We held our Q3-17 investment strategy meeting on June 28. The most significant changes we made following our deliberations were, in the equity area, an increase in our exposure to international equities, more specifically Europe; and within the fixed income area, a very slight reduction in our allocation to short term bonds.
We continue to remain positive for the outlook for the global economy. We see the U.S. economy accelerating somewhat this year and next in the range of 2.5% or a bit higher in terms of real GDP growth with the potential for stronger growth in 2018. This is positive for corporate profit growth, the primary driver of stock prices. What has been driving the stock market higher of late, in our opinion, is rising corporate profits. In the first quarter of 2017, corporate profits rose at an annual rate of about 9% and are currently forecast by Factset to grow at about 10% for the full year in both 2017 and 2018. The trend of rising corporate earnings should provide support for higher stock prices assuming valuations remain steady.
One problem or “issue” for U.S. equities currently is valuation. The U.S. stock market as reflected by the S&P500 is currently trading at around 18.5x this year’s expected earnings. This is approaching the upper end of the market’s long-term valuation range of around 12-20x. This does not imply that the stock market cannot go higher; we believe it can based on our outlook for the economy and rising corporate earnings. However, it does reflect an element of risk for equities that needs to be considered in our investment policy and risk management.
There are several ways in which we manage risk in your portfolios. One is through diversification of your investments by asset class (e.g., stocks, bonds, commodities, real estate, etc). This helps to dampen portfolio volatility while providing a more stable long-term return. Other ways in which we manage risk are through changes in tactical strategies following our quarterly meetings and through our selection of securities holdings that we believe will best serve you in implementing our strategies. One of the ways we are currently mitigating the risk of higher U.S. stock valuations is through allocating more equity investments towards international stocks such as Europe, which currently have lower valuations than U.S. stocks. Another way we are actively seeking to mitigate portfolio risk is through a relatively high exposure to “value” stocks, which tend be dividend-paying and less volatile than growth stocks. The goal is delivering the best risk-adjusted return we can and an important element in achieving this goal is reduction of portfolio volatility.
Within the fixed income area, there were no major strategic changes. We continue to remain underweight in the long-maturity sector because we believe interest rates could continue to rise based on Fed policies of normalizing the Fed funds rate and reducing its bond holdings built up during the period of “quantitative easing”. We maintained a normal/neutral weighting in the intermediate bond area and continue with our overweight of short maturity bonds. These allocations are intended to keep your effective duration at a below average level. We expect a below average duration should help to mitigate the capital impact of further increases in interest rates.
Robert E. Toomey, CFP, CFA