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Markets in Motion - Boo - Trick or Bear

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Markets in Motion - Boo - Trick or Bear

The market action in October, the month of Halloween, is not what it seemed. Belief bias is shutting out all information other than your most convicted ideas, generally to the detriment of what’s happening in reality. Belief bias is the tendency when an individual’s own values, beliefs, prior knowledge, etc. affect their judgment more so than the strength of an argument based on how strongly the facts support that conclusion.

The idea that global equities are in anything but a correction, on the way to a final euphoric surge is misguided. Yet you wouldn’t have known it by how investors and traders’ (trick 2018-11-chart-1or) treated that asset class last month. The main driver of the October sell-off was bond yields breaking higher. The February correction followed a similar pattern. Rising rates do not mean it’s time to abandon the equities. It just signals a rotation out of interest-rate sensitive sectors, and a hedge in cash, not bonds. We began this shift in June, and we believe it’s starting to play out in a big way. A great example is how since the beginning of the drawdown, our flagship strategy, Global Tactical Allocation, was able to outperform its benchmark and handily outperform risk benchmarks like the S&P 500 and MSCI ACWI.

To avoid belief bias, you need to take in all the evidence, not just the things you see (like stock prices going down) or listen to what other people believe (like all the financial pundits calling for the bull market in equities to be over). What are we afraid of in what could be the final 18-24 months of this global expansion? It isn’t overall credit 2018-11-chart-2conditions, which remain loose and favorable for business activity while interest rates are still very low compared to past pre-recession conditions. However, if we begin to see credit conditions tighten considerably, along with a higher rate environment, you’ll see us start to move in a far more defensive position. Until we see that, a mixture of high-quality equities focused on factors that incorporate both growth and value are solid places to be. Consider Apple Inc. (AAPL), the largest equity if looking at market capitalization and the first company to crack the $1 trillion-dollar market-cap ceiling. Despite the recent volatility in its stock price, AAPL is still consistently one of the most innovative and profitable companies in any universe. It has landed in both growth and value indexes in the US and abroad with great justification.

If we’re right as we near the end of the credit expansion, equities should outperform long-duration bonds and commodities. Our thesis remains that the end of this expansion will be more like 1998-2000, where innovative companies and companies with pricing power lead the final surge. We’ve weathered some market storms (ignoring the “sirens” of a Halloween sell-off) and are back on the ship.

This month, we reduced our fixed income exposure in favor of cash equivalents. Interest rates will continue to move higher leading to uninspiring returns to duration. We exited our positions in 10-year Treasuries and high yield bonds. Our counter-trend move into 10-year Treasuries has played out. With tightening credit spreads and rising potential default risk, the high yield asset class no longer offers an attractive risk premium. We added to our emerging markets exposure, where the biggest risk – a big Chinese growth slowdown or collapse in its currency – is unlikely.

Portfolio Positioning

2018-11-chart-3

  • 2018-11-chart-4Avoiding foreign currency fixed income: By avoiding foreign currency fixed income, we hope to benefit from higher US dollar interest rates. Like last month, we continue to expect spreads between the US dollar and foreign currency interest rates to narrow, and therefore we believe we will profit by concentrating all our fixed income exposure in US dollar-denominated holdings.
  • Avoiding long duration fixed income in our portfolios: Interest rates may continue to rise as economic growth remains strong, inflation reemerges, and global central banks step away from the extraordinary measures they employed during the financial crisis. Thus, we are avoiding long duration fixed income in our portfolios.
  • Maintaining exposure to four US equity sectors/factors: Value, Small-Cap Value, Technology, Healthcare & Medical Devices: Our view remains consistent with last month as we continue to see lower valuation equities providing us with a defensive holding, which we feel is prudent in the later stages of the US credit cycle. Small-Cap Value gives us broader exposures to currency-neutral industrial and financials. The pace of disruption of old industries by new products and processes has continued to accelerate, and technology gives us exposure to this process of creative destruction. Aging demographics and strong corporate balance sheets in the healthcare sector should provide tailwinds for medical devices.
  • Maintaining exposure to Emerging Market Equities: The fundamental picture remains strong and the most important risk to emerging markets – a big Chinese growth slowdown or collapse in its currency – is unlikely. We believe that these risks are now mainly contained, or largely priced in which should bode well for equity markets.
  • Maintaining exposure to Small-Cap Japanese equities: Favorable valuations, accelerating earnings growth, an extraordinarily cheap currency, and the Bank of Japan’s ongoing aggressive monetary easing support our exposure to Small-Cap Japanese equities.
  • Supporting exposure to Global Consumer Staples equities: With tight labor markets bolstering consumer confidence, which, combined with decent valuations, we believe an overweight position to consumer staples is warranted. The aging bull market is vulnerable to downside risk which should favor this classically defensive sector.
  • Maintaining a position in Mortgage REITs. In the absence of a commodity boom, we want to get paid cash dividends for any remaining inflation hedges. Our two major alternative positions are both high yielding.

GTA Portfolio Changes
Since August 31, 20181

We’ve added to our position in US Value Equities. As we enter the later stages of the US credit cycle, it is prudent to begin building a position in defensive US equities. So, we initiated a position in an ETF targeting companies with low valuations.

We added to our positions in Technology and Healthcare equities. As we’ve mentioned, they both have growth and value factors, and we believe will do well for the remainder of the current credit cycle.

We initiated a position in US Small-Cap Value Equities. This position underscores our relative value thesis, has low sensitivity to trade tensions, and has strong tailwinds from corporate tax policy.

We initiated a position in Mortgage REITs. In the absence of a commodity boom, Mortgage REITs offer an attractive yield, even in a gradually rising rate environment.

We exited our position in Energy Equities. Energy equities have de-coupled from the barrel of oil and no longer warrant an overweight position in the portfolio.

We initiated a position in Global Consumer Staples Equities. Tight labor markets bolster consumer confidence, which combined with decent valuations, present a nice entry point for consumer staples. The classically defensive sector serves as another tool in our tactical positioning.

We exited our position in Broad Commodities. We eliminated the remainder of this hedge. We see Fed tightening adding a headwind for precious metals, a slowdown in Chinese growth and environmental reforms limiting Industrial metals upside, and agriculture markets remaining well supplied through 2018, outstripping demand.

Recent Portfolio Changes

We lowered our allocation to fixed income – exiting our positions in 7-10 Year Treasuries and High Yield Bonds. We entered 10 Year treasuries to take advantage of a counter-trend rally, in an otherwise cyclical bear market for bonds, given oversold, lop-sided technical conditions and bearish sentiment. That has played out, and we continue to believe government bond yields will grind higher. High Yield has been an important allocation during the current economic expansion. But with tight credit spreads and potential default risk rising, the asset class no longer offers an attractive risk premium.

We increased our position in Cash Equivalents. We favor cash yields at the expense of allocations to long-dated fixed income. Interest rates will continue to move higher leading to uninspiring total returns to duration.

We added to our position in Emerging Market equities. The most important risk to emerging markets – a big Chinese growth slowdown or collapse in its currency – is unlikely. We are still watching the effects the tariff and trade wars with China could have on Asia, but our overall outlook is a little more positive, and we believe that these risks are now mainly contained, or largely priced in which should bode well for equity markets.


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Please do not hesitate to contact us with any questions!
Best regards,

John A. Forlines III

Chief Investment Officer
Investment Committee Member

W.E. Donoghue Team

Global Tactical Allocation Strategies
Investment Management

1Information as of 11/21/2018. Individual account allocations may differ slightly from model allocations.
2Some Emerging Markets allocation overlaps with regional allocations.
3Excludes GTA’s 15% alternative, cash, and cash equivalent positions.
4Contains international exposure

Past performance is no guarantee of future results. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. Returns can vary dramatically in separately managed accounts as such factors as point of entry, style range and varying execution costs at different broker/dealers can play a role. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Forecasts are inherently limited and should not be relied upon as an indicator of future results. There is no guarantee that these investment strategies will work under all market conditions, and each advisor should evaluate their ability to invest client funds for the long-term, especially during periods of downturn in the market. Some products/services may not be offered at certain broker/dealer firms.

The investment descriptions and other information contained in this Markets in Motion are based on data calculated by W.E. Donoghue & Co., LLC (W.E. Donoghue) and other sources including Morningstar Direct. This summary does not constitute an offer to sell or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities. This report should be read in conjunction with W.E. Donoghue’s Form ADV Part 2A and Client Service Agreement, all of which should be requested and carefully reviewed prior to investing.

The Global Tactical Allocation Composite (“Composite”) was created on July 1, 2009. The Global Tactical Conservative Composite (“Composite”) was created on February 1, 2014. The Global Tactical Income Composite (“Composite”) was created on February 1, 2014. The Global Tactical Growth Composite (“Composite”) was created on February 1, 2015. W.E. Donoghue acquired 100% of the assets of JFG on December 29, 2017.

Composite returns are calculated gross of investment management fees, net of investment trading expenses and underlying fund costs but do not reflect the effect of income taxes on the investment returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. Performance reflects the reinvestment of dividends, income, and capital appreciation. Composite returns are calculated monthly, which are described in greater detail in the firm’s Form ADV Part 2A, using the time-weighted total rate of return methodology. Monthly returns are geometrically linked to calculate quarterly and annual returns. As fees are deducted quarterly, the compounding effect will be to increase or decrease their impact by an amount directly related to gross portfolio performance, and dependent on direction, magnitude, and order of returns. For example, on a portfolio with a 2% annual fee, if gross performance is 10%, and performance is equally distributed across all four quarters, the compounding effect of the fees will result in a net annual performance of 7.81%. No leverage, derivatives, or shorts are used. Past performance is not indicative of future results.

There can be no assurance that the purchase of the securities in this portfolio will be profitable, either individually or in the aggregate, or that such purchases will be more profitable than alternative investments. Investment in any Global Tactical Portfolio, or any other investment or investment strategy involves risk, including the loss of principal; and there is no guarantee that investment in W.E. Donoghue’s Portfolios or any other investment strategy will be profitable for a client’s or prospective client’s portfolio. Investments in W.E. Donoghue’s Portfolios, or any other investment or investment strategy, are not deposits of a bank, savings, and loan or credit union; are not issued by, guaranteed by, or obligations of a bank, savings, and loan, or credit union; and are not insured or guaranteed by the FDIC, SIPC, NCUSIF or any other agency. The composite strategy provides diversified exposure to various asset classes such as equities, fixed income, and alternatives utilizing liquid exchange-traded products. Diversification does not guarantee a profit or protect against a loss.

The Blended Benchmark Growth is a benchmark comprised of 65% MSCI ACWI, 25% Citi World Government Bond Index, and 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Growth returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark's constituents is available upon request.

The Blended Benchmark Moderate is a benchmark comprised of 50% MSCI ACWI, 40% Citi World Government Bond Index, and 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Moderate returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark’s constituents is available upon request.

The Blended Benchmark Conservative is a benchmark comprised of 35% MSCI ACWI, 55% Citi World Government Bond Index, and 10% S&P GSCI, rebalanced monthly. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Citi Government Bond Index (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The Blended Benchmark Moderate returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark’s constituents is available upon request.

The Blended Benchmark Income is a benchmark comprised of 90% Bloomberg Barclays Global Aggregate Bond Index, and 10% MSCI ACWI, rebalanced monthly. The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. There are four regional aggregate benchmarks that largely comprise the Global Aggregate Index: the US Aggregate (USD300mn), the Pan-European Aggregate, the Asian-Pacific Aggregate, and the Canadian Aggregate Indices. The Global Aggregate Index also includes Eurodollar, Euro-Yen, and 144A Index-eligible securities, and debt from five local currency markets not tracked by the regional aggregate benchmarks (CLP, MXN, ZAR, ILS and TRY). A component of the Multiverse Index, the Global Aggregate Index was created in 2000, with index history backfilled to January 1, 1990. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Blended Benchmark Income returns do not include fees or expenses that are associated with managed accounts. You cannot invest directly in an index. A more detailed description of the benchmark's constituents is available upon request.
The information contained in this presentation related to JAForlines represents the strategies and performance achieved prior to the acquisition.

W.E. Donoghue & Co., LLC is a registered investment advisor with the United States Securities and Exchange Commission in accordance with the Investment Advisors Act of 1940.

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