Why Mr. Cautious Is 82% Invested In Stocks

The InvesTech Research approach to investing is just the sort of portfolio worth parsing right about now. Not just because the 9% annualized return for its model portfolio since the March 2000 dot-com peak is nearly double the return for the S&P 500. But for how chief investment officer James Stack generated that performance.

Stack stresses a “safety first” approach: relying on both current technical indicators, and the firm’s ardent respect for market history, the shop isn’t in the least bit interested in relative value. When it senses valuations are too high and technical indicators are pointing to a big down market, they will go heavily into cash. That helped keep losses from the 2007 peak to the early 2009 trough to about half that of the S&P 500.

^SPX Chart

^SPX data by YCharts

So with the rocky start to 2014, it seems especially smart to check InvesTech’s level of worry. The takeaway from the latest InvesTech newsletter published February 7th is that the model portfolio remains just a tad defensive, but no big shifts have been made in the past few months.

It’s important to define InvesTech’s definition of modestly defensive: its model portfolio currently recommends an 18% allocation to cash and the remaining 82% that is invested in the stock market has a tilt toward defensive sectors including health care and consumer staples.

And it’s also important to understand that Stack is not envisioning clear skies ahead. With his historian’s hat on, he views the current pullback as “healthy” given that we hadn’t had a 5% pullback in more than eight months, longer than the seven-month average time between speed bumps. Nor is he ruling out a full-fledged correction (decline of at least 10%.)

“A 10% correction comes around on average every 25.6 months during a bull market…it has now been 32 months since the last 10% correction, so we shouldn’t be surprised if this correction isn’t over yet.” Stack also says the data tea leaves leave open the distinct possibility that we could be in for more than a 10% correction.

With the possibility of a 10% or higher correction in the ether, why is this “safety-first” investor still 82% invested in stocks? Because his signals aren’t currently raising warning signs that we’re headed for an all-out bear, and he notes that average recovery periods for larger corrections is within six months. Translation: Being substantially out of the market right now doesn’t make sense if the expectation is that we might have a normal correction that would then stoke the fire for the next leg up.

From the February newsletter: “In the absence of clear warning flags, it’s better to give the bull market the benefit of doubt and watch the correction run its course. Our 82% invested allocation and more defensive sector selection should add to our downside defenses in the meantime.”

The InvesTech newsletter uses sector-specific ETFs for its stock exposure. The three largest sectors (after the 18% slug of cash) are 15% in the Technology Select SPDR ETF (XLK), 14% in the Health Care Select SPDR ETF (XLV) and 13% in the Consumer Staples Select SPDR ETF (XLP). At 5% of portfolio assets, the Consumer Discretionary Select SPDR ETF (XLY) is the big underweight; that sector accounts for more than 12% of the S&P 500.

While the 15% Technology Sector allocation seems out of sync with the defensive tilt, it is nonetheless underweight the sector’s 18.9% weight in the S&P 500. While tech indeed does tend to lose more than the S&P 500 during market corrections of more than 10%, InvesTech notes that going back to 1974 its average losses during those drawdowns have on average been fully recouped within three months from the correction bottom.

The top 10 holdings in the Technology Select SPDR portfolio account for about 60% of assets, led by Carl Icahn’s focus du jour, Apple (AAPL), which accounts for nearly 14% of the ETF’s assets. While growth investors continue to lament the lack of Jobsian earnings momentum, Apple has a whole lot of value-investor appeal.

AAPL Free Cash Flow Per Share (TTM) Chart

AAPL Free Cash Flow Per Share (TTM) data by YCharts

While there are other fallen tech angels in the top 10, including Microsoft (MSFT), and IBM (IBM), you also have the likes of Google (GOOG), as well as Qualcomm (QCOM) which recently boosted its second quarter guidance. As noted earlier at YCharts, Qualcomm has been a recent pickup for noted value funds, including Oakmark. The Oakmark fund boosted its Qualcomm stake by 25% in the fourth quarter.

The top five holdings in the Health Care Select SPDR ETF are Johnson & Johnson (JNJ), Pfizer (PFE), Merck (MRK), Gilead Sciences (GILD) and Amgen (AMGN) The ETF has bucked the downtrend so far this year, gaining more than 2.5% through the first five weeks of the year. Merck has been the star of the top 5.

JNJ Total Return Price Chart

JNJ Total Return Price data by YCharts

But with a PE ratio above 35, Merck is a tad pricey. Beginning a year ago its 12 month trailing PE multiple began to diverge from its longer-term norms.

MRK PE Ratio (TTM) Chart

MRK PE Ratio (TTM) data by YCharts

Of the health ETFs top five holdings, only the Pfizer Rating is currently tagged as Attractive by YCharts’ Pro Ratings system, with an overall score of 9 out of 10 and a price that currently trades more than 10% below where its long-term valuation would peg it.

For the income oriented, Pfizer’s 3.3% dividend yield is more than 50% higher than the average for the S&P 500. After slashing its dividend in 2009 Pfizer has been increasing the payout steadily since early 2010 and with a payout ratio below 30% has plenty of room to keep up the dividend growth.

Somewhat uncharacteristically, the Consumer Staples Select SPDR ETF has fallen more than the general market in 2014. Then again this classic defensive sector also has some large exposure to emerging markets. Top 5 holdings Coca-Cola (KO) and Philip Morris (PM) are both down about 8% year to date. One consumer staple bucking the trend is Constellation Brands (STZ), which has gained nearly 9% this year, showing no signs of slowing from its near-100% rise in 2013. Yet Constellation Brands’ valuation isn't in nosebleed territory.

Last year the global wine, spirits, and beer juggernaut completed its buyout of the 50% of Crown Imports (its joint venture with Grupo Modelo) that it didn’t already own. That gives Constellation U.S. distribution rights to popular Modelo beers including Corona. To help pay for that deal, Constellation added on more than $1.5 billion in debt and its Constellation Brands’ debt-to-equity ratio is now near 1.5x.

That’s not a troubling level, and is not near Constellation’s highs. Just something to be aware of if you’re inclined to do some more investment research.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

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