SPY - Position Your Portfolio For A Choppy Market

2023-05-25 17:14:55 ET

Summary

• Economic indicators including employment, consumer spending, and consumer debt continue to send mixed signals to the market.
• While off to a strong start, the potential for choppy or sideways returns is increasing given the economic crosscurrents.
• Increasing the current income component of total returns may help nervous investors reduce portfolio volatility and stay invested through the present uncertainty.

With what appears to be the end of tightening monetary policy comes the uncertainty of what is next. While the blow-ups in the regional banking sector seem to be contained (at least for now) and unemployment remains at 50+ year lows, there are a few early signs of potential slowdown in the economy. Initial jobless claims have ticked up in recent weeks, as have delinquencies on debt payments by consumers. Corporate earnings have largely outperformed analyst estimates, albeit by growing at slow rates, or at least declining by less than expected. According to FactSet , of the S&P 500 companies that have reported first quarter 2023 earnings, 78% reported a positive EPS surprise and 75% a positive revenue surprise. Despite declining by 2.5% for the quarter year-over-year, earnings exceeded expectations of a 6.7% decline. FactSet research also states that analysts expect further declines in earnings in the second quarter, but for positive growth to return during the second half of the year.

The issue of raising the debt ceiling remains unresolved and is looming behind the concerns mentioned above. As has been the case for the last several years, there are numerous conflicting pieces of evidence that make evaluating the strength of the economy difficult. This difficulty often translates into consumers and businesses pulling back on spending and taking a wait and see approach. Given these conditions as a backdrop, it is reasonable to expect financial markets to be choppy and move sideways.

The chart below from the Department of Labor shows the seasonally adjusted initial jobless claims over the last year, as well as the moving average. While in the short term there is noise in the data, it appears that initial claims have started an upward trend since around January of this year. While this data would typically imply a negative outlook, hiring has remained strong, with a net effect of a low and stable unemployment rate.

The chart below from the St. Louis Fed illustrates data dating back to 1948. The last time the unemployment rate in the U.S. reached 3.4% was in 1969. This means that far more Americans are employed today than at any other time in the country's history. The only time the labor market was better was during the post-WWII boom during the 1950s, making this the strongest job market for anyone working today.

Consumer spending and the general financial health of consumers remains strong, although again there appear to be early signs of weakness. Looking at data from JPMorgan ( JPM ) below, delinquencies on car loans and credit cards have been rising for nearly two years, which would normally be concerning. However, despite this trend the overall rate of delinquencies remains at or below pre-pandemic levels, and generally lower than long-term trends.

The amount from each paycheck households are allocating toward debt service tells a similar story as delinquencies. While the trend indicates potentially deteriorating conditions, the overall level remains healthy when compared to long-term trends and averages.

Consumer spending growth has been slowing since spiking during the pandemic in 2021. Once again, while the trend is negative, this might be more a function of reverting to long-term trends and not a sign of weakness. Time will tell on this factor, but it is reasonable to expect many analysts to see this slowdown in consumer spending growth as a signal of broader economic weakness. Given the volatility of this and other economic indicators, I view this as a short-term concern.

Positioning for Choppiness

In a sideways or choppy market, it can become more difficult to capitalize on fast-growing companies and stock prices. This market purgatory or state of being in limbo can result in a malaise and muted returns if the choppiness lasts long enough, creating an environment most investors would prefer to avoid. If that's where we're headed, then it is critical to protect the downside, allow for upside appreciation, and capture value through both income and growth where available.

Dividend Payers

Within equity allocations, this means extracting a higher proportion of total returns from dividends. As a long-term investor, I prefer to generate both capital appreciation and current income. Because of this, most of my equity allocation is invested in high-quality businesses, largely held within diversified ETFs. An area that I believe is attractive in this environment and meets the requirements for long-term investors is dividend aristocrats. The ProShares S&P 500 Dividend Aristocrats ETF ( NOBL ) provides this exposure through a diversified portfolio of nearly 70 large cap and mid-cap holdings across all sectors except for communication services. The top 10 holdings represent only about 16% of portfolio value, meaning no single company or sector has a disproportionate impact on fund returns.

Recent performance has trailed the S&P 500 due to the outperformance of mega cap tech, but the fund has a history of performing relatively well during sideways markets and doing so with lower volatility than the broader market.

The chart below shows the total returns of NOBL versus SPY from around the all-time highs reached at the end of 2021. During the subsequent decline and sideways trading, NOBL has outperformed the broader market on a total return basis, and with lower volatility.

Covered Call Strategies

Another strategy to increase the share of total returns generated through current income is to employ a covered call strategy. While these strategies reduce portfolio volatility and increase current income, I generally do not like them as they limit upside appreciation. That said, in an environment of uncertainty and choppy trading, using this type of strategy might be effective in generating positive returns while staying fully invested.

The Global X S&P 500 Covered Call ETF ( XYLD ) provides a covered call strategy on the S&P 500. Global X also has comparable funds that write covered calls on the NASDAQ 100 ( QYLD ) and the Russell 2000 ( RYLD ) as well as numerous other thematic funds. While the expense ratio is 0.60%, the trailing 12-month yield is over 12% generated from an S&P 500 market weight portfolio. Like the dividend aristocrats, this fund is focused on generating current income while delivering a total return with lower volatility compared to the broader market.

Like with NOBL, recent performance has trailed the S&P 500 for the same reasons, but to a much lesser extent given that the underlying holdings are the same and held in very similar proportions. This underperformance is expected given the relative strength so far this year, as this type of strategy can cap returns during a rising market.

The chart below shows the total returns of XYLD versus SPY from the end of 2021 through now. Like with NOBL, the decline and choppy trading has been favorable to XYLD, resulting in outperformance over this period on a total return basis.

Final Thoughts

The key to long-term investment success is to stay invested for the long-term. While simple in theory, it can be more difficult in practice. Headlines and general uncertainty have a history of driving investors to make emotional decisions. These decisions may provide some short-term relief, but are often expensive in the long run in the form of forgone investment returns. The strategies suggested in this article are intended to keep portfolios invested while reducing risk and shifting total returns in favor of current income versus capital appreciation. This is a tactical approach meant to protect the downside while keeping the upside intact. I believe that implementing these strategies can keep investors in the game while searching for more exciting opportunities once some uncertainties are eliminated. As always, these suggestions should be considered within the broader context of strategic asset allocations as well as personal needs and constraints. Any overweight or underweight positions need to be considered carefully to understand the impact on long-term total returns. Thank you for reading. I look forward to seeing your feedback and comments below.

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