yields were rising sharply.  That degree of underperformance has occurred only four other times over the past 40 years, followed each time eventually by a sharp reversal in favor of value.  Dividend yields for these income-oriented funds are now more than twice that of the 1.9% yield for the S&P 500.  With Treasury yields declining at present, we expect income-oriented funds to perform well. 

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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Small-company stocks may be less liquid and subject to greater price volatility than large-capitalization stocks.

Federated Advisory Services Company