Thursday, June 14, 2018

Research Director Monthly Commentary: June 2018

The Fed: More Goldilocks

While it may seem boring, this is important from the standpoint of your investment portfolio: yesterday, as expected, the Federal Reserve raised its Federal funds (overnight interbank lending) target rate range by 25 basis points to 1.75-2.00%. The importance is not so much the rate itself (still highly accommodative) but rather the outlook commentary and posture of the Fed’s economic viewpoint. The viewpoint appears to continue to support a “goldilocks” environment for stocks.

The Fed’s commentary following its FOMC meetings is sliced and diced six ways to Sunday by the media and investment industry pundits. Our take on the Fed’s commentary is pretty straightforward: 1) the Fed is essentially saying that the economy is looking very good; 2) inflation and inflation expectations remain stable and moderate, around 2%; 3) there is no change in the Fed’s interest rate policy, which is continued steady quarterly increases in the Fed funds rate: two more this year and probably three more next year. We believe this outlook is actually quite positive (almost “goldilocks”-ish) for stocks because it indicates the Fed, in both its actions and outlook, remains committed to providing a monetary backdrop that is conducive to economic growth which, in turn, is supportive of corporate profit growth, the single most important driver of stock prices.

Some pundits have raised alarm bells that the Fed rate policy ultimately sets the stage for inverting the yield curve and tipping the economy into a recession. These same pundits take a guess at when the next recession starts, and some of them are now saying 2020. While pundits are paid to write and stay stuff that sounds smart (and granted many of them are smart), we respectfully submit that not only is it difficult to forecast a recession, but also we believe the current expansion could be surprisingly durable and last longer than many now expect. Our reasoning? Currently there do not appear to be major economic or financial imbalances that usually precede an economic downturn. Inflation continues to remain moderate. Fed policy remains accommodative. The corporate profit outlook remains healthy. Valuations based on forward P/E are not exceedingly high at 17x.  

So what does this have to do with financial planning? We, as a fiduciary to our clients, need to have a framework for setting investment policy. Along with factors such as the economy, inflation, corporate profits, valuation, and geopolitical risks, Fed policy is a critical element in assessing the investment environment. Based on these factors, we still believe the outlook for stocks remains quite positive and this gets reflected in our allocation to equities, which we are currently overweighting in our strategies . While the risks of a trade war have been prominent in the news of late, at this point, we still believe the risk of an all-out damaging trade war remains low. We will be holding our Q3 investment strategy meeting on June 27 and will have a further update on our investment strategy at that time.

Robert Toomey, CFA/CFP
Vice President, Research



Monday, May 7, 2018

Research Director Monthly Commentary: May 2018

More On Volatility
As we mentioned in our March comment, we expected stock market volatility to increase this year and it  has. The low volatility experienced in 2016 and 2017 lulled many investors into believing low vol was here to stay. This was not to be the case, nor could it be. Market “corrections” (downward moves of 10%-20%) have historically occurred on average about once a year, while market “adjustments” (downward moves of 5-10%), have historically occurred about 3 times a year. To not have not a downward move of even 5% for a period of about 21 months (March 2016 to December  2017) was not only a record, but entirely unsustainable. 

What has contributed to the increased volatility this year? Several factors: concerns over Federal Reserve policy, concerns over rising inflation, concerns over the potential for a trade war with China, and more recently, increased legal troubles for President Trump. We believe the concerns over Fed policy and inflation have been overblown. The Fed continues to maintain a steady and well telegraphed interest rate policy and, absent a dramatic acceleration in inflation (which we do not expect), we believe Fed policy should not lead to damagingly high interest rates. With regard to inflation, we had some good news in the April payroll report in which the pace of both job creation and wage growth cooled off from previous readings. Wage growth of 2.6% is in line with the long-term pace during this recovery and we believe does not have inflationary implications, at least as of now.

With respect to the potential of a trade war with China, we believe investor concerns over this issue are justified; however, we believe a more probable outcome is that China and U.S. will ultimately reach some reasonable and mutually accommodative position. We believe China understands there has to be more of a balance in trade with the U.S. to sustain a positive long-term relationship and access to vital U.S. markets. With respect to Donald Trump’s legal problems, it is difficult if not impossible now to predict an outcome or ending for this. Uncertainty around any country’s executive leader is problematic for the market and we expect this issue could continue to contribute to market volatility in the near term.

What’ the point? So the point about this rather dry analysis is to put recent stock market volatility into context. We have heard some concerns from clients about the recent volatility. We want to assure clients that a) volatility is normal, b) we understand what is causing it, and c) we believe underlying economic fundamentals remain favorable for stocks. We often get the question “should I pull my money out til this is over?”….. in other words, try to time the market? We have long understood, and studies show, that market timing is difficult if not impossible. One interesting statistic on this: according to BTN Research, the total return for the S&P500 over the past 10 years has been 8.5% per year. If you missed the 10 best percentage gain days over this period, the return drops to an annual gain of 1.3%. There will be periods of variability, some more violent than others. Trying to time the ups and downs of the market will almost always lead to disappointment and lower long-term returns. With regard to investing, it is important to keep volatility in context, maintain a long-term view, and adhere to a disciplined investment process.

Despite the recent volatility, we remain constructive on stocks. Valuations based on forward price/earnings for stocks remain reasonable and about in line with the long-term average (about 16x), so stocks are not overvalued. Valuation is the single most important factor in determining long-term stock returns. While there is some concern about a peaking in earnings growth in 2018 (also contributing to recent volatility), we believe it is likely that even if earnings growth slows, which it will, corporate cash flows should increase significantly in 2018 and 2019 as a result of the tax bill. As corporations return this cash to shareholders, we expect a lot of it will get “recycled” into the stock market, thereby providing fuel for higher valuations and stock prices over time. Another way of looking at it is we expect investors most likely would pay up for stronger and perceived sustainable cash flow.

Robert Toomey, CFA/CFP
Vice President, Research

Thursday, March 29, 2018

Q2 Investment Meeting Summary: “Living With Volatility”

We held our second quarter investment strategy meeting on March 28. Stock market volatility so far in 2018 has increased which, as readers may recall, we predicted earlier this year. We believe the two most important factors that have affected market volatility recently are a) uncertainty over U.S. trade policy (and related fear of a trade war) and b) anxiety over the course of Federal Reserve policy. Other contributing factors have been some recent “green shoot” indicators of a pickup in inflation and rising interest rates. We would note that the very low volatility experienced in the financial markets through most of 2016 and 2017 was an aberration: 17 months without even a 5% correction was not only a record, but also not sustainable. To put this in historical context, over the past 70 years, the stock market experienced a correction (a pullback of 5-20%) on average every eight months. We would also note that historic intraday volatility is about 1%, which means that daily market moves, both up and down, of around 1%-2% should not be considered unusual or cause for alarm.

The recent rise in market volatility (risk) does not necessarily translate into a rise in fundamental risk, in our opinion, and we believe the market may be reacting in more of an emotional way than keeping the focus on fundamentals which we believe continue to support a positive case for equities. So what are the positive fundamentals for stocks? 1) Corporate profits, the single most important driver of stock prices, are set to grow in the range of 15-20% this year and about 10% in 2019. 2) We believe concerns over Federal Reserve policy are overblown. New Fed chief Powell has made it clear that the Fed expects to maintain a steady rate policy and also that inflation does not appear to be accelerating in a way that might result in a major change in Fed policy. 3) Historically, rising interest rates have not been an impediment to rising stock prices; in fact a recent study by Fidelity shows that the stock market has better odds of advancing when interest rates are rising than when interest rates are declining. 4) Economic fundamentals remain sound both in the U.S. and globally and economic indicators continue to point to healthy growth in most of the developed world. 5) At this point, we do not believe that the Trump administration’s actions to improve the U.S. trade position will end up causing a global trade war. We do not deny there are risks, particularly Trump’s trade strategy and forthcoming very high level of U.S. government debt issuance; however at this point we believe the risk/reward continues to favor an overweight in equities. The return outlook for bonds remains lackluster but we believe they remain important for portfolio diversification and risk management.

As a result of our deliberations, we slightly reduced allocations to both equities and fixed income, which results in a slight increase in cash. We remain overweight a neutral allocation in both U.S. and international equities as we believe equities still offer good opportunity for growth. Within U.S. equities, we did not change any sector holdings. In international equities, we eliminated our position in the large 50 European stock ETF (FEZ) and initiated a position in emerging market equities (SPEM). Within REITs, we reduced our allocation by about 4% but maintained two positions, a general REIT ETF (VNQ) and an industrial REIT (FR). Within fixed income holdings, we maintained our lowest possible allocation to long bonds and slightly reduced our allocation to intermediate bonds. Within the short bond area, we eliminated our position in short corporate bonds (SPSB) and initiated a position in floating rate bonds (FLOT) as we believe floating rate securities will be better able to maintain their value in a rising interest rate environment.

 Robert Toomey, CFA/CFP
Vice President, Research

Thursday, March 1, 2018

Research Director Monthly Commentary……..March 2018

All About The Fed

We’ve been getting some questions from clients recently about market fundamentals in light of the recent stock market correction. We noted in our January comment that we expected volatility to pick up this year and the market obliged in February with our first real “correction” (a decline of over 10%) in over 17 months (a rather long time without a correction, BTW, given that the long term average is about once every 12 months). Has the recent correction removed the risk of further volatility? Probably not. And as with any market correction, there will most likely be a period of backing and filling of the sharp technical decline if not a re-test of the February 9 bottom. That would be a normal process for any corrective phase.  

There is some good news to come from the correction. Corrections are a normal part of the market cycle and help to contain excessive speculative trading activity, normalize valuations, and maintain a more balanced market. As we stated in our January comment, we expect stock market volatility to remain elevated primarily because of investor uncertainty over Federal Reserve policy: how many times will the Fed raise rates this year? New Fed Chair Jerome Powell’s testimony this week also brought the Fed into sharper view, which may have added to market volatility this week. Interest rates and Fed policy are important in the valuation of all financial assets. The good news is we believe the backup in bond yields over the past several months has gone a long way towards adjusting (or normalizing) yields for Fed policy steps of what we believe will most likely be three or four rate hikes this year.

 In terms of answering client questions about “the fundamentals”, as of now, they remain good for stocks. Corporate earnings fundamentals remain strong driven by corporate tax reform, increased capital spending, as well as synchronized global economic growth. Corporate earnings should be strong both this year and next. The economy remains strong. Valuation remains reasonable at about 17x forward earnings, and the recent correction helped to temper valuation which had gotten somewhat stretched. Inflation, another factor that can affect stock valuations, remains constructive. While we do see inflation rising somewhat this year, a moderate 2-2.5% inflation environment should be viewed as positive and should not be deleterious to stock valuations, in our opinion.

One client asked “if the tax windfall is 'used up' in 2018, what does that mean for 2019?”. It is a good question. At this point, it appears 2019 should be another good year for the U.S. economy due to the positive lag effect on capital spending and continued strong employment. We think the fears over some great slowdown or dropping off the (economic) cliff in 2019, as some have suggested, are overblown. And given the below average growth of the early part of this cycle, it is entirely possible that this recovery could extend for a longer period than most now believe.

The recent market volatility has not materially changed our investment strategy and we have continued to recommend that clients stay the course and remain invested. Diversification of client portfolios by asset class is a cornerstone of our investment policy. We do this because we believe it helps to mitigate portfolio volatility and essentially “prepare” for inevitable increased market volatility. We will be holding our quarterly investment strategy meeting at the end of this month. I suspect there may be a bit more discussion about inflation, or potential for rising inflation, and U.S. stock valuation in light of rising interest rates. As long as inflation remains moderate and Fed policy remains steady, a moderately rising rate environment should not derail the bull market in stocks.

Robert Toomey, CFA/CFP
Vice President, Research




Wednesday, January 31, 2018

Research Director Monthly Commentary: February 2018

Higher Vol in 2018
2017 was a memorable year for the stock market and certainly a significant (positive) outlier in terms of returns. The total return for the S&P500 in 2017 was 22%, which is way above the 100-year average annual return for large-cap stocks of about 9%. We believe it is unlikely 2017’s level of return will be repeated in 2018.
We think the risk for increased market volatility (and some sort of stock market correction) in 2018 has risen for a couple of reasons: 1) the current ebullient level of investor sentiment and 2) what appears to be a developing seachange in the interest rate regime. Over the past few trading sessions the market has experienced a very modest (1.8%) pullback due largely to the recent backup in bond yields. The concern is that as a result of the stimulative impact of the recently-passed tax bill and the potential for acceleration in economic growth, the Federal Reserve may now have to be more aggressive in raising interest rates this year. It could happen. That said, the underlying fundamentals for U.S. stocks actually remain quite positive. Corporate profits and cash flows appear poised for another year of strong growth and there should be follow-on benefits from the tax bill in 2019 in the form of rising capital spending which is highly stimulative.

As a result of all this, we expect earnings estimates will continue to be revised upwards this year. Valuation, which appears a bit stretched based on trailing earnings (21x), is not particularly high when considering higher forward earnings estimates for 2018 and 2019. And with respect to changes in interest rate regimes, history has shown that stocks can and do rise in the early stages of a rising interest rate environment as long as corporate profits remain healthy and inflation remains moderate. We expect both these conditions to continue in 2018 and 2019.

So what does this have to do with financial planning? A few things……We manage the majority of investible assets for most of our clients in conjunction with their financial plans. As fiduciaries, we have a responsibility to conduct research and make sound investment decisions for their benefit. An important part of this responsibility is managing investment risk which we do in a number of ways: diversified asset class holdings, a disciplined investment model, and due diligence in the form of both research and our quarterly investment strategy meetings. At some point, there will be another correction the timing and magnitude of which no one can predict. Our investment strategy and active risk management are ways of preparing for and mitigating the effect of a market correction. The point is rather than try to “time” a correction, which is virtually impossible, we stay true to a time-tested investment discipline which we believe will deliver more stable long-term returns with less downside risk in times of market turbulence.

Robert E. Toomey, CFA/CFP
Vice President, Research
January 31, 2018


Tuesday, December 26, 2017

First Quarter Investment Strategy Meeting Summary

We held our first quarter investment strategy meeting on December 20, 2017. As you know, at these meetings we discuss and analyze factors that affect our investment outlook and holdings in your portfolios. The primary outcome of the deliberations resulted in an increased weighting in small and mid-cap equities and a slight reduction in our macro allocation to bonds. There were no significant changes in the securities we are using for sector representation except for REITs in which we added two securities, a medical REIT and an industrial REIT, in order to further reduce exposure to the shopping mall category.

With respect to macro issues, we think the main drivers of the stock market remain positive looking into 2018. The U.S. economy, which is currently strong, appears poised for another strong year of growth. Employment and consumer spending remain strong. The consumer sector represents about 70% of the economy. The corporate sector is also in a strong position relative to both earnings and cash flow. We expect another strong year of corporate earnings growth in 2018 with potential for an acceleration in capital spending, which would add additional fuel to the economy. These factors are the positive underpinnings for stock prices. Continued low to moderate inflation, transparency of central bank policies, and a synchronized global recovery are also factors that support the positive outlook for stocks.

Despite these positives, there are some concerns or risks in our outlook. First, is the risk for an acceleration in inflation. As of now, we expect inflation could rise modestly in 2018 to potentially to 2.5% from less than 2% currently. We believe if we are wrong and inflation accelerates to the area of 3% or more, this could result in several problematic events: the Fed could accelerate its pace of interest rate increases; inflation concerns among investors could result in a decline in valuations for financial assets; and both of these events could precipitate a market correction. In addition, stock valuations are elevated: at about 18.5x forward earnings, the S&P 500 valuation is now about 23% above its long-term average valuation of about 15x. We would not be surprised to see some increased volatility in stocks in 2018 but as of now, we still expect stocks can continue to rise in 2018. We continue to believe returns for bonds will be below average due to rising interest rates.

Of course the new tax bill was a major topic of discussion at our meeting. I will not go into a detailed review of the bill but suffice to say that the bill does appear to be a net positive for both the consumer and corporate sectors. Most consumers should see some net benefit from the tax bill as all tax brackets were reduced by about 10%.There will certainly be situations where individuals have a tax configuration in which they do not benefit, but we think this will prove to be a relatively small portion. From the corporate side there are several features that are particularly positive in our opinion: a 40% reduction in the tax rate, elimination of the corporate AMT, and allowance of immediate expensing of capital expenditures. Not all of this benefit will be immediate. It will take a couple of years for the tax law changes to be fully felt; but net net, the new law should release material new capital into both the stock market and the economy which should be positive for growth. The downside to the bill, of course, is the potential risk of rising federal deficits. The two most recent examples of tax rate overhauls were in the Kennedy and Reagan administrations. In both cases, the several years following the tax overhauls resulted in strong economic growth, a rising stock market, and reduced federal deficits. Time will tell if this tax overhaul results in a similar outcome.

Robert Toomey, CFA/CFP
Vice President, Research

Thursday, December 14, 2017

Research Director Monthly Comment- December 2017

The Market Prediction Game

 It is that time of year and Barron’s magazine this week ran its annual “market forecast” issue in which the Wall Street brain trust (market strategists) makes their predictions about stock and bond returns for the coming year. Earlier in my career I used to consider this a very important and prescient article but over the years have come to discern that the accuracy of Barron’s group of strategist predictions are usually about in line with the broad averages of market predictions: about 50-50; or in other words, about the equivalent probability of a coin toss.
Given where we’ve been over the past nine years, the article seemed more like entertainment. This is not to put these folks down. They are all bright, highly credentialed, hard working, and have a high level of knowledge in their field. They are making reasoned educated guesses and some of those will be correct (or close). But the nature of the forecasting game is the markets have an uncanny way of fooling the great majority of investors (or investor “consensus”). And just because you are dying to know, here are the fearless consensus 2018 forecasts for several key market variables:

                Stock market total return: +7%

                Yield on 10-year U.S. Treasury on December 31, 2018: 2.8% (current: 2.35%)

                Corporate profit growth: +10%

                U.S. real GDP: 2.6%
Our take on all this? We generally agree that fundamentals for stocks remain positive for a number of reasons. There do not appear to be excesses in the credit or bond markets that would precipitate a major market adjustment. While aggregate stock valuation is elevated at about 18x forward earnings, we do not believe it is at such an extreme level that it would prevent the market from rising further. What are some of the risks? 1) that inflation is higher than expected; and 2) market sentiment is quite bullish now, which can be viewed as a negative “contrary” indicator.


Where do we put our energy? So what’s the point about market prognostications? It is the fact that over long-periods of time, it has been shown that both short-term market forecasting and market timing activity associated with this forecasting is difficult if not impossible and the best place for us to place our energy in managing our client’s capital is a) managing risk, b) setting appropriate portfolio allocations, and c) working diligently to select the best investments to achieve client financial plan objectives. It has been shown that diversified portfolios can and should deliver higher risk-adjusted returns than all-equity portfolios over time because they are inherently less volatile and, as a result, returns are more stable. This is extremely important for both financial planning and risk management and especially important for older clients who are not in a position to suffer a serious asset drawdown.


Robert Toomey, CFA/CFP

Vice President, Research

December 14, 2017