AAII Model Portfolios: Third-Quarter Model Fund Portfolio Review & Portfolio Updates


The October AAII Model Portfolio Update is now available online.


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 SectorSPDR.com, 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. The breadth of 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.

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.

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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.

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