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Appreciation Strategy

Third Quarter 2018

Key Takeaways
  • Large and mega cap stocks drove the market to new highs in September, but small and mid cap names lagged.
  • We lowered risk in the portfolio by reducing our positions in several stocks with impressive fundamentals but elevated valuations.
  • Economic fundamentals are excellent and the yield curve, while quite flat, is still in a zone consistent with the potential for good market returns.
Market Overview and Outlook

The stock market generated a strong 7.7% return in the third quarter despite trade conflicts and numerous bouts of financial and political uncertainty across the globe. Concerns over the broad-based implications of U.S. trade policy continued to dominate the financial news flow. The first half of the quarter was marked by the U.S. dollar reaching new highs, oil prices declining and the yield curve flattening. That said, a trade settlement with Mexico and Chinese intervention to stabilize the yuan in late August settled the markets’ fears, resulting in little change in the dollar and oil for the quarter. As expected, the Federal Reserve raised short-term interest rates by 25 basis points to 2.25% in late September.

The best-performing sectors of the S&P 500 were health care, information technology (IT) and industrials. Energy, materials and the interest-rate-sensitive real estate and utilities sectors lagged. Health care names appeared to benefit from sector rotation while economic strength helped industrial and discretionary stocks. Trade worries limited gains for energy and materials stocks.

U.S. economic indicators are uniformly powerful. Unemployment — at 3.7% in September — continues to be strong and jobless claims hit a five-decade low during the quarter. Unemployment is currently at levels below the commonly accepted non-inflationary rate, putting the Federal Reserve on inflation watch. Wages rose 2.9% and 2.8% in August and September, respectively; levels not yet alarming but the highest of the current cycle. The powerful September ISM indicates real GDP growth of over 4%. Consumer confidence hit a new cycle high and September’s seasonally adjusted annual rate of auto sales was 17.4 million, the best in several months. Capital expenditures were also the highest of the business cycle, helped by incentives in recent tax reform. Share repurchases for the S&P 500 were $191 billion in the second quarter, the highest ever.

Recent commentary from the Federal Open Market Committee suggests that Fed policy is no longer considered “accommodative” (the federal funds rate now equals the Core PCE deflator, making real short rates 0%). The market currently anticipates one additional 2018 rate increase (25 basis points) in December and two or three more in 2019. The shape of the yield curve remains positive, but not by much.

Higher interest rates are sparking concerns that housing has peaked; homebuilding stocks have come under considerable pressure year to date (down 30%). We recently met with several major homebuilders who suggested that while overall demand growth has slowed, there has yet to be contraction (up low single digits today versus high single digits over the last 18 months). Markets that have weakened include California and Seattle, with less foreign buying, and the Northeast, where reform around state and local tax deductibility have hurt affordability. Importantly, sales continue to rise in the first-time buyer market owing to employment and confidence.


"We see some opportunity in select energy names while taking note of inflationary cost pressures."


The North American trade outlook is brighter after agreements were reached with Mexico and Canada, while the Chinese situation continues to deteriorate. The “new NAFTA” deal contains adjustments on certain industries (e.g., dairy products, lumber and autos), but — most importantly — the dispute resolution procedure is unchanged. The trade situation with China has worsened as President Trump has steadily ratcheted up tariffs and the Chinese have responded in kind.

Weak energy stock prices diverged from the underlying commodity, which hit a three-year high during the first week of October. We see some opportunity in select E&P and services names while taking note of inflationary cost pressures. Also, some large capitalization pharmaceutical stocks still offer value. While retail stocks were among the best performers in the third quarter, the Amazon threat remains, and we are concerned that these stocks may be ahead of themselves. Caution is warranted in the semiconductor space as there are signs that the cycle has peaked.

We use market breadth as one indicator of the overall health of the stock market. An expensive market hitting new highs powered by fewer stocks is a warning sign. Market breadth peaked in late August and deteriorated significantly in September. Large and mega cap stocks drove the S&P 500 Index to new highs in September, but small and mid cap names lagged. We lowered risk in the portfolio by reducing our positions in several stocks with impressive fundamentals but elevated valuations.

The sharp market run-up in the third quarter, accompanied by a deterioration in breadth, leaves our outlook more cautious than a quarter ago. Valuations remain at all-time highs on many measures and trade friction with China is not likely to be resolved anytime soon. That said, economic fundamentals are excellent and the yield curve, while flat, is still in a zone consistent with the potential for good market returns. The Appreciation strategy of owning large, high-quality stocks is well-suited for today’s market, offering upside participation if the economy remains robust and preserving capital should a trade war erupt or should the Fed’s tightening result in an inverted yield curve.

Portfolio Highlights

The ClearBridge Appreciation Strategy had a positive return during the third quarter of 2018, outperforming the Strategy’s S&P 500 Index benchmark.

On an absolute basis, the Strategy had gains in 10 sectors in which it was invested during the quarter (out of 11 sectors total). The main contributors to the Strategy’s performance were the IT, health care, financials and industrials sectors. The sole detractor was the energy sector.

In relative terms, the Strategy outperformed its benchmark impacted by stock selection. In particular, stock selection in the IT, the newly created communication services sector, which expands the telecommunication services sector to include select companies from the consumer discretionary and IT sectors, and financials sectors added the most to relative performance. Conversely, stock selection in the energy sector dragged on relative performance during the quarter.

On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Microsoft, Apple, Berkshire Hathaway, Johnson & Johnson and Merck. The greatest detractors from absolute returns were positions in Facebook, Vulcan Materials, Anadarko Petroleum, Pioneer Natural Resources and Schlumberger.

During the quarter, we established a position in Broadcom in the IT sector and closed positions in Kraft Heinz in the consumer staples sector, CVS Health and Roche in the health care sector, Lennar in the consumer discretionary sector and Red Hat in the IT sector.

Scott Glasser

Co-Chief Investment Officer, Portfolio Manager
28 Years experience
26 Years at ClearBridge

Michael Kagan

Portfolio Manager
34 Years experience
25 Years at ClearBridge

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  • All opinions and data included in this commentary are as of September 30, 2018, and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge nor its information providers are responsible for any damages or losses arising from any use of this information.

  • Performance source: Internal. Benchmark source: Standard & Poor’s. Neither ClearBridge Investments LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

  • Past performance is no guarantee of future results.