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


Friday, November 10, 2017

Research Director Monthly Commentary: November, 2017

Wow, November and holidays already ! …… seems like this year has flown by. Along the lines of “flying” we’ve seen some “flying” in the stock market this year, to wit: YTD, the S&P500 is now up by over 15%,  well above the long-term average annual return of about 10%. At about 18x forward earnings estimates, valuation for the S&P500 is elevated but not at “nose bleed” levels. As long as the economy and corporate earnings continue to grow, which we expect, we believe the stock market overall can continue its upward path.

 We’ve seen the stock market wobble a bit in the past few days largely due to concerns that the Trump administration’s proposed tax plan could be delayed. There does seem to be the political will to get a tax package through Congress but it is difficult now to know or predict its final form. We believe there is a certain level of investor expectation of a tax package this year and if it fails, it could result in a modest market correction.

Speaking of corrections, one unique characteristic of this stock market over the past several years is the lack of corrections, or let’s say, much lower frequency of such. Corrections are a normal characteristic of any market. Since 1900, corrections (meaning: pullbacks) of 5% or more have historically occurred about 3 times a year, while corrections of 10% or more have occurred about once a year. Interestingly, we have not had a correction of either magnitude since August 2015. Some market pundits are predicting that we are overdue for a correction, and base on history, would appear to be true. The problem however, is we cannot predict when one will occur or its magnitude. Is that a “risk”? Yes. Can we prepare for such a “risk” actually occurring? Yes and we do.

One of the best ways to prepare for market corrections is to invest in a portfolio that is diversified across several asset classes. We do this for all of our clients. These asset classes (stocks, bonds, commodities, real estate, etc.) have varying return correlations and, when held together, can help to dampen portfolio volatility and hence provide some level of protection from market pullbacks. But it is not “buy and hold forever” strategy. We meet quarterly to assess the market and economic outlook and from this meeting make tactical changes to our holdings within each sector to best position clients for what we see coming over both the short and longer-term. The goal is to deliver improved risk-adjusted returns (meaning return per level of risk taken) which, we believe, is the most important measure of return in wealth management.

Financial Planning: In the financial planning area, one of the bigger issues we have been dealing with for our clients is the issue of low yields on bonds. Historically, most retirees have relied on a higher portion of bonds in their portfolios to provide income. With the drastic decline in interest rates over the past 10 years, bonds no longer provide an adequate level of income. There are several things we have been doing at S.R. Schill to compensate for this situation: 1) tactical allocations across term structure of interest rates; 2) having some exposure to short-term high-yield bonds; and 3) increasing our holdings of bond surrogates and hyrids, such as preferred stocks.

Robert Toomey, CFA, CFP
Vice President, Research
November 10, 2017

Friday, September 29, 2017

Q4-17 Strategy Meeting: More Goldilocks

We held our fourth quarter investment strategy meeting on September 27. I titled this commentary “Goldilocks” because right now we have a set of conditions in the financial markets that are positive for stocks….not too hot, not to cold, but just about right: stable economic growth, growing corporate profits, expectations for continued low inflation, and still highly accommodative global monetary policy. By implication, we believe this set of factors is supportive of higher stock prices in the near term. That said, there are some concerns in the overall picture such as above average valuations and geopolitical factors (e.g. North Korea); but at the moment, we do not view these as serious enough to offset the generally positive conditions for stocks.

 One factor on which we spent some time was the possibility of a policy mistake by the Federal Reserve. The Fed has gotten itself into a difficult position having reduced interest rates to a well below normal level; however, it did not anticipate that inflation would remain as low as it has. This raises a question of gauging how fast the Fed should raise rates: raising them either too fast or too slowly both raise some problems for the economy and financial markets. We believe the Fed is aware of these problems and we believe it will most likely pursue a gradualistic policy that should not destabilize the financial markets. We expect the Fed to raise the Fed funds rate in December and again in the spring of 2018.

We discussed the situation in North Korea and the broader issue of “black swan” events. The problem with geopolitical “black swan” events is that, by definition, they cannot be predicted and therefore hedging for a specific “black swan” event is virtually impossible. We did not take any hedging actions specifically related to North Korea but we did set a trigger which would require that in the event North Korea takes military action against another sovereign nation, we would reduce invested capital to its lowest allocation in our models. We also set a trigger in the event inflation goes higher than we expect: it is a “combination” trigger that would cause us to reduce investment exposure in the event  that 1) inflation measured by “core” CPI rises above 3% and 2) the yield on the 10-year U.S. Treasury bond goes above 3%.

With respect to changes in our investment holdings, we continue to maintain a tilt towards value stocks because we believe 1) valuations are high for “growth” stocks and 2) value stocks tend to be do better in a rising interest rate environment. We also maintain an overweight position in international equities in part because of their lower valuations relative to U.S. stocks, particularly Europe. Tilting our holdings toward value stocks also acts as a way of hedging against potential market volatility as “value” stocks tend to be lower volatility in nature due to their perceived stronger cash flows and higher dividend payouts.

In line with our tilt towards value stocks, we added positions in the health care and financial sectors. Health care remains a very positive secular growth story and financials should benefit from rising interest rates. Within fixed income, we continue to underweight long bonds and overweight short maturities in order to keep durations on the shorter end. In the long bond area, we added a position in preferred stocks as a way of increasing income in this sector.

Bob Toomey, CFA/CFP
Vice President, Research




Friday, June 30, 2017

3Q-17 Investment Meeting Summary

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
Vice President, Research