SUMMARY
Just choppin’ around, except for AI.
Equity and bond markets continue to chop around, with continued strength in artificial intelligence-related technology/semiconductor stocks. Even stocks in the utilities sector rallied strongly for a bit under the narrative that artificial intelligence support will require significant energy needs. Energy stocks also rallied strongly until OPEC+ announced no real support for additional production cuts, which resulted in a quick selloff in oil prices. Other than that, most other areas of the equity market just sort of chop around, and the choppiness could continue.
I’m always focused on diversification across investment styles, geography, income-generating assets, and prefer leaning towards higher quality companies. While I pay attention to the macro and have opinions on the macro environment, I don’t attempt to overly trade based on short-term macro data. I’ve covered investment managers that attempt to do that and no one is consistently getting it right or always significantly outperforming anything else.
Looking at my investments, my higher quality growth exposure continues to do well, although my concerns about too much momentum and higher valuations remain. My mid and small cap equity exposure has lagged larger cap growth stocks but my discipline and structural exposure to higher quality mid and small caps remain, due to what I believe to be better valuations.
I continue to like international developed, emerging markets and international mid/small caps. These companies also appear to remain attractive on a valuation basis, which works for me. I also continue to prefer exposure to active global equity managers to maintain active diversification globally. I believe there will always be strong, high quality, growing companies throughout the world and anticipate having allocations to non-U.S. equities for the foreseeable future.
I continue to really like high income-generating assets. I remain a fan of diversified exposure across option income, dividend growth, tactical high income strategies and closed end fund strategies that offer attractive income and growth potential. If higher beta areas of the equity markets decline sharply and equity valuations become more attractive, I may be able to use this high income allocation as “dryer powder” to increase equity exposure.
I continue to have some structural exposure to leveraged equity, with heavier allocations to leveraged small caps as they have lagged the broader markets. I also have some tactical leveraged exposure to China and biotech as these areas remain well off their highs. China rallied significantly so I reduced some of that leveraged positioning in Q2, but I maintain the tactical position. These leveraged positions can be very volatile, so I’ll continue to try to take advantage of rebalancing opportunities as they present themselves.
Within fixed income, a diversified allocation to strong, multi-sector active bond managers continues to make sense to me. I can withstand some moderate volatility from credit exposure, so as a long-term investor, I prefer to be overweight credit-sensitive bonds relative to government bonds.
In general, I didn’t have any real movement across my investment positioning in Q2, just tactical rebalancing and some reduction in a leveraged position to Chinese equities. Unless risk assets materially decline from here, I’ll maintain my neutral positioning relative to my risk profile with some minor tactical leveraged positions. I continue to try to target an average long-term equity return of 6-8%+ and fixed income return of 4-6%, and think my diversified allocations can get me there.
The broader U.S. economy continues to show signs of deceleration and inflation data is cooling, but the economy appears fine over the short-term and high quality companies continue to show earnings growth. I’m good with that. Investors will start to think about the presidential election, but the markets know both Biden and Trump, so there might not be enough to move the markets there. If there is a party majority in the White House and in Congress, then markets may be a bit more active as political decisions may have a better chance to be implemented.
Without much volatility this year, I would anticipate volatility to pick up at some point, but from my perspective, there isn’t anything material for me to change my investment positioning at this time. Steady as she goes.
RISK ASSETS
Equity markets can decline 8-10% on average in any given year. Sometimes it’s more, sometimes it’s less. The issue is no one knows from what level that can occur. Maybe the decline is after a 15% rally, a rally that investors can miss if they’re overly concerned for whatever reasons and waiting for that “inevitable” sell-off.
Since equity markets can continue to grind higher when there isn’t a lot of negative news, trying to time when that market decline could happen can be a bad strategy, in my opinion. I don’t try to do it as that’s a short-term trading mentality. I continue to focus on the long-term and tactically rebalance if I need to. That’s what I’m doing with my risk assets in this environment.
Risk assets continue to perform relatively well, with mega cap AI-related companies driving a lot of the U.S. equity market. I don’t have any desire to chase specific areas of the equity market or the broader U.S. large cap indices (S&P 500, NASDAQ).
Valuations appear a bit stretched over the short-term in the large cap indices, but when you dig a bit deeper into the indices and across market cap, there do appear to be opportunities with somewhat attractive valuations for longer-term investors.
Foreign equities continue to look attractive based on relative valuations. Outside of the U.S., I continue to prefer higher quality growing companies. The European Central Bank has implemented its first rate cut, and with valuations attractive, having exposure to high quality European companies makes sense to me. China’s equity market has started to perform a bit better as the economy appears to be bottoming. With some potential government support and relatively attractive valuations, I’m willing to have exposure to Chinese equities and broader emerging markets tied to the Chinese economy.
I continue to like diversified exposure to higher income-generating assets and strategies. A diversified allocation across option income, dividend growth, closed end fund strategies and higher income-generating credit continues to deliver attractive income yields. This can provide some income return if we enter a more volatile choppy market environment.
I anticipate more market chop and continue to remain patient if a deeper market sell-off arrives at some point. I remain diversified across higher quality growing companies across market cap and geography and allocate to higher income-generating assets.
U.S. EQUITIES
I prefer to remain allocated across higher quality companies across market cap. Even though higher quality large cap growth company valuations aren’t great, I believe it’s a great long-term allocation, so I’ll hold through short-term valuation concerns.
Quality mid and small cap companies continue to appear attractive to me for longer-term positioning. Economically-sensitive mid/small cap companies could struggle if the economy worsens, but valuations in these higher quality mid/small cap companies remains attractive, in my opinion. If the economy remains at least “ok” and the Fed starts cutting interest rates, mid/small caps could find some investor support.
Investment Momentum is a Force
Momentum is a powerful force, especially when a portion of the equity markets are driven by quantitatively-driven computer trading programs that continue to buy stocks with high positive price momentum. U.S. large cap AI-related companies continue to show positive momentum for the moment. Who knows how long it lasts and it can last a long time, that is until the momentum changes.
My issue is that momentum can push equities much higher than fundamentals would otherwise suggest, and once “everyone” believes in the “story” and the story reverses, momentum can reverse sharply to the downside.
Remember 2021 when the hyped up “new technology, innovation stocks” rallied to extreme heights, then declined significantly, some down over 60%? These companies had weaker fundamentals, lower quality balance sheets, and shaky long-term stories. Didn’t matter. Some stocks were up 100s of percent in a short period of time. Then they crashed. That’s momentum, positive and negative. Good on the runup but most people don’t get in at the bottom before the run, they usually get in closer to the top, then lose after the sell-off.
I don’t just blindly buy equities with strong momentum, but rather rebalance positions when momentum may push areas of the market farther than they maybe should over the short-term. This is portfolio risk management.
I also don’t significantly underweight these areas that have done well due to a momentum-driven rally or if valuations over the short-term are modestly stretched. These can be good long-term areas to remain invested for the long-term, so I remain invested rather than trying to be cute and try to tactically trade based on short-term technicals or valuation.
Right now, I think there may be a lot of momentum-driven reasons for the big run in AI-related companies, but there are still strong opportunities in different areas of the market with companies that have solid growth prospects, have strong balance sheets and relatively attractive valuations. I try to maintain discipline and diversify across these higher quality companies positioned for longer-term success, rather than chasing shorter-term trends and trying to accurately time momentum-driven rallies/sell-offs.
FOREIGN EQUITIES
I continue to like to be diversified outside of the U.S., with a preference for higher quality growing companies across sectors, and exposure to both foreign developed and emerging markets.
Broadly speaking, foreign equity valuations remain attractive relative to the U.S., and governments appear to be starting to provide support to their economies, which could be bullish.
The European Central Bank recently cut their interest rate target, which can provide potential support to the European economy. China has indicated additional support to its real estate market and other potential stimulus to support its economy. Europe and China are large economic drivers of the global economy, and their potentially stimulative efforts could drive additional investor interest to foreign equity markets.
I continue to prefer to get exposure to foreign markets through investment strategies that tend to focus on higher quality companies. I’ll generally gain foreign equity exposure through global equity managers and dedicated active managers, across growth, core and value strategies for diversification.
I don’t generally allocate to broad, traditional market cap-weighted strategies to get exposure to international markets. The U.S. is a bit unique as the largest companies are some of the highest quality growth companies in the world, so lower cost passive exposure to the S&P 500 can work for now. International indices don’t have that high quality growth bias, so I prefer focused quality factor tilts and active management instead.
HIGH INCOME
High income-generating assets and strategies remain attractive to me. With U.S. large cap equities appearing a bit stretched and could experience some choppiness, high income generation provides some income that’s attractive, in my opinion.
I continue to prefer my diversified allocation across high quality dividend growth, option income, dynamic multi-asset income strategies, closed end funds and high income-generating bonds (below investment grade credit, emerging markets debt, securitized credit, etc.). Depending on the allocation mix, the income yield could be 6%+, which is attractive to me in this environment.
High yield bond spreads are relatively neutral to tight, so I don’t need to be overly aggressive here. Market volatility has been muted, so income from option writing has been on the lower end. Dividend growth stocks remain attractive from both income (albeit lower than other strategies) and longer-term capital appreciation potential. Closed end fund discounts are relatively neutral as well, so don’t need to be aggressive here either.
In addition to the higher income generation, my allocation to high income can also be used as dryer powder in periods of significant weakness in equity markets. We haven’t had any real weakness in equities in some time, so my dryer powder high income allocation remains (while generating attractive income).
In my opinion, there is no real reason to get overly aggressive on high income-generating assets if you’re coming from more conservative assets. For me, high income remains a solid allocation as a complement to my allocation to equities in this environment.
COMMODITIES
I really don’t have high conviction in commodities at the moment. I’m not really bullish or bearish, but I don’t allow myself to be neutral. I want to take a position and not cheat with a “neutral” position. So if anything, following a decent run-up in precious and industrial metals, I’m slightly bearish at the moment.
Gold could stagnate for a bit at these levels. There are some indications that the recent run-up was at least partially driven by the Chinese government buying gold, which appears to have stalled a bit as prices ran to new highs. If China, as a major buyer of gold, has paused its purchases of gold, gold prices could stagnate and remain choppy for a while.
If global central banks are cutting interest rates, the global economy decelerates, and the U.S. dollar experiences some weakness, there may be a fundamental case for gold support.
Oil prices experienced some recent downside volatility as OPEC+ indicated less desire to extend production cuts, resulting in higher supply. There are also indicators showing oil supply remains pretty solid with the potential for demand slowing. If there is excess oil supply, oil prices may experience downside pressure from current levels. A range of $60-$90 on WTI Crude Oil prices could remain. We’re on the upper side of that range right now, so I’m neutral to bearish at the moment on oil prices.
Copper prices have had a strong run, which will generally give me pause following a strong rally. With an apparent strong continued demand for energy and infrastructure for artificial intelligence, plus a potential reacceleration in growth in parts of Europe and emerging markets, copper may continue to find price support for the intermediate future.
CONSERVATIVE ASSETS
Interest rates on investment grade, conservative bonds remain attractive for investors. Rates from 5% on the short-end of the yield curve to over 4% through intermediate- and longer-term Treasuries and even higher for those willing to take some credit risk exposure.
A diversified multi-sector bond portfolio, depending on the credit quality allocation, could get yields of 4-6%+, which may be attractive for investors seeking less portfolio volatility than a pure equity portfolio.
If the U.S. economy continues to show deceleration in growth and inflation continues to come down, even if it’s slowly, the Fed may start to cut interest rates. Falling interest rates can add potential price appreciation to interest rate-sensitive bonds, which is a plus in that environment.
Interest rates still remain at a relatively high level (at least compared to the last 5+ years) at a potential 4-6% yield to maturity (total return), which is an attractive starting point. I anticipate bonds to have less downside volatility than equity markets and the Fed may be cutting interest rates over the next 12 months putting upward pressure on bond prices. For these reasons, I remain moderately bullish on conservative assets.
U.S. GOVERNMENT BONDS
U.S. government bonds remain a solid option for investors seeking bond income with little risk of default. With interest rates still above 4% across the Treasury yield curve, investors can lock in 4%+ rates at longer maturities. This could be attractive for those that are seeking little to “no” default risk and for those that believe interest rates may start to come down as the Fed cuts the fed funds rate.
If interest rates do start to decline across the yield curve, bond prices have the potential to rally based on duration alone, which is what U.S. Treasuries could offer. Treasuries don’t generally trade with a credit risk, so additional volatility from a weakening economy may not pertain to Treasuries. For this reason, conservative investors may find intermediate-term Treasuries to be attractive at these levels.
As someone who can accept higher volatility for higher potential returns, I continue to prefer a diversified allocation to investment grade credit-sensitive bonds over U.S. Treasuries.
U.S. INVESTMENT GRADE CREDIT
Investment grade credit continues to be attractive at these higher interest rate levels. I prefer to remain diversified across sectors, with exposure to corporates, mortgages, asset-backed securities and other idiosyncratic credit opportunities.
Credit spreads remain a bit tight and could be subject to spread widening if the U.S. economy materially weakens from here. To offset some of that risk, if the economy does weaken, the Fed has plenty of firepower to cut interest rates, which may result in interest rate-sensitive bonds to rally.
The mix of falling interest rates and upward pressure on bond prices, with downside pressure on bond prices from credit spread widening, could result in a bit of a wash in a moderately weaker economic environment. For this reason, and with the higher starting yields from investment grade credit, I continue to remain moderately bullish on a diversified allocation to investment grade credit.
OTHER
I use this section to talk about other potential strategies, generally whether or not hedges are needed on asset classes.
With U.S. mega cap stocks tied to the artificial intelligence theme trading at what appear to be extended valuations over the short-term, some hedges might be appropriate on these allocations at this time. There continues to be opportunities outside of the AI-themed companies across market caps and geographies, so a blanket hedge on equities doesn’t make sense for me at this time.
Rather than sophisticated/complicated alternative strategies to hedge equity positions, I still continue to prefer allocating to higher income generating assets and strategies instead. If I were a more conservative investor, and with interest rates still at attractively higher levels, reducing equity risk and allocating to higher-yielding investment grade credit could also be considered.
It’s a similar story with fixed income. With interest rates at attractive levels with the potential for the Fed to start cutting interest rates over the next 12 months, I don’t see much of a need for hedges on fixed income. It doesn’t appear that the Fed wants to raise rates and is probably more biased towards cutting interest rates or keeping them where they are, so hedges on duration may not be necessary.
Conservative investors may want to reduce credit spread risk as spreads are relatively tight, but as previously stated, if rates decline in a weakening economy, even credit-sensitive bonds can experience the positive impact of duration with rates falling and bond prices rallying.
So from a hedged standpoint, I prefer to reduce equity risk through traditional income-generating assets and not heavily utilize alternative hedged strategies, and I don’t have a desire to have any real hedge on interest rate risk.