Market Update

The S&P 500 rose 0.8% last week to finish at 4391.34. The Nasdaq rose 0.1% as rising interest rates pressured growth stocks. The 10-year Treasury yield rose to 1.612%. The 10-year yield was 1.3% only a month or so ago. Several of the big money banks are anticipating a 2.0% to 2.25% 10-year yield by year-end. Their forecasts assume the Federal Reserve starts reducing its bond-buying this year. Rising rates favor value stocks. High price-to-earnings-growth stocks will continue to suffer if rates continue to rise.

The S&P 500 fell as low as 4278.94 Monday before recovering to 4300.46 by the close. The Monday low was the low for the week. The high for the week was reached early Thursday. The S&P peaked at 4429.97 before trading sideways the rest of the day. Friday’s weak payroll report didn’t have an impact on investors as the S&P traded sideways after the news. The short-term trend is down. The S&P needs to clear 4465.40 to re-establish an uptrend. It will need to break above the 50-day moving average first, which sits at 4440. A break below 4278.94 would confirm the downtrend and set up a test of the rising 200-day moving average at 4250.

Earnings season is upon us. The big banks will start reporting this week. The forecast is for 27% year-over-year earnings growth for S&P 500 companies. Importantly, analysts’ earnings estimates are no longer rising, according to Barron’s. Instead, analysts are lowering estimates, which is more typical. Normally, estimates a year out start high and are lowered throughout the year. The Covid earnings recovery has been different. Earnings estimates were consistently too low and had to be raised. The question is whether the market has priced in the reduced expectations. Investors may not yet appreciate that earnings estimates are dropping once again. The S&P is trading at 20.6 times 12-month forward earnings, well above the 20-year average of 15.5 times. Any earnings disappointments are likely to trigger selling.

Economic Update

Factory orders rose 1.2% in August up from 0.7% the month prior. Core capital goods orders rose 0.6% in August up from 0.5% in July. Rising orders are a positive for the economy. The ISM services index was a strong 61.9% in September. It was 61.7% in August. The strength in the ISM services index suggests the economy is shaking off the delta variant. Any reading above 50% signals expansion and readings above 60% are considered strong.

The payroll number was weaker than expected. September payrolls grew only 194,000, well below the 500,000 forecast. Last month the economy added 366,000 jobs. The unemployment rate fell to 4.8% from 5.2% and average hourly earnings rose 0.6%. Average hourly earnings climbed 0.4% in August. The weaker than expected jobs number was due in part to a 169,000 upward revision to prior months. Seasonal adjustments might also have been affected by Covid. State and local employment fell by 123,000 on a seasonally adjusted basis. Educational workers declined by 180,000 on a seasonally adjusted basis but rose by over one million unadjusted. One indication that the job market is strong is the more than 11 million job openings nationwide. Unfortunately, the labor participation rate fell as the labor force shrank by 183,000.

Knowing What You Own

Building a diversified portfolio is not easy. Mutual fund holdings are not readily available. Mutual funds have latitude in what they own as well. The American Funds Growth Fund of America is a large-cap U.S. growth fund that benchmarks itself to the Russell 1000 Growth index. The Russell 1000 Growth index is 100% large-cap U.S. growth stocks. Yet the American Funds Growth Fund is allowed to have up to 25% of its assets in international stocks. Likewise, the American Funds Growth Portfolio invests in several other American Funds. It currently has 22% exposure to international and emerging market stocks. It also owns both large and small-cap companies. Meanwhile the American Funds American Balanced Fund invests in a broad range of securities including common stocks and investment-grade bonds. Its common stock investments can include international and emerging market stocks. The American Balanced Fund has 54% in U.S. stocks, 11% in international stocks, and 24% in bonds currently. It can change that allocation whenever it wants though.

So how do you know what is in those eight-plus mutual funds that you have in your portfolio? The answer is most people don’t, and that includes their investment advisors. We use a Morningstar program called X-ray to find out. Morningstar knows what investments are in each fund. The X-ray report shows us what the entire portfolio owns. It allows us to see how much credit and interest rate risk investors are taking with their bond exposure. It allows us to see geographic diversification. It allows us to see the sector and industry weightings of the stocks in the portfolio. We can see if the portfolio tilts toward growth or value, large or small, domestic or foreign. It also allows us to see fund overlap. Morningstar calls it the stock intersection report.

Financial advisors are focused on bringing in assets. It is how they get paid. They also want their clients to believe that they are managing their money. Advisors want to spend most of their time looking for new clients. The result is little time spent on actual portfolio management. Eight plus mutual funds give the appearance of complexity and active management. X-ray often puts the lie to that appearance. We almost always find an expensive stealth index portfolio. A portfolio devoid of active management. There are no overweights of one sector or another, no overweights of a particular industry. There is almost always a very high correlation to the S&P 500. And the kicker? There is almost always tremendous overlap in what the mutual funds own. Alphabet, Amazon, Microsoft, Facebook, and Apple, for instance, will show up in five, six, even seven of the mutual funds in the prospect’s portfolio. In other words, many of the mutual funds are the same investment and provide little to no additional diversification. But the optics are good for the advisor trying to make it look as if he’s managing his client’s money.

Knowing what you own is a key requirement for successful portfolio management. Most people don’t, and that includes financial advisors. Not knowing what you own means taking risks without realizing what risks you are taking. There is no way to manage your portfolio without an understanding of your exposures. Save the fees if you can’t manage your portfolio. Build an index portfolio instead. Indexing allows you to know exactly what you own and guarantees that there is no overlap in holdings. Using individual stocks also allows you to avoid overlap. It is the other way to make sure you know what risks you are taking. Norwood Economics uses individual stocks and index ETFs to build portfolios for its clients. We want to make sure we know what our clients own and what the risks are in their portfolios. We want to do what we are getting paid to do instead of only pretending.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist