August 2018 Model Shadow Stock Portfolio Update

No changes were made to the Model Shadow Stock Portfolio this month. The next quarterly review will take place at the end of the month.

For information on how to receive updates of changes to the Model Shadow Stock Portfolio, keep reading.

Market Recap for July

U.S. stocks rebounded in July as they shrugged off the growing trade tensions between the U.S and China. Instead, investors and traders focused on the surging U.S. economy and the continued strength in corporate earnings.

For July, the Dow Jones industrial average gained 4.8% (including dividends) while the broader-based S&P 500 index posted a total return of 3.7% and the Nasdaq 100 composite gained 2.8%. The S&P 500 closed July less than 2% away from its all-time high of 2,872.87, set on January 26, 2018, according to Bloomberg. All 11 of the major sectors that make up the index were up on a total-return basis. Leading the way for the month was industrials, up 7.3%, while the weakest sector was real estate, up 1.1%. Only four of the sectors outperformed the S&P 500, however: industrials, health care, financials and consumer staples.

Large-caps outperformed smaller companies in July, reversing the year-to-date trend. However, small-caps did not lag by much, as the S&P SmallCap 600 index posted a total return of 3.2% for July versus 3.7% for the S&P 500.

Value also tended to outperform growth in July, reversing the trend thus far for the year, too. However, this was only at the large- and mid-cap levels. Small-cap value lagged in July, as the S&P 500 Value index recorded a total return of 4.1% in July versus a total return of 2.6% for the S&P SmallCap 600 Value index. Growth was strongest among small caps with the S&P SmallCap 600 Growth index climbing 3.8% in July on a total-return basis.

Looking at the S&P 500 factor indexes, dividends and value ruled in July. The dividend aristocrats, enhanced value, high-yield dividend aristocrats and value factors all outperformed the S&P 500 on a total-return basis. Interestingly, however, the low-volatility high-dividend factor was the weakest in July, adding 2.0%.

Volatility was muted in July, which is typical during the summer. The VIX closed July at 12.83 after falling 20.3% for the month.

According to FactSet, the second-quarter blended earnings growth rate for the S&P 500 was 24% at the end of July. If 24.0% is the actual growth rate for the quarter, it will mark the second-highest earnings growth since the third quarter of 2010 (34.1%).

At the end of July, for the second calendar quarter of 2018, 81% of the companies in the S&P 500 had reported quarterly results. Of these, 80% have reported a positive earnings surprise and 74% have reported a positive sales surprise. If 81% is the final number, it will mark the highest percentage since FactSet began tracking this data in the third quarter of 2008.

Looking to the third quarter, during July analysts lowered the third-quarter bottom-up earnings per share (EPS) estimate by 0.6% (from $41.00 to $40.76), according to FactSet. This decline in the bottom-up earnings per share estimate recorded during the first month of the third quarter was smaller than the five-year (1.6% decline), 10-year (2.2% decline) and 15-year (1.6% decline) averages.

Real gross domestic product (GDP) growth rose 4.1% on an annualized basis in the second quarter, the best quarterly showing since the 4.9% annualized growth rate in the third quarter of 2014, according to the Bureau of Economic Analysis. This 4.1% growth was well above the average 2.3% growth in the current expansionary period (third quarter of 2009 through the second quarter of 2018). Also, first-quarter GDP growth was revised up from 2.0% to 2.2%.

The U.S. economy continued to add jobs, too, although at a somewhat slower pace in July. For the month, 157,000 jobs were created, below expectations of 193,000, according to Commonwealth Financial Network. Also, June’s employment report was revised up from 213,000 to 248,000, which could account for July’s shortfall.

Consumer spending accelerated in the second quarter at a 4.0% annualized rate, according to the Commerce Department. In the first quarter, the increase was only 0.5% on an annualized basis. For June, it rose 0.4% while data for May was revised up from 0.2% to 0.5%. U.S. retail sales increased 0.5% in June while data for May was revised higher from 0.8% to 1.3%. May’s rise in retail sales was the largest since September 2017, according to CNBC.

One weak spot in the economy continued to be housing. Both existing and new home sales declined in June. Also, homebuilder confidence is slipping as rising construction costs have lowered the profitability of new homes and has led to a decline in housing starts and permits. Economists point to rising housing costs that are outstripping the rise in wages as a contributing factor, along with rising mortgage rates.

U.S. consumer prices were relatively flat in June as the consumer price index (CPI) edged up 0.1% after rising 0.2% in May. In the 12 months through June, the CPI increased by 2.9%, the biggest gain since February 2012, according to CNBC. Excluding the volatile food and energy components, the CPI rose 0.2%, matching May’s increase. The resulting annual increase in “core” CPI was 2.3%, the largest rise since January 2017.

The personal consumption expenditures index (PCE), the Federal Reserve’s preferred inflation measure, excluding the volatile food and energy components, gained 0.1% in June. It had risen by 0.2% in May.

The Federal Reserve kept the benchmark federal funds rate unchanged following its July meeting. The central bank is still signaling plans to raise rates at least two more times this year and has penciled in three rate hikes in 2019. According to the CME FedWatch tool, as of August 9, there is a 31.9% probability of only one more interest rate hike this year and a 62.9% likelihood of two more increases this year.

Model Shadow Stock Portfolio Performance & News

The AAII Model Shadow Stock Portfolio lagged in July, as several stocks in the tracking portfolio suffered sharp post-earnings declines. The AAII Model Shadow Stock Portfolio, which is a real-money portfolio of micro-cap value stocks, lost 1.72% in July. The Vanguard Small Cap Index fund (NAESX) added 1.82% on a total-return basis, and the DFA U.S. Micro Cap fund (DFSCX) gained 2.20% in July.

The breadth of the portfolio, which measures the general direction of the underlying stocks in the actual Shadow Stock tracking portfolio, turned negative in July. Of the 31 stocks that were in the portfolio at the end of June, only 12 posted gains in July versus 17 in June. The strongest stock in the Model Shadow Stock Portfolio in June was PCM Inc. (PCMI), which gained 45.9%, while the weakest holding in the tracking portfolio was Container Store Group Inc. (TCS), which fell 21.2% for the month.

Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.5% versus the Vanguard 500 Index fund’s (VFINX) gain of 9.6% per year on average. Over the same period, the Vanguard Small Cap Index fund (NAESX) posted an average annual gain of 10.4%.

As of the end of July, 13 stocks met the initial selection criteria for the Model Shadow Stock Portfolio, down from 15 at the end of June. Of these, four are currently held in the Model Shadow Stock tracking portfolio (down from seven the month before): Delta Apparel Inc. (DLA), Hallador Energy Co. (HNRG), Olympic Steel Inc. (ZEUS) and Strattec Security Corp. (STRT). Companies held in the Model Shadow Stock Portfolio that currently meet the initial purchase rules are designated as “currently qualifies” in the notes column of the Model Shadow Stock Portfolio table on AAII.com; however, the notes will not match the list here since the webpage is constantly updated.

As of the end of July, RCM Technologies Inc. (RCMT) and Vishay Precision Group Inc. (VPG) were approaching the price-to-book-value limit of 3.0, with price-to-book-value ratios of 2.55 and 2.64, respectively. Shadow Stocks with a price-to-book-value ratio above 3.0 at the time of a quarterly review are removed from the tracking portfolio, assuming there is a suitable replacement.

Currently, no stocks held in the Model Shadow Stock Portfolio are approaching the market-cap cutoff of $1.2 billion (three times the initial limit for consideration of $400 million).

Following its fourth-quarter earnings release on July 20, SigmaTron International (SGMA) is on earnings probation. The company reported a GAAP diluted loss per share of $1.04 and its trailing 12-month GAAP diluted loss from continuing operations is $0.76. The company took two noncash charges in the quarter; without them, the company would have reported a pretax profit of $503,680 for the fourth quarter. However, SigmaTron does not report adjusted earnings and no analysts track the company. Based on the GAAP earnings per share data, SigmaTron is on earnings probation. If the company reports a quarterly loss next quarter, SigmaTron will be removed from the portfolio. However, if the company reports positive earnings next quarter, even if trailing earnings remain negative, the company would not meet the earnings sell rule and would remain in the portfolio. Historically, SigmaTron reports its first-quarter results in mid-September.

The next quarterly review of the AAII Model Shadow Stock Portfolio will take place at the end of this month. Any changes to the portfolio will be announced at the time they are made in a special Model Portfolios Update email (sign up at www.aaii.com/email), as well as highlighted in the mid-September AAII Model Portfolios Update email and the Model Portfolios column in the October 2018 issue of the AAII Journal.

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

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