ETF Model Portfolios Can Adapt to Overvalued Markets

Financial advisors who are seeking ways to enhance their practices can utilize fundamentals-based model portfolios to reduce the risk of wealth-destroying downturns.

In the recent webcast, Beware the Bubble: Investing in an Overvalued Market, Matthew Bartolini, Head of SPDR Americas Research, State Street Global Advisors, provided an overview of the current market conditions, with many segments making robust gains in the ongoing rally.

For starters, developed ex-U.S. instruments outperformed U.S. equities for the first time in five months over May, while fixed income posted another monthly gain as 10-year yields declined further. Meanwhile, the U.S. dollar headed south in May, close to its lowest level of the year.

The gains reflect investor risk appetite improving by its largest margin of the year in May, buoyed by re-opening optimism and positive vaccine progress in advanced economies. The current market may also reflect increased complacency. While equity implied volatility increased moderately last month, high yield implied volatility remains tranquil.

Things are returning to normal as vaccine efforts drive a shift in consumer trends. As vaccination efforts pick up, mobility is approaching its post-pandemic highs, with visits to parks, retail, and recreation improving the most. Furthermore, robust stimulus measures have elevated personal savings, which may provide dry powder to fund pent-up demand and support the recovery of service consumption.

Looking at global valuations, Bartolini pointed out that developed ex-U.S. equities appear more attractive than broad emerging markets. However, Brazil has shown attractive valuations on both an absolute and relative basis.

Focusing on the U.S. markets, Bartolini noted that the value and dividend yield factors have outperformed on the back of rising inflation, while momentum was the only underperforming factor in May. Additionally, the energy and financials sectors ranked amongst the top three in valuation, earnings sentiment, and price momentum.

Looking ahead, Bartolini argued that following strong Q1 earnings results, cyclical sectors are expected to continue leading earnings growth in Q2 with upbeat earnings sentiment. In addition, as the pandemic is receding in Europe, upbeat earnings sentiment and attractive valuations bode well with European equities.

In anticipation of rising inflationary pressures and Federal Reserve action to dampen an overheating economy, most economists expect the Fed to reduce bond purchases in the last quarter of 2021, well before the first rate hike. The rollback in accommodative measures probably won’t affect U.S. equities too negatively. For example, despite the Fed’s taper talks in 2013, risk assets, except emerging market assets, posted strong gains on continued improvement in economic conditions

However, Bartolini warned that with rates still well below their historical levels, income generation remains challenging for bond investors.

In this market environment, Frank Donovan, Vice President, Business Development, Model Capital Management, warned of a potential pullback after the strong risk-on rally, pointing out that Shiller’s cyclically-adjusted P/E, at 37, has been higher only in the 1999-2000 period.

Donovan cautioned that while stocks are best to build wealth, bear markets destroy it. Serial bear markets have persisted in the 1970s and 2000s, with more severe examples include the United States from 1929 to 1954 and Japan from 1990 to the present.

Donovan also highlighted the potential negative effects of rising inflation. He argued that inflation will likely rise until the Fed addresses it. Rising inflation hasn’t been seen since the 1970s.

“We think this environment will be supportive of commodities,” Donovan said.

As a way to help financial advisors better-adapt to the potential shifting market conditions, Donovan highlighted Model Capital Management’s forward-looking approach to tactical asset management.

Specifically, Model Capital Management offers a Tactical Growth Limit-Loss strategy that can provide U.S. market exposure and participation in rising markets while heavily emphasizing risk management in down markets. The Tactical Income strategy generates income from exposure to U.S. fixed income markets, and total return from participation in multiple fixed income markets.

Financial advisors who are interested in learning more about investing in the current market environment can register for the Wednesday, Jun 16 webcast here.