What Was Done Well (And Not So Well) For Clients In 2018

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Includes: AAPL, CME, EEM, FB, JPM, JSOAX, KRE, MSFT, OAKIX, SCHW, TBF
by: Brian Gilmartin, CFA

Here is a quick summary of how clients were positioned in 2018, and what worked and what didn't:

Microsoft (NASDAQ:MSFT) remains clients' largest position and has been since 2013. A core position was kept in the stock during the last decade ('00-'09), but the weight was lifted in client accounts beginning in April 2013, with the Value Act stake, and it continued to be lifted as the Board removed Ballmer and put Satya Nadella in place. Microsoft is "old tech" rather than "new tech," which makes more comforting keeping it as the #1 position since the stock went through a 16-year base, between 2000 and late 2016, when it finally broke out above the early 2000 peak of $53-54. MSFT is up 25% YTD as of this weekend.

Schwab (NYSE:SCHW): The Schwab position is roughly 4-5% of client accounts and the stock returned -18.9% this calendar year-to-date, thus trailing the S&P 500 dramatically. The Financial overweight was my worst call of 2018 so far, which is what happened to the sector in 1994 (see below) with other top 10 positions being JPMorgan (NYSE:JPM), CME, and KRE (regional bank ETF). CME has helped to a small degree, with an YTD return of +30%, but JPM and KRE have returned -4% and -16% respectively. CME should have a decent fourth quarter in terms of results since the exchanges love market volatility, and CME is no exception.

Bond allocations: Clients were overweight cash all year comprising anywhere from 50% to 60% of fixed-income allocations, with the Schwab's taxable and tax-exempt money-market funds being the primary investment vehicles since Schwab is our client custodian. TBF (or inverse Treasury ETF) is between 5% and 10% of client accounts, while one "strategic income" fund was held in client accounts, i.e. the JPMorgan Strategic Income Fund (MUTF:JSOAX).

The short-end of the Treasury yield curve held the best value in my opinion, so some client bond allocations held 3-month to 1-year Treasuries and will continue to do so until the Fed funds rate reaches 3%.

Duration and credit risk were avoided within bond portfolios all year.

Clients saw good alpha in their fixed-income allocations in 2018, although with AGG being down just 1.8% YTD, and the 3-year return being just +1.66% (Price, per Morningstar trailing return data), the performance or the numbers just don't resonate with clients.

Portfolio changes in 2018: Clients were overweight tech coming into 2018, but that was reduced with the sale of Apple (NASDAQ:AAPL) and Facebook (NASDAQ:FB) earlier in the calendar year. Here was the first Apple article written where it was noted that Apple's cash flow to net income was deteriorating. The sale price on Apple was roughly the mid-$160s. The big rally from $180 to $230 during the third quarter was missed. Some Apple is still held in taxable accounts with a very low tax basis. Clients with taxable accounts just don't like large capital gains. Here was another Apple article written in late November '18 that discusses whether the company might be owned again for clients. Doesn't mean the stock will get there. It was interesting that Seeking Alpha didn't pick up either article as they usually do. Apple gets an unusual amount of attention from the financial media, possibly due to the fact that its market value is still over 3% of the S&P 500 by market cap, and since Technology and the Communications Services were reconfigured, Apple's earnings weight within the Tech sector (post creation of Communications Services) is over 20% per IBES by Refinitiv.

  • Tech - a growth sector - was an overweight coming into 2018, but is now closer to an equal or underweight with just Microsoft and Amazon (NASDAQ:AMZN) within the top 10 weights within client accounts (Note the Tech sector's expected 2019 growth rate today versus its P.E.).
  • Financials - a value sector - will likely remain an overweight into 2019.
  • There are other assorted positions within Healthcare, Consumer Staples, Consumer Discretionary, Industrials, and Communication Services.
  • The Emerging Markets weighting was lifted in client accounts throughout 2018, so that it is now between 5% and 10% in most accounts. November saw EEM +8% in the month, but the OakMark International Fund (MUTF:OAKIX), which is developed and emerging markets, has had a tough year.
  • Utilities, Basic Materials, and Real Estate comprise only about 10% of the S&P 500 by market cap.

Summary/Conclusion: The third-quarter rally in Tech cost clients a little alpha in the quarter and YTD numbers, but the Tech underweight has worked since; however, the continued pressure on the Financial sector into year-end hasn't been a positive. No big changes are planned for 2019, although Facebook's stock looks like it is bottoming. Clients (and I) still like owning businesses with "sustainable competitive advantages," although within the Financial sector, that's a tough distinction.

Expected 2019 S&P 500 Sector Growth Rates and Current P.E.:

  • Cons Disc: +9%, trading at 22x
  • Cons Spls: +5.3%, trading at 20x
  • Energy: +16.4%, trading at 17.5x
  • Fincls: +9.7%, trading at 13x
  • Hlthcare: +7.2%, trading at 21x
  • Industrials: +11.6%, trading at 16x
  • Basic Materials: +6.1%, trading at 15x
  • Real Estate: +5.3%, (No sector P.E. given by Bespoke)
  • Info Tech: +5.1% trading at 19x
  • Comm Serv: +6.7%, trading at 19x
  • Utilities: +4.8%, trading at 18x
  • S&P 500: +8%, trading at 15x

(Sources: The growth rates are from IBES by Refinitiv, while the sector P.E. is from Bespoke's "Sector Snapshot" published every Thursday).

Some thoughts on 2019 will follow in the next week, but readers should remember as they see the plethora of 2019 "forecasts": opinions and predictions are like the exit portal for solid bodily waste, i.e. everybody has one (as was so eloquently explained to me by a client several years ago). Take all opinions and predictions with a grain of salt, which absolutely includes this blog.

2018 was a year of "P.E. Contraction" which this blog first wrote about in December 2017, which wasn't a prediction but - like all predictions - more thinking-out-loud.

My own quick back-of-the-envelope calculations showed that about half or 24-25% of the 2018 S&P 500 EPS growth was corporate tax rate reduction driven so - so far - the S&P 500 is flat on 2018 in terms of total return on "12% "organic" EPS growth.

2018 was a lot like 1994 too, particularly for the Financial sector given the FOMC Fed funds rate hikes. In 1994, the S&P 500 finished +1% on the year (total return) while SPY is down 1% YTD per Morningstar trailing return data. In May of this year, the year 1994 was referenced again since it helps to give readers some analog to sector and benchmark performance.

With retail investor sentiment so negative and detailing 2018's S&P 500 P.E. Contraction and analog to 1994 for Financials, I'm actually feeling optimistic about the S&P 500's "expected return" for 2019.

Thanks for reading.