Executive Summary

The U.S. Continues to Be a Bright Spot: Over the last three and five year periods, international stocks have been disappointing laggards compared to their U.S. equity counterparts. The third quarter was no exception.

Risk-off in High Yields: Volatility in the credit markets during the third quarter resulted in quality outperforming and credit suffering losses. High yields declined for the first time in five quarters.

Interest Rates Remain Low: Global rates remain very low, even negative across many European markets’ short term bonds markets. This has helped buoy U.S. treasuries and strengthen the dollar.

The global markets put in a sloppy performance during the third quarter as economic growth concerns and geopolitical events weighed on stocks and buoyed government bonds. The bright spot in the global economy is the U.S. as Europe flirts with outright recession and the Japanese economy has contracted in two out of the past three quarters. U.S. growth appears to be accelerating as the year progresses. First quarter growth contracted 2.1%, much of it explained away as weather related, while second quarter economic activity surged 4.6%. Labor market conditions remain solid as the economy has averaged 220,000 new jobs per month so far in 2014 and the unemployment rate dropped to 5.9% in September, a six-year low. All told, third quarter GDP is tracking near 3.5%, a respectable pace after 4.6% growth in the second quarter.*

The widening growth disparity between the U.S. and the rest of the developed world resulted in quite a bit of dispersion in global market performance during the third quarter as assets flowed into the U.S. For example, for the quarter the S&P 500 gained 1.13%. The MSCI All Country World Index lost 2.16%, the MSCI All Country World ex-U.S. declined 5.27%, MSCI EAFE lost 5.88%, and the MSCI Emerging Markets index lost 3.49%. Even in the U.S. there was a large performance gap with a quality bias as leadership narrowed. Small cap stocks were particularly hard hit with the Russell 2000 Index down 7.36% for the quarter.

The U.S. and Europe are now following different road maps with the U.S. Federal Reserve scheduled to cease their bond buying program in October while the European ECB is trying to stimulate a stagnating economy. In the U.S., the debate has turned to when the Federal Reserve will hike overnight interest rates. A growing consensus among economists is that the FOMC will begin to raise the fed funds rate sometime in the latter half of 2015. Historically, the Federal Reserve has begun hiking rates about twelve months following the end of an easing campaign. However, given the current growth trajectory of the U.S. economy, the rate hike could come sooner and we expect it to happen possibly as early as March 2015, and probably June 2015 at the latest. Even if the FOMC has the urgency to pull the trigger before mid-2015, we believe the earlier schedule would be largely immaterial to the economic environment.

Interest rates have remained very low globally. Short-term rates across many European markets did the unthinkable, with two year rates going negative during the quarter in many countries. Even European 10-year rates have plunged as Europe’s economy falters. German and French 10-year rates hit record lows and all of major Europe, and even the peripheral European counties of Spain and Italy, have lower 10-year rates than U.S. Treasuries. Treasury bonds remain buoyed by growth concerns in Europe and demand for U.S. bonds abroad, resulting in U.S. dollar strength. The trade weighted U.S. dollar has risen for 12 straight weeks and was up 7.72% for the quarter. The rising dollar makes U.S. based investments more attractive to foreign investors.

There was a lot of volatility in the credit markets during the third quarter with quality outperforming and credit suffering losses. For the quarter, the Barclays 7-10 Year Treasury index gained 0.47%, the Barclays Aggregate Bond index gained just 0.17%, and the Barclays High Yield index lost 1.87%. High yield bonds have performed very well over the past several years and the decline was the first quarterly loss in five quarters. In fact, it was only the second quarterly loss in three years. Credit spreads remain very tight historically and longer-term credit fundamentals remain well supported with a friendly Fed and a strengthening economy. There was a risk-off environment for high yield bonds as retail investors fled on the first hint of weakness, resulting in record outflows from high yield mutual funds and ETFs. However, so far institutions proved willing to buy high yield bonds as retail investors fled.

Q3 Portfolio Analysis & Performance

Key Contributors and Detractors


U.S. Equity Core

Top Contributors

  • ClearBridge Aggressive Growth
  • iShares S&P 500 Growth

Top Detractors

  • JPMorgan Small Cap Growth
  • Goldman Sachs Small Cap Value

In looking at market index returns during the third quarter of 2014, the narrowness of the market becomes quickly apparent. Through July 30th, the S&P 500 is up 8.34% while the Russell 2000 is down 4.41%. International markets, particularly European markets, are down even more. The S&P 500 and large cap U.S. stocks have been clear winners, and the question is whether the S&P 500 and U.S. markets will finally be dragged down too. In the U.S. Equity Core portfolio small cap holdings, while a modest 13% of the portfolio, were major laggards. While Goldman Sachs Small Cap Value held its own relative to the small cap value category, JPMorgan Small Cap Growth was a major underperformer. Prior to 2014, small caps had been substantial outperformers, so they were due for a relative breather. Large cap growth, particularly the iShares S&P 500 Growth and ClearBridge Aggressive Growth Fund, were outperformers. Looking forward, we would anticipate making the Equity Core portfolio more aggressive and adding to our small cap allocation. However, we do not see signs of a major bottom at which we might make such a change. The modest 5% corrections that the S&P 500 has seen have not created the buying opportunity and extreme longer-term pessimism that we would most like to see. When the S&P 500 leaves mid and small cap stocks in the dust as it has in 2014, any portfolio that allocates down the capitalization scale will lag behind, and that has been true for the U.S. Equity Core portfolio in 2014.

U.S. Equity Income Core

Top Contributors

  • American Century Value
  • JPMorgan Large Cap Growth

Top Detractors

  • iShares Russell 2000
  • Loomis Sayles Strategic Income

The U.S. Equity Income Core portfolio allocates partially to stocks and bonds, with a bias towards quality equity holdings with a record of downside outperformance and towards higher income, aggressive fixed income holdings. During the third quarter of 2104, high quality large cap growth stocks – in our portfolio, the JPMorgan Large Cap Growth fund – were an outperformers. Small cap stocks, as represented by the Russell 2000 ETF (IWM), declined 7.4% and were a substantial laggard. The portfolio’s fixed income allocation continues to focus on lower quality corporate bonds, accepting the maximum amount of credit risk that the portfolio’s risk constraints allow. In the long run, this strategy has paid off for our clients, and we do not foresee any reason to change at this time as we believe this strategy can also defend against rising interest rates.

International Equity Core

Top Contributors

  • Vanguard Emerging Markets ETF
  • iShares Core MSCI Emerging Markets

Top Detractors

  • Artisan International Small Cap
  • Oppenheimer International Growth

International equities enjoyed a brief renaissance in the second quarter of 2014. Since then, however, international stocks have taken a dive, hit hard by an extremely strong dollar and talk of a potential return to recession in Europe. Emerging markets continued to have relative strength within the international equity sphere, posting modest losses of about 3% on the quarter. Both of our emerging markets equity holdings, Vanguard Emerging Markets ETF and iShares CORE Emerging Markets Equity, were top contributors. Oppenheimer International Growth and Artisan International Growth were the biggest detractors, largely due to their sizeable positions in European stocks. Our next move in the portfolio might be to increase our position in Artisan International Small Cap upon a substantial equity correction. We would view that as adding to a position in a manager with a great long-term track record but that has undergone short-term underperformance.

Fixed Income Core

Top Contributors

  • Navigator Duration Neutral Bond
  • BlackRock U.S. Mortgage Inst’l

Top Detractors

  • Loomis Sayles Investment Grade Bond
  • Brandywine Global Opportunities Bond

Fixed income investments have performed much stronger in 2014 than many expected. Fears of rising interest rates have proven to be unfounded, surprising many. The Fixed Income Core portfolio can be counted among those that are very uncomfortable with the risk-return relationship that fixed income offers, particularly longer-term Treasury bonds. In that sense, our defensiveness with regard to interest rates in 2014 has been wrong. As 2014 has developed, many have now switched to the view that persistently low long-term interest rates are here to stay. For the first time in many quarters, credit underperformed as high yield and credit risk was out of favor. Thus our allocations to the credit sensitive Brandywine Global Opportunities Bond and Loomis Sayles Investment Grade Bond underperformed. Navigator Duration Neutral Bond and BlackRock U.S. Mortgage Fund were outperformers, as their generally conservative stance on credit helped them maintain value. We believe that in the long run caution with regard to interest rates will serve our investors well, as the risk-reward relationship presented by Treasury bonds has rarely if ever been this unfavorable.


U.S. Style Opportunity

Top Contributors

  • iShares S&P 100 Index
  • iShares S&P 500 Growth

Top Detractors

  • iShares Russell Midcap Value
  • PowerShares S&P 500 High Beta

It is a difficult, nearly impossible task to keep up with the S&P 500 when a narrow concentration of gains among exclusively large cap stocks takes over markets. While the S&P 500 gained 1.1% during the third quarter, the S&P 400 Mid Cap Index fell 4.0%, and the Russell 2000 fell 7.4%. One had to have an exclusively large cap orientation to avoid losses, and by the second half of the third quarter the Style Opportunity portfolio was indeed 100% allocated toward large caps, as it remains today. Large Cap Growth (IVW) and the mega-cap S&P 100 (OEF) make up the majority of the portfolio, with the remainder in the S&P 500 High Beta ETF (SPHB). The first three quarters of 2014 have been dominated by large caps. While the S&P 500 is up 8.3%, the small cap Russell 2000 is down 4.4%. The 1200 basis points gap between large and small caps has at least put an end to frothy small cap valuations relative to large caps. However, small cap valuations remain high in the absolute, as do all U.S. equity valuations. With valuations making U.S. equities higher risk overall, we may still be facing further small cap underperformance in the coming weeks. In the longer run, we are awaiting a chance to re-enter small caps, as their higher beta provides an excellent chance to add alpha over time. However, small cap relative strength remains only a distant vision in our relative strength rankings at this point.

U.S. Sector Opportunity

Top Contributors

  • iShares NASDAQ Biotechnology
  • PowerShares QQQ

Top Detractors

  • S&P Oil & Gas Exploration & Production SPDR
  • First Trust ISE Revere Natural Gas ETF

Among broad market indexes both here in the U.S. and abroad, the S&P 500 has been very difficult to beat. To a remarkable extent, this has also been true within the domestic U.S. Sector ETF sphere. The S&P 500 Index itself ranks extremely high in our Sector ETF ranks, so much so that we have a 20% position in the Index itself. Only two broad sectors, Technology and Health Care, rank higher than the S&P 500 itself. A concentrated, narrow market this has been, indeed. Selected allocations to Transportation (IYT) and recently, Financials (XLF) have been the only other bright spots that we could find. Most of the other broad equity sectors are weak and underperforming, including Industrials, Materials, Consumer Discretionary, Energy, and Utilities. Technology and Health Care appear to be unaffected by the slow growth world that we have entered, as their persistent leadership in relative strength can attest. Biotechnology (IBB) and the NASDAQ 100 (QQQ) were the portfolio’s biggest contributors while Oil & Gas Exploration (XOP) and Natural Gas (FCG) were the biggest detractors.

International Opportunity (Developed, Emerging & Frontier)

Top Contributors

  • iShares MSCI Thailand
  • iShares MSCI Frontier 100

Top Detractors

  • Market Vectors India Small Cap ETF
  • iShares MSCI Turkey

Finance theory states that international equities provide valuable diversification for a U.S. equity investor. However, over the last three and five year periods, international stocks have been disappointing laggards. Over a three year period (through 09/30), the S&P 500 (SPY) has gained 22.8% per year, while the developed markets EAFE (EFA) is up 14.0% and Emerging Markets (EEM) has gained 7.8%. Over 5 years, the S&P 500 has gained 15.0% per year, while EAFE is up only 6.5% and Emerging Markets has gained 3.2%. The best thing that a U.S. based investor could have done over the past number of years was to just avoid international markets entirely. We cannot do that in the International Opportunity portfolio, of course. However, we do include the U.S. as a country for purchase. Not surprisingly, U.S. equities rank higher than almost all other nations, and as a result we have allocated 20% to the S&P 500 (SPY). The powerful deflationary forces that haunt Europe and commodity-oriented nations have led to stock market and particularly, currency weakness. Extremely poor relative strength has pointed us away from these areas. The current portfolio includes a number of smaller, selected countries that have displayed relative strength versus the rest of the world, including Taiwan (EWT), the Philippines (EPHE), Canada (EWC), and India (EPI). China’s strong economy and stable currency have also led us towards a broad China ETF (GXC). Thailand (THD) and the Frontier Markets (FM), two markets not particularly correlated to the global economy, were the portfolio’s top contributors; India Small-Cap (SCIF) and Turkey (TUR) were the portfolio’s largest detractors.

Alternative Strategy (Commodities, Currency, Real Estate, Absolute Return)

Top Contributors

  • iPath Bloomberg Cocoa ETN
  • iShares S&P 100 Index

Top Detractors

  • VelocityShares Inverse VIX Short-Term
  • Energy Select Sector SPDR

The Alternative Opportunity portfolio contains a well-diversified mix of themes which breaks down as follows: Alternative-Oriented Mutual Funds 36.0%, Tactical Global Equity 26.0%, Fixed Income 12.0%, Commodities 12.0%, and Cash 14.0%. The portfolio’s mutual fund holdings are longer-term allocations that target seasoned and respected managers who have disciplined approaches toward a number of areas: long/short U.S. equities, long/short global fixed income, alternative asset manager selection, and managed futures. Each of these managers are conscious of managing volatility and potential downside in their methodologies. Within the rest of the portfolio, we take a targeted and tactical approach to managing equity, fixed income, and commodity exposure. The portfolio continues to favor equities on a tactical basis, though our optimism has eased as market breadth fades and participation wanes. Within commodities, we rely on our proprietary relative strength rankings along with others’ technical trading models. Palladium (PALL), Livestock (COW), and Cocoa (NIB) highlight current commodity holdings. iPath Bloomberg Cocoa ETN (NIB) and the S&P 100 Index (OEF) were the top contributors during the quarter while VelocityShares Inverse VIX ETN (XIV) and the Energy Select Sector SPDR (XLE) were the top detractors.

Global Tactical (Unconstrained)

Top Contributor

  • SPDR S&P 500 ETF

Top Detractor

  • Vanguard Emerging Markets ETF

The philosophy of the Global Tactical portfolio is to use our proprietary matrix to rank the relative strength of various asset classes, and then to allocate to those asset classes with the highest rankings. Stocks have occupied the top of our Global Tactical portfolio for well over a year now, and for most of that time they have been 100% of the portfolio. Over the past year, U.S. equity has remained at the core of the portfolio with international equity the only other area of focus. Recent allocations to Asian and Emerging Markets equities were relatively short-lived, as a majority of the portfolio’s assets returned to U.S. equities fairly quickly. Despite strong performance by fixed income in 2014 so far, bonds have not been able to earn a place in the Global Tactical portfolio, though they are slowly and steadily rising in rank. If current trends continue, the Global Tactical portfolio could make a large allocation to Treasuries sometime soon. The U.S. still dominates the portfolio with a 79.0% weight.

Fixed Income Total Return (Low Quality, High Quality, Short Term Cash)

Top Contributor

  • BlackRock High Yield Bond

Top Detractor

  • Eaton Vance Income Fund of Boston

Credit markets were under stress during the third quarter of 2014, and returns in the Fixed Income Total Return (FITR) portfolio were therefore negative. The Barclays High Yield Corporate Bond Index declined 1.87% for the quarter, while the Barclays Aggregate Bond Index rose 0.17%. Treasuries outperformed credit, as the market took a general risk-off stance. The FITR model was responsive to the market, as our model lost almost all of its strength during August and September. Now that it is early October, our model is close enough for just a small amount of market weakness to trigger an exit of our high yield bond position. As a review, the Fixed Income Total Return (FITR) portfolio moved to a 100% fully invested position in high yield bonds nearly a year ago on July 18, 2013. The portfolio’s primary evaluation regarding which asset class to own involves comparing the relative strength of high yield bonds versus Treasuries. By that measure, high yield bonds currently have only a very slight edge on Treasuries. Our best forecast for the markets’ path this year predicted a more volatile and turbulent third and early fourth quarter – and that has indeed been the case. However, in a matter of days we enter a seasonally very strong time period historically. The fourth quarter of a midterm election year is the strongest of any quarter in the midterm election cycle. In addition, signs of a short-term bottom and extreme short-term pessimism have begun to appear. While our model remains ready to go on the defensive if there is further weakening in the credit markets, we believe the intermediate term future looks brighter. That being said, as much as we believe in our forecast, the Fixed Income Total Return portfolio is not influenced by any forecast. It is only influenced by its model, and it remains watchful and ready to turn defensive upon further market weakness.

Sentry Strategy (Hedge/Volatility)

Despite substantial weakness for small and mid cap stocks during the third quarter, the S&P 500 still has not seen a 10% correction since 2011 – a three year period. The market’s recent weakness created a lot of noise, but the correction was under 5%. Hedging one’s equity exposure during such a bull market is difficult and ultimately a losing endeavor – all one can do is responsibly manage the cost of hedging while maintaining a minimal hedge required to safeguard client assets. Under these circumstances, the Sentry fund is a net loser in client portfolios, waiting for its day when protection will shine.

Within the Sentry Managed Volatility Fund, during the third quarter we did increase the fund’s protection from loss. On September 10th (when the S&P 500 was at 2000), we moved up the strike price on our S&P 500 puts from 1750 to 1900. These puts represent about 25% of the fund’s portfolio. Since then markets have undergone a modest correction, and the put protection has gained over 20%. Profits in puts and shorting volatility are very fleeting, so we would expect to sometime very soon take profits in our put protection positions and roll the protection lower. The portfolio also initiated some new volatility strategies during the quarter in the form of swaps. In this case, the swaps can go long or short volatility depending upon its trend. Historically, we have seen this strategy provide a very dynamic downside protection for investors that at the same time does not produce as much of a drag on returns during major market rallies.


The global markets have been in correction mode since peaking in early July. The stronger markets have gone sideways while weaker markets have experienced mid-single digit declines. This year has been an atypical mid-term election year as the markets haven’t experienced as much volatility as is historically normal in a mid-term year. For example, the U.S. has only had one correction of greater than 5% and three other declines in the 3% range. That is mild compared to other mid-term election years in recent memory. Now we are entering into the most favorable seasonal period of the 16 quarters in the Presidential Cycle. The fourth quarter of the mid-term year is the strongest of the sixteen quarters, with the S&P 500 averaging a 7.5% gain since 1941. The catalyst to kick off this seasonal strength is the midterm elections, November 4th this year. Since 1982, the 30 calendar days leading into the midterm elections have all been positive. Over a longer-term horizon, the next four quarters are also the strongest four quarters historically of the sixteen in the Presidential Election Cycle.

Based on the strength of the U.S. economy and macroeconomic research, U.S. interest rates could justifiably be 100 basis points higher than they are today. Evidently they have been held lower by a number of factors including foreign inflows, the low rates globally, Federal Reserve bond buying program, and geopolitical turmoil. The U.S. economy is certainly doing well enough to suggest higher interest rates lie ahead. With quantitative easing ending in the U.S. this month and the U.S. Federal Reserve preparing investors for a higher federal funds rate in 2015, the stage is set for U.S. interest rates to move higher. That seems to be the consensus call, so we will be alert to what may be wrong about that scenario as we move forward.

We know the Fed is preparing the market for higher interest rates. Higher rates have not been a major detriment to the market in the past, at least initially. The S&P 500 has posted strong gains the year before tightening cycles have begun, rising a median of 16.3% versus the long-term average of 8%. After the initial hike, the market has continued to rise but at a slower 5% median gain one year after the first hike. So, even in the face of higher rates in 2015, we look for the market to post continued gains.

*Source: Bloomberg; Renaissance Macro Research.

The opinions expressed are those of Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There are no guarantee of the future performance of any Clark Capital Investments portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The Investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.

The S&P 500 measures the performance of the 500 leading companies in leading industries of the U.S. economy, capturing 75% of U.S. equities.

The Dow Jones Industrial Average is a stock market index that shows how 30 large publicly owned companies based in the U.S. have traded during a standard trading session in the stock market.

The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performers of developed markets outside the U.S. and Canada.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

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The Barclays U.S. Government and Credit Bond Index measures the performance of U.S. dollar denominated U.S. Treasuries, government-related, and investment grade U.S. corporate securities that have a remaining maturity of greater than 1 year. In addition, the securities have $250 million or more of outstanding face value, and must be fixed rate and non-convertible.

The Barclays U.S. Corporate High-Yield Index covers the U.S. dollar denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

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