Third-Quarter Model Fund Portfolio Review & Portfolio Updates

Following his October quarterly portfolio review, James Cloonan did not make any changes in the holdings of the AAII Model Fund Portfolio.

September and Third Quarter in Review

Looking back, the third calendar quarter of 2016 turned out to be the best one yet for the U.S. stock market. However, almost all of the quarterly success is attributable to July, during which U.S. stocks stormed back after the sharp sell-off at the end of June that followed the U.K.’s Brexit vote. Stocks were up marginally in August, and September—historically the worst month for U.S. stocks—generated mixed results.

After enjoying near-historic calm throughout much of the quarter—at one point the S&P 500 went 43 days without a price move greater than 1% up or down—volatility saw an uptick at the end of September. Much of the volatility is owed to central banks and worries that they would pull back sooner than expected on their easy-money policies, which have powered global stock markets for the last several years. While the Bank of Japan and European Central Bank had bit parts in the play, it was the Federal Reserve that stole the show. At the conclusion of the September meeting of the Federal Open Market Committee (FOMC), U.S. short-term interest rates remained unchanged.

Following the September FOMC meeting, Fed chair Janet Yellen stated that the case for a rate increase “has strengthened in recent months,” but lukewarm inflation—and possibly a hesitation to increase rates ahead of the U.S. presidential election in November—gave the Fed pause. Barring any economic data setbacks or external market shocks, the consensus is that rates will go higher by the end of the year, most likely at the December FOMC meeting. As of the market close on October 10, the CBOE’s FedWatch Tool showed only a 29.8% probability that rates will be unchanged by the end of the year, down 5.1 percentage points from the previous day.

The U.S. economy does continue to strengthen. U.S. payrolls have grown by an average of more than 200,000 per month for the last three months and consumer confidence is at its highest level since 2007, before the financial crisis. In addition, the housing market continues to expand, as new home sales were up 20% year over year in September while home prices rose 5%.

Looking ahead, corporate earnings should dominate October and possibly contribute to an increase in market volatility, as companies report their third-quarter results. According to S&P Global Market Intelligence, as of the end of September, operating earnings for the S&P 500 index are expected to fall 0.8% from a year ago ($29.40 versus $29.64). If this holds true, it would mark the fifth consecutive quarter of year-over-year earnings declines for the S&P 500, the first time this has happened since 2009. FactSet Research Systems has the estimated earnings decline for the S&P 500 in the third quarter at 2.1% as of the end of September. This would be the first time the index has recorded six consecutive quarters of year-over-year declines in earnings since FactSet began tracking the data in the third quarter of 2008.

During the third quarter, analysts lowered earnings estimates for companies in the S&P 500 by 2.9%. By means of comparison, the average decline in the EPS estimate for the S&P 500 companies over the last four quarter has been 4.9%. During the last five years, the average quarterly decline in the EPS estimate has been 4.3%.

Perhaps the biggest risk to U.S. stocks in the coming months is the U.S. presidential election. By the time the November model portfolio update is released, we should know who the 45th president (and 48th vice president) of the United States will be. At this point, many analysts have a Hillary Clinton-Tom Kaine victory priced into the market. However, if the outcome should change, expect a swift reaction by the market as assets are reallocated to match presumed policies. Beyond that, though, many believe that it will be business as usual in Washington D.C.—political gridlock.

Results for U.S. stocks were generally mixed in September. The Vanguard market-cap-weighted S&P 500 index fund (VFINX) eked out a 0.01% gain in September after adding 0.13% in August. The Guggenheim S&P 500 Equal Weight ETF (RSP) posted a 0.07% gain for the month while the PowerShares Russell 1000 Equal Weight ETF (EQAL) added 0.47% for the month, indicating that smaller stocks outperformed larger stocks for September.

This is somewhat represented in the various S&P indexes for September. The S&P SmallCap 600 index outpaced the S&P 500 and S&P MidCap 400 indexes with its 0.64% gain, while the mid-cap index fell 0.64%. The Vanguard Small Cap Index Fund (NAESX) posted a 0.39% gain for September.

Growth dominated the large-cap market segment in September, as the S&P 500 Growth index posted a total return of 0.40% for the month, versus a 0.37% decline for the month in the S&P 500 Value index. Value fared better than growth in the mid- and small-cap segments. The S&P MidCap 400 Value index added 0.02% on a total return basis in September (the S&P MidCap 400 Growth Index posted a total return decline of 1.36%) and the S&P Small Cap 600 Value index registered a total return of 0.83% versus a 0.46% total return for the S&P SmallCap 600 Growth index.

Sector performance in September and the third quarter indicates a “risk on” rotation toward higher-growth areas and away from defensive, high-yield sectors. According to, energy was the strongest sector in the quarter, rising 3.7% and benefiting from the continued rise in oil prices. The sector also received a boost by an announcement from the Organization of the Petroleum Exporting Countries (OPEC) that its member countries had reached a preliminary agreement to cut production by roughly 700,000 barrels per day (bpd), according to FirstTrust. If this holds, this would be the first OPEC production reduction deal since 2008. For September, WTI crude oil prices rose 7.9%. Financial stocks were hit by the announcement that the Fed would delay short-term interest rate cuts, as well as some high-profile negative news from the likes of Wells Fargo & Co. (WFC) and Deutsche Bank (DB). For the month, the financial services sector fell 2.6% and the financials sector lost 2.5%.

For the quarter, technology stocks soared 10.6%, outpacing all other sectors. In all, only three of the 11 S&P Select Sector SPDR ETFs were down for the quarter—real estate (-2.1%), consumer staples (-2.9%) and utilities (-5.9%). Year to date, the energy sector is riding the wave of higher oil prices, posting a 19.5% gain for the nine months ended September 30. All 11 S&P select sectors are up year to date, with financial services bringing up the rear with a 0.5% gain.

The S&P 500 posted a 3.9% total return in the third quarter. According to Oppenheimer Asset Management, tech stocks Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB) and Alphabet (GOOGL) were the top five contributing stocks to the S&P 500, representing 41% of the S&P 500’s quarterly gain. These stocks also contributed to large-cap growth outperforming its value counterpart for the third quarter, as the S&P 500 Growth index advanced 4.8% on a total return basis versus 2.9% for the S&P 500 Value index. However, value outperformed growth across the mid- and small-cap segments in the quarter: The S&P MidCap 400 Value index was up 4.5% in the third quarter versus a 3.7% increase in the S&P MidCap 400 Growth index, and the S&P SmallCap 600 Value index climbed 7.23% while the small-cap growth index gained 7.17%.

Overall for the third quarter, small-cap stocks outperformed the large- and mid-cap segments. The S&P SmallCap 600 index was up 7.2% for the three months ended September 30, while the S&P 500 index gained 3.9% and the S&P MidCap 400 index added 4.1%.

Model Shadow Stock Portfolio Performance & News

The AAII Model Shadow Stock Portfolio, which is a real-money portfolio of micro-cap value stocks, rose 2.1% in September. Breadth for the portfolio was slightly positive, as 19 of the 30 holdings in the Shadow Stock portfolio posted gains for the month. Four of the shadow stocks climbed more than 15% in September, while two saw losses in excess of 15%. Overall, the Model Shadow Stock Portfolio outperformed the DFA U.S. Micro Cap Fund (DFSCX), which was up 0.7% in September.

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

Ennis, Inc. (EBF) reported financial results for the second quarter ended August 31, 2016. Net sales from continuing operations were $91.2 million, compared to $100.5 million in the same quarter last year, a 9.3% decrease. Diluted earnings per share from continuing operations were $0.26, compared to $0.37 for the same quarter in 2015. However, non-GAAP earnings were $9 million, or $0.35 per diluted share, which beat the I/B/E/S consensus of $0.26 per diluted share by 34.6%.
Flexsteel Industries, Inc. (FLXS) announced an 11% increase to its regular quarterly dividend, raising it from $0.18 to $0.20 per share of common stock.
Hooker Furniture Corp. (HOFT) reported second-quarter financial results for the period ended July 31, 2016. The company reported consolidated net sales of $136.2 million, a 126% increase from last year’s consolidated net sales of $60.1 million. Net income for the quarter was reported at $5.3 million, or $0.46 per diluted share, compared to second-quarter 2015 net income of $3.9 million, or $0.36 per diluted share. Earnings beat the I/B/E/S consensus estimate of $0.42 per diluted share by 9.5%.
Kimball Electronics Inc. (KE) announced that it is extending its stock repurchase plan, begun in October 2015. The company is authorized to repurchase up to an additional $20 million worth of common stock. The extension brings the total amount of authorized share repurchases under the plan to $40 million.
Renewable Energy Group (REGI) reported that sales volume reached a new milestone in August, marking the first time in company history that it sold more than 50 million gallons of biomass-based diesel.
SigmaTron International (SGMA) reported financial results for the fiscal-2017 first quarter ended July 31, 2016. The company reported adjusted earnings of $0.03 per share, down 81% from a year ago. Revenues decreased 8.25%, to $58.9 million, from a year ago.

Year to date, the AAII Model Shadow Stock Portfolio is up 14.2%, compared to the S&P 500 as represented by the Vanguard S&P 500 index fund, which is up 7.7%. The DFA U.S. Micro Cap Fund (DFSCX) is up 10.6% for the nine months ended September 30.

Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.6% versus the Vanguard S&P 500 Index fund, which as gained 9.0% a year, on average, over the same period.

There are no changes in the Model Shadow Stock Portfolio this month. The portfolio underwent its quarterly review at the end of August, and last month we announced several changes to the portfolio selection rules and the portfolio holdings. In the future, we will inform members of changes to the AAII model portfolios via special email alerts and web notices. Be sure you are signed up to receive these free notices by logging into, going to and selecting the Model Portfolios Update email. These changes are also discussed in Jim Cloonan’s Model Portfolios column in the October issue of the AAII Journal.

Thirteen stocks passed the Individual Investor’s Shadow Stock Screen (*IISSP) in Stock Investor Pro as of September 30, 2016. This was decline from the 14 stocks that passed at the end of August. Of these 13 passing stocks, four are in the actual Model Shadow Stock Portfolio—AV Homes Inc. (AVHI), Beazer Homes USA (BZH), Key Tronic Corp. (KTCC) and TravelCenters of America (TA). While the number of current holdings that qualify is unchanged from last month, two current holdings that qualified last month fell off the list: Hallador Energy Co. (HNRG) and Salem Media (SALM). Qualifying companies are those held in the Model Shadow Stock Portfolio that currently meet the initial purchase rules. (They are designated as “qualified” in the notes column of the Model Shadow Stock Portfolio table.) Hallador’s price-to-book value ratio climbed above the 1.0 limit to qualify, although it was well below the 3.0 sell limit at 1.06 as of September 30, 2016. Salem’s 26-week relative strength ranked in the 27th percentile of all U.S.-traded stocks at the end of September, below the new 50th requirement to qualify. (Please note that we have added percentile rank data to the actual portfolio and passing company tables at the AAII Model Shadow Stock Portfolio area of

One current Shadow Stock holding—RCM Technologies Inc. (RCMT)—is nearing the valuation limit. At the time of this writing, the stock’s price-to-book value ratio stands at 2.5, which is nearing the 3.0 sell limit for the portfolio. In addition, two stocks are currently on probation for generating negative normalized earnings over the last 12 months (trailing four quarters). Ducommun Incorporated (DCO) has been on probation since reporting its third-quarter 2015 earnings. However, for the subsequent three quarters, the company has reported flat or positive adjusted quarterly earnings. So, although trailing earnings have remained negative, the company has not reported another quarter of negative adjusted earnings that would trigger the portfolio’s earnings sell rule. The company is next expected to report quarterly earnings on October 31, after the market close, although the company has yet to confirm this. In addition, The L.S. Starrett Company (SCX) saw its trailing 12-month earnings go negative following its fiscal fourth quarter that ended June 30, 2016. As a result, this company has been added to the earnings probation list.

The next quarterly review of the AAII Model Shadow Stock Portfolio will take place in early December. Any changes to the portfolio will be announced at the time they are made in a special Model Portfolios Update email, and will be highlighted in Jim Cloonan’s Model Portfolios column in the January 2017 issue of the AAII Journal.

Click here to see the current AAII Model Shadow Stock Portfolio purchase and sell rules. The size and value limits are subject to revision depending on prevailing market conditions.

Model Fund Portfolio Performance

The AAII Model Fund Portfolio climbed 1.18% in September, compared to a 0.02% total return for the SPDR S&P 500 ETF (SPY). The Model Fund Portfolio has gained 10.1% year to date, while the SPDR S&P 500 ETF is up 7.7%. Since its inception in June of 2003, the Model Fund Portfolio has a compounded annual average return of 8.5%, while the SPDR ETF has an 8.4% average annual return over the same period.

Following his October quarterly portfolio review, James Cloonan did not make any changes in the holdings of the AAII Model Fund Portfolio. You will find his commentary, as well as answers to questions he has received regarding the new Level3 Portfolio, in his Model Portfolios column in the November 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.