Second-Quarter Review and July Model Fund Portfolio Update

Having closed the books on the second quarter of 2016, we can look back to see that it somewhat mirrored the first quarter: An initially disappointing quarter was once again saved by a late-quarter rally. After experiencing a 9% drawdown in the first quarter, investors had to endure a 5% drawdown in the second quarter. In both instances, however, the broad market indexes were able to end the quarter in positive territory. In fact, the last week of the second quarter was the best week for the S&P 500 year to date, with a 3.2% gain. All of this, as always, underscores the need to look past near-term market volatility and focus on your long-term investment strategy.

The biggest market news-maker in the second quarter was, undoubtedly, the somewhat unexpected vote by U.K. citizens to leave the European Union (Brexit). While the long-term implications of this vote will not be known for years—and it could take up to two years for Britain and the EU to negotiate the exit—the short-term impact was a rise in economic uncertainty in Great Britain and Europe as well as heightened political uncertainty in Britain. Just as nature abhors a vacuum, so too do stock markets hate uncertainty. While it is rare that anything is known with absolute certainty, higher-than-usual uncertainty makes forecasting more difficult. These forecasts help shape expectations, which in turn help drive financial markets.

Uncertainty also breeds volatility in the stock market, so it’s not surprising that there was a spike in market volatility following the Brexit vote. The CBOE Volatility Index (VIX) hit a high of 25.76 the day after the Brexit vote, but was below the 2016 high of 28.14 set on February 11. By the end of the first quarter the VIX had retreated to 13.95, while it closed the second quarter at 15.63. Furthermore, according to Bloomberg, global equity markets shed $3.6 trillion, or 5.7%, in market capitalization in the two trading days following the Brexit vote. However, by the end of the quarter, the global markets had rebounded to only being down 1.7% from pre-Brexit levels.

Uncertainty related to global economic growth, especially in the aftermath of the Brexit vote, was a contributing factor to the Federal Reserve’s decision to keep short-term interest rates unchanged in June. Furthermore, the Fed lowered its expectations for the path of future interest rate increases. At the end of the quarter, most Fed-watchers felt that a near-term rate increase was highly unlikely. However, following the release of June jobs data, the CME Group FedWatch Tool showed a 100% probability (as of July 11) of a 25 to 50 basis-point rate increase at the Federal Open Market Committee (FOMC) meeting at the end of the month.

As we enter the second-quarter earnings season, we continue to see a downward trend in U.S. corporate earnings. According to S&P Global Market Intelligence, the aggregate second-quarter 2016 S&P 500 operating earnings estimate is forecasting a 5.3% decline from a year ago. If S&P 500 operating earnings do fall in the second quarter, this would mark the first time since 2009 that the S&P 500 recorded a year-over-year earnings decline in four successive quarters. On the bright side, S&P believes that the first-quarter decline in aggregate earnings of 6.8% represents the trough quarter through the end of 2017.

U.S. stocks, in general, posted gains in June. The market-cap-weighted S&P 500 Index fund (VFINX) ticked upward by 0.3% in June, while the Guggenheim S&P 500 Equal Weight ETF (RSP) slipped lower by 0.1%. This indicates that the largest of the large caps were powering the S&P 500 index in June.

However, smaller stocks tended to enjoy the biggest gains in June. The S&P SmallCap 600 index gained 0.6% on a total return basis in June, while the S&P MidCap 400 index added 0.4% in total return. The Vanguard Small Cap Index Fund (NAESX) posted a 0.3% gain for June.

Value also outperformed growth across all market-cap segments in June as well as for the second quarter. The S&P 500 Value index rose 0.9% in June; investors looked to higher-yielding stocks as the Fed indicated that short-term interest rates will likely be lower for longer. In contrast, the S&P 500 Growth index fell 0.4% for the month. This pattern was repeated for the S&P SmallCap 600 segment—a 0.8% gain in June for Value versus 0.4% for Growth—and the S&P MidCap 400, which posted a 0.5% gain for Value and a 0.4% increase for Growth during June.

Sector performance in June also reflected the “risk off” shift by investors to higher-yielding sectors. As measured by the S&P Select Sector SPDR ETFs, the top sector in June was utilities, climbing 7.7%, followed by real estate with a 6.4% gain. With the likelihood of low interest rates pushed farther out, financial firms—which rely in part on higher interest rates for higher earnings—fared the worst in June: Financial services were down 5.4% for the month while financials lost 3.2%. For the second quarter, energy benefited from a rebound in oil prices, posting an 11% gain, while utilities came in second with a 6.7% increase. Technology (-1.7%) and consumer discretionary (-0.9%) were the only sectors to end the quarter with losses. Year to date, utilities are once again the biggest winner, adding 23.2% through the end of June, followed by energy with a 14.7% year-to-date gain. On the other end of the spectrum, financial services (-5.9%) and financials (-3.1%) were the only two sectors with year-to-date losses at the end of the quarter.

The AAII Model Shadow Stock Portfolio, which is a real-money collection of micro-cap stocks, climbed 1.3% in June. Sixteen of the 30 stocks that were in the Model Shadow Stock Portfolio at the end of May were up in June, including six that were up more than 10% for the month and four with more than a 15% gain in June. These stocks helped offset the two shadow stocks that fell more than 15% for the month. Overall, the Model Shadow Stock Portfolio outperformed the DFA U.S. Micro Cap Fund (DFSCX), which was down 0.2% in June.

Year to date, the AAII Model Shadow Stock Portfolio is up 3.1%, compared to the S&P 500, as represented by the Vanguard S&P 500 index fund (VFINX), which is up 3.8%. Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.2% versus the Vanguard S&P 500 Index Fund, which has gained 8.9% a year, on average, over the same period.

Here are some news highlights from June for the current holdings in the actual AAII Model Shadow Stock Portfolio:

Ennis Inc. (EBF) declared a quarterly cash dividend of $0.175 per share of common stock. Due to the company’s recent sale of its apparel segment, a special one-time cash dividend of $1.50 per share has also been declared on common stock. Both dividends are payable on August 8, 2016. The regular quarterly dividend is in line with previous installments of $0.175 per share payout.

Ennis also reported its financial results for the first quarter ending May 31, 2016. Net sales from continuing operations for the quarter were $90.4 million, a decrease of 6.6%, compared to $96.8 million for the same quarter last year. Diluted earnings per share for continuing operations for the quarter were $0.26, compared to $0.34 for the same quarter last year, but this is due to the completed $110 million sale of its apparel segment to Gildan (GIL). The combined results for continued and discontinued operations were $0.36 per diluted share, matching results from a year ago and exceeding the I/B/E/S estimate of $0.308 per diluted share.
Hooker Furniture Corp. (HOFT) reported its quarterly results for the period ended May 1, 2016. Consolidated net sales came in at $121.8 million, compared to $60.96 million a year ago. The boost came from Hooker’s acquisition of the business Home Meridian International. Hooker also reported consolidated net income of $2.5 million, or $0.22 per diluted share, compared to $0.32 per diluted share in the prior year quarter. This came in below the I/B/E/S consensus estimate of $0.46 per diluted share.
REX American Resources (REX) announced first-quarter 2016 adjusted earnings per share of $0.43, 14% below the same period a year ago and below the I/B/E/S estimate of $1.01 per share. First-quarter revenue decreased 4.8%, to $100.2 million, compared to the same period a year ago. The company attributed the decline in revenue to the 6.4% decline in the average price per gallon of ethanol and the 13.1% decline in dried distiller grains pricing.
Seneca Foods Corp. (SENEA) reported fiscal-fourth-quarter 2016 adjusted earnings per share of $1.38, a 431% jump from a year ago. Net sales for the quarter increased by 9.3%, to $303.7 million. Net earnings for the fiscal year ended March 31, 2016, increased to $54.5 million ($5.42 per diluted share), 451% above the previous year’s figure of $9.9 million ($0.90 per diluted share). Net sales for the fiscal year decreased 0.9%, to $1.3 billion from a year ago.
Shoe Carnival Inc. (SCVL) declared a quarterly cash dividend $0.07 per share. This is an 8% increase over the prior quarterly cash dividend. The dividend is payable on July 18 to shareholders of record as of July 5.

The AAII Model Fund Portfolio fell 0.4% in June and is now up 2.9% year to date. Only three of the funds in the portfolio posted gains in June. The portfolio, which was started in June 2003, has a compound annual average return of 8.1%, just below the 8.2% average annual return of the VFINX over the same time period.

July Portfolio Updates

There are no changes in the holdings of the Model Fund Portfolio this month. However, there are changes in the portfolio rationale, which will likely bring about changes in the holdings in the near future. AAII founder James Cloonan discusses this in his column in the August issue of the AAII Journal.

Click here to learn about how the current mutual funds and exchange-traded funds (ETFs) in the AAII Model Fund Portfolio were chosen.

There are no changes to the Model Shadow Stock Portfolio this month. The portfolio underwent its quarterly review at the end of May and no changes were made. However, two new stocks were added to the probation list—CDI Corp. (CDI) and LMI Aerospace (LMIA)—because of negative trailing earnings per share.

Based on current market conditions, there were no rule changes to the Model Shadow Stock Portfolio this month. Twenty-eight stocks passed the predefined Model Shadow Stock screen in Stock Investor Pro at the end of June, up from 24 at the end of May. Four of the 30 stocks currently in the portfolio qualified for purchase at the end of June, unchanged from last month. These companies are Key Tronic Corp. (KTCC), L S Starrett Co. (SCX), Salem Media Group Inc. (SALM) and Willis Lease Finance Corp. (WLFC).

The next quarterly review of the AAII Model Shadow Stock Portfolio will take place in September. Any changes to the portfolio will be highlighted in the September AAII Model Portfolio Update email and in the Model Portfolios column in the October issue of the AAII Journal.

Click here to see the current purchase and sell rules. The size and value rules are subject to revision depending on prevailing market conditions.

New Level3 Passive Portfolio

This month, James Cloonan is introducing a new model portfolio that will replace the Alternate All-ETF Portfolio that he has been tracking in his Model Fund Portfolio columns in the AAII Journal. This new portfolio, the Level3 Passive Portfolio, is based on research carried out for the writing of his upcoming book “Investing at Level3.” It is an ETF portfolio of index funds meant to be:

The complete equity portfolio for investors who wish to maintain their own portfolio but do not choose to be involved in individual stock selection or non-index mutual fund selection; or
A semi-permanent portion of an overall portfolio where some assets are in individual equities or more aggressive funds.

For more information on the new Level3 Passive Portfolio, see the Model Portfolios column in the August issue of the AAII Journal.