Archive for category: Models

There are no changes to our thematic strategies for July.  Entering the third quarter, we continue to favor large cap and value.  The bias toward value influences our ongoing favorable view of international markets on a relative basis vs. the growth-dominated U.S. market benchmarks.  Among economic sectors, we still prefer value-oriented financials and industrials.  We have upgraded our view of health care and added it to select client portfolios that use thematic ETF strategies.  We see a shift toward growth in our Style model that could lead to a move back to neutral in August.  The Market Cap model remains solidly in large cap territory.

Our preference for large cap makes the S&P 500 (SPY) our preferred investment for capitalization strategies. For Value, we are sticking with the Russell 1000 Value (IWD).  As a reminder, if our Market Cap preference is for large or mid cap, we always use large cap for Style exposure.  For international developed markets, our preferred vehicles are EFA and VEA.  For emerging markets, we use EEM and VWO.  For both cases, the stock price correlations are near 100%, so we view the ETFs as interchangeable.  For financials, industrials, and health care, we use XLF, XLI, and XLV, respectively.

Our thematic strategies performed well in the second quarter.  Losses are significant given the historic declines in the major averages but accurate thematic decisions limited losses somewhat.  The decision to shift fully to value provided the most value added.

Greater detail on our current thematic strategies and their recent performance will be included in quarterly client letters.  Due to the July 4^th holiday, letters will go out via email early in the week starting July 11^th.

SPY, IWD, EEM, VWO, EFA, VEA, XLI, XLV, and XLF are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov.

 

 

 

We are sticking with our preference for large cap and value after reviewing our updated models.  We also continue to think exposure to international makes sense in strategies primarily focused on thematic exchange traded funds (ETFs).  For clients with strategies using Northlake’s Market Cap and Style models, holdings in the S&P 500 (SPY) and Russell 1000 Value (IWD) will continue to be maintained.

The market sell-off accelerated in April with the NASDAQ and growth stocks leading the market lower.  In our 2022 Market Outlook published in January, we said that a below average year was in store with for the major stock averages with a greater chance for significant downside than upside.  We also predicted higher interest rates.  These forecasts have thus far proved accurate.  However, we underestimated the magnitude of the moves in stocks and interest rates.

The war in Ukraine clearly exacerbated inflation that was the center of the shift in Federal Reserve policy from easing to tightening.  What once looked like a transitory inflation phase now seems like a longer lasting period.  We do think inflation will begin to recede as we get to summer and depressed prices caused by the pandemic fall away in the year-over-year comparisons.

The problem for stock market is that the natural slowing of the economy as it normalizes post the pandemic is being met by a much more aggressive tightening policy by the Federal Reserve to fight inflation.  The Fed is determined not to let long-term inflation expectations get built into investor, consumer, and business views.  That is how inflation becomes a multiyear problem.  We think the Fed is correct to act more aggressively than planned.  The long-term inflation outlook still looks favorable given the impact of demographics, technology, and maturity of the world’s major developed economies (and China).  Thus, taking the pain now makes sense.  Unfortunately, this is a bad set up for investors as the Fed appears willing to sacrifice the economy which hits corporate earnings and stock prices.  Bond prices fall as intermediate and long-term interest rates rise to keep in sync with the much higher short-term interest rates the Fed controls through the Federal Funds rate.

We think the markets have gotten too bearish.  With the benefit of hindsight, we should have held somewhat higher levels of cash reserves.  However, Northlake’s experience and market history suggest market timing is extremely difficult.  Not only do you have time the sale well, but you also must buy back in a timely fashion.  Getting one right is tough enough!  At this point, we think investors should buckle down and ride it out.  We are confident that the current levels in the major market indices will look attractive in six to 12 months even if the correction continues in the near-term.

We have been fortunate with our strategic choices, especially the recommendation of value.  IWD is only down 4.5% since we shifted fully to value on February 1^s.  The Russell 1000 Growth (IWF), which we sold to buy more IWD is down 13%.  Large cap has not held up as well as normal in a severe stock market correction due to the dominance of the large technology stocks in the S&P 500.  International is down similarly to the U.S. stocks in 2022 but we see signs of improvement especially for emerging markets that benefit from higher commodity prices.  China’s move last week to back off its regulatory crackdown on its leading technology companies is a hopeful sign as well.  Strength in the U.S. dollar remains the biggest obstacle for international markets.

SPY and IWD are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov.

We are departing from our usual monthly blog update that focuses solely on our Market Cap and Style models and thematic strategies to provide our current thoughts on market volatility surrounding the Russian invasion of Ukraine and our decision thus far to sit tight and not make major changes to client portfolios.

March 2022 Model and Strategy Update

At the beginning of February, we shifted our preferences to large cap and value from mid cap and neutral after reviewing our models.  We received our latest updates this morning and each model moved modestly further in favor of the new recommendations.  Thus, current client accounts using our Market Cap and Style strategies will continue to hold positions in the S&P 500 (SPY) and the Russell 1000 Value (IWD).  Client accounts using our thematic strategies but not our models continue to be overweight value and include an international component.  International is facing incremental pressure relative to the U.S. due to the Russian invasion of Ukraine but we continue to see great value abroad after several years of severe underperformance vs. U.S. markets.  International also provides diversification benefits.

Market Volatility and the Invasion of Ukraine

Given the historic market volatility and sharp correction, we want to offer some thoughts on the potential stock market impact from the Russian invasion of Ukraine.  Most importantly, at this time, we expect market volatility to continue but we are sticking with the plan and making no major shifts in client account strategies. 

Predicting what is going to happen in Ukraine seems impossible, and to be honest, it is beyond our knowledge base.  We understand markets, but we are not experts in geopolitics and war. We can look back on prior crisis environments to see how the stock market has reacted, and do so below.  It might surprise you that the history contains a lot more good news than bad news. 

Before we get to that, we wanted to share a good summary of the unpredictability of what happens next from Jefferies strategist David Zervos.  We always look forward to David’s notes and this week’s update proved no exception. This quote captures Northlake’s thoughts about the inability to make predictions:

“There could be escalation or de-escalation. There could be a complete destruction of Ukraine or an internal revolt against Putin by his own army and people. There could be serious financial market chaos from the sanctions, or the losses could be contained. There could be sharp rises in energy prices as the Russian supplies are withdrawn from global markets. Or prices may retreat as the US reopens shale and the Europeans temporarily pull back against their ESG goals.”

We would add to David’s points that the Federal Reserve and other global central banks could stay the course and tighten monetary policy or change course and tighten more slowly or even reverse course.

We think it is important to reiterate that even before the Russian invasion there were headwinds for the stock market that led us to expect a below-average year for market returns with a higher possibility of negative returns than had been the case since the recovery from the Great Financial Crisis began in 2009.  Take away Ukraine and the market still faces tightening monetary policy by the Federal Reserve and most global central banks, elevated inflation that looks set to persist for at least several more quarters, slowing GDP growth as stimulus wanes, higher interest rates, and a likely shift in spending from goods to services as the impact from COVID wanes. 

The table below is a summary of market returns during prior crisis periods.  It clearly shows that downside comes quickly, averaging just 18 days to the low and lasting no more than 50 days.  The downside can be severe, with four instances of over 20% drops, three of which reached over 30%.  The average decline is 12%, about how far the S&P 500 has fallen so far in the Ukraine crisis.  Importantly, recoveries have been strong and consistent.  Looking out 3, 6, or 12 months, there are only 9 instances of negative returns across all time frames in the 29 crisis periods.  The rebounds averaged 11%, 16%, and 25%, respectively, 3, 6, and 12 months later.

We are not predicting the recovery will be as good as in past crises or the downturn as short.  As we began, the path of the current crisis is impossible to predict.  We also reiterate that the same headwinds exist that we outlined in early January.  The history of crises does show why investors have been willing to buy the dip so far over the past week.

Northlake has taken no major action in response to the Ukraine crisis.  We expect volatility to remain high, but we want to stick to the investment plan for each of our clients for now.  As a reminder, we reached out to each of you with an overview of investment strategy in the second half of 2021.

We begin 2022 sticking with our preference for small and mid caps, while remaining neutral on growth vs. value.  Our Market Cap and Style models favor the S&P 400 Mid Cap (MDY) and are neutral on the Russell 1000 Growth (IWF) and Russell 1000 Value (IWD).  These positions will be maintained.  On our thematic strategies, we also continue to favor small cap value and find exposure to international developed markets and emerging markets attractive.

Northlake has maintained a preference for small and mid cap and value for some time.  The set up for these areas to produce sustained outperformance has existed for some time.  However, despite some very strong stretches (late 2020, early 2021, November 2021), large cap growth has held onto leadership.  We will have more detail in our 2022 Market Outlook but we see the combination of tighter monetary policy, above average economic growth, higher inflation, and a massive valuation discrepancy creating a favorable backdrop for small cap, mid cap, and value. We also see COVID losers that have significant overlap with small and mid cap and value outperforming in 2022 as each successive wave of the pandemic has less economic impact due to vaccinations and a reluctance to impose strict new mobility restrictions.

We still expect rotation among these big picture themes on a short-term basis driven by investor sentiment toward the path of real and nominal interest rates, COVID developments, the economic environment, and corporate earnings expectations and reports. 

To clarify one potentially confusing issue, we see the issues in growth stocks more heavily concentrated in speculative stocks that are unprofitable and trade at a multiple of revenue.  Rotation toward small and mid cap and value could hurt the relative performance of large cap growth stocks like Apple, Alphabet, and the other FAANGs.  However, these companies produce strong earnings and cash flow that are used to support shareholder value.  These stocks also have reasonable valuation metrics despite strong performance again in 2021.

MDY, IWF, and IWD are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. SPY is held in select Northlake client accounts.  Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov.