Prep Your Portfolio for the Fourth Quarter

After stumbling in the early months of 2018, the market is back on solid footing. Both the Dow Jones industrial average and the S&P 500 finally broke out of correction territory over the summer.

Looking ahead to the fourth quarter, investors have an opportunity to finish the year strong.

“Generally speaking the fourth quarter has been the best-performing quarter of the calendar year for stocks,” says Chris Shuba, CEO and founder of Helios Quantitative Research in Loomis, California. “The S&P 500 index has returned an average 5.35 percent in the fourth quarter over the past 30 years.”

Certain sectors may perform better than others between September and December. Historically, “there’s a bullish seasonal bias into year-end, led by industrial stocks and consumer discretionaries,” says David Russell, vice president of content strategy for TradeStation. In nine of the last 10 years, TradeStation data shows those two sectors rising in the fourth quarter.

[See: 8 Stocks Most Exposed to Hurricane Florence.]

Heading into the final stretch of the year, it’s a good time to assess a portfolio’s readiness.

Early November could be a game-changer. While broader historical market trends can affect fourth-quarter performance, investors also have midterm elections to contend with this year.

“Stocks typically increase 5 to 6 percent during fourth quarters that have midterm elections,” says Mike Bailey, director of research at FBB Capital Partners in Bethesda, Maryland. He says there may be less upside this year because stocks have already returned nearly 10 percent year to date.

Albert Brenner, director of asset allocation strategy at People’s United Advisors, says volatility may increase leading up to the elections, as “uncertainties regarding the outcome factor into estimates for future earnings.”

That could lead to lower stock prices, but any downturn is likely to be temporary Brenner says. He says investors who want some portfolio protection ahead of the elections could consider the iPath S&P 500 VIX Short Term Futures ETN (ticker: VXX) or put options on the S&P 500.

Once the election results are in, stocks could rally.

“The market has been up 12 months after every midterm election since World War II,” Brenner says. He adds, however, that this year could be an outlier if Democrats end up with majorities in both houses of Congress, which could trigger volatility.

Keep an eye on interest rates. Another rate hike may be a lock for September, but the Federal Reserve has yet to make up its mind on another increase for December. In the meantime, it may be wise to de-risk your portfolio to a degree, says David Spika, president at GuideStone Capital Management in Dallas.

“We’ve now set the record for the longest equity bull market in history, the Fed is raising rates and reducing its balance sheet and the yield curve has flattened significantly — all events that have historically led to a market correction and economic slowdown,” Spika says.

He says a good place to reinvest capital from stock sales is into low volatility equity strategies or diversified liquid alternatives strategies, “that may hold currencies, long/short equities, convertible securities or option selling strategies.” In terms of specific defensive sectors, Spika says consumer staples and health are good place to invest, as they tend to have low economic sensitivity.

Brenner says short-term interest rates are high enough that investors are close to realizing a positive real return for holding cash, especially if the Fed moves ahead with a September rate hike. Treasury bills may also be a good buy now for “investors who want to sit on the sidelines until the election drama is over.”

[Read: How to Avoid Investment Tax Shock.]

Treasurys and high-quality corporate bonds can both benefit your portfolio as yields continue to rise. Bailey says these investments should continue to be a favored strategy through the fourth quarter.

Stick with investments closer to home. “The international market is too volatile because of trade war fears, and we expect that volatility to continue until trade agreements are reached,” says Brad Bertrand, investment advisor representative and the founder and president at Retirement Solutions in Oklahoma City.

Bertrand says the outlook on international markets could change rapidly but the fourth quarter may be too early to begin buying into that sector. Right now, he says, domestic large-cap value stocks are the place to be.

U.S. small-caps could also be a compelling sector for the fourth quarter and beyond.

“Overall, the U.S. economy continues to do well and almost all leading indicators are positive for 2019,” says James Hickey, chief investment strategist, HD Vest Financial Services in Irving, Texas. “The markets still have not fully priced in the 2017 tax reform and the protectionist policies of our current administration should create opportunities for small-cap companies because it should bring more manufacturing back to the U.S.”

Don’t neglect basic housekeeping duties. Remember to do a fee audit and plan for tax loss harvesting in the fourth quarter.

“Investors should always be cognizant of what they’re paying for,” says Eric Krusiewicz, senior product strategist at Symmetry Partners. “If there’s no justifiable added benefit for paying higher fees, seek a more cost-effective option.”

Krusiewicz says to review the cost basis for the securities in your portfolio and consider selling losing stocks to offset current gains or carry them forward for future potential gains. “The closer you get toward the end of the year, the better the opportunity you have to get a sense of your tax liabilities for the year,” he says.

Joe Heider, president of Cirrus Wealth Management in Cleveland, says if you’re harvesting losses in the fourth quarter, to give yourself at least 60 days to review the portfolio.

This year in particular because of tax reform, the fourth quarter “is an excellent time to verify your portfolio is designed to produce maximum after-tax gains,” he says. “Many investors look only at their gross rate of return without regard to tax liabilities, thus reducing their net return.”

Take time to revisit your goals before the year is out as well.

[See: 7 Ways the Midterm Elections Could Impact Investors.]

“Clients and their advisors should be meeting regularly to discuss their needs, review portfolios and determine the next course of action,” says Jeremy Bryan, portfolio manager at Gradient Investments in Arden Hills, Minnesota. “This can be done at any time but if you aren’t meeting at least once per year with your advisor, the fourth quarter would make a great time to set a meeting.”

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