Tuesday, July 31, 2018

Research Director Monthly Commentary for July/August

Time to Play Defense?

The stock market appears to be in a now familiar “recovery” pattern from the 12% correction it underwent in the January-April period of this year. As corrections go, 12% is “run of the mill”, about in line with the historic average for corrections of 13.3% decline. As we have said before, corrections such as this are quite normal and are, in fact, healthy for the market because they help to temper market excesses.  

Currently, there are some interesting internal dynamics going on in the stock market: hyper-growth stocks (or “FANG” such as Facebook, Apple, Netflix, Google) appear to be taking a breather after carrying the market for some time, in fact years. Some market pundits are of the opinion that if these hyper-growth stocks falter, it is a bad sign for the market. We disagree for several reasons: 1) there are many other sectors of the market, particularly industrial, financial and energy sectors, that have underperformed and we believe may be in a better position to take over market leadership; 2) we believe many of the hyper-growth stocks have strong long-term fundamentals and while as a group, could underperform for a period, they ultimately have superior long-term growth prospects which should help support their valuations (and stock prices) over time.

The bond market is currently in a defensive mode due to rising interest rates. Bond prices move inversely with interest rates and we expect the bond market to remain in a defensive mode for some time, thereby keeping total returns for bonds below the long term averages. We still need and use bonds for diversification purposes because bonds prices have historically risen when stocks decline, particularly in a bear markets. That said, we do expect returns on bonds to be below the long-term averages for the foreseeable future.

Do we see now as time to get defensive on equities? The answer is no. Underlying economic fundamentals remain excellent: employment is strong; workers’ incomes are rising; consumer and capital spending remain strong; and the tail winds of lower corporate tax rates and immediate expensing of capital investments should all help to sustain the current economic recovery much longer than many pundits currently project. All of this positive for corporate profits, which are the primary driver of stock prices. And with respect to concerns about the much-discussed Fed raising interest rates, we fully expect this will continue; however, we see it 1) as a positive because it is helping to normalize interest rates; 2) we believe the Fed will not accelerate rate increases; 3) the rate increases are sign of a healthy economy; 4) the Fed Funds rate is still well below the historic relationship to nominal GDP, which means monetary conditions are still no where near “tight”.

Concept of “inherent defense”………..So does this market analysis matter to your portfolio? Yes, primarily in the sense that as fiduciaries and managers of your money, we need to remain vigilant in monitoring market fundamentals as it pertains to investment strategy. But remember that your portfolio is diversified across nine asset classes, including three in equities and three in bonds. Holding multiple asset classes helps to mitigate portfolio volatility and deliver higher risk-adjusted returns. In addition, your portfolio is allocated across these nine asset classes in a way that provides necessary growth for your financial plan strategy while keeping risk to a minimum; in other words, if your financial plan shows that you can achieve your goal with a less aggressive allocation, we believe it is prudent to invest in the less aggressive allocation in order to mitigate portfolio volatility.

So, while we may not believe it is “time to play defense” with respect to equities, remember that our strategy of allocated portfolios, “due diligence” in the form of our quarterly investment strategy meetings, and quarterly rebalancing all act to provide a level of “inherent defense” in your portfolio that should help to mitigate risk and volatility when markets do become more turbulent.
Bob Toomey,
Vice President, Research




Monday, July 2, 2018

Q3 Investment Meeting Summary

We held our Q3 investment strategy meeting on June 27, 2018. At our meeting we were fortunate to have a prominent local bond portfolio manager, Dean Amundson, join us. Dean’s knowledge and experience provided us with extremely helpful insights into the current bond market.

One concern that has increased within the bond area is the flattening of the term structure of interest rates (also known as the “yield curve”) which has been occurring as the Federal Reserve raises its short-term inter-bank lending rate (the Fed funds rate). The concern is that if the Fed pushes this rate much above the yield on the 5 or 10 year Treasury note (now at 2.53% and 2.85%, respectively), it could create what is known as an inverted yield curve. An inverted yield curve has historically been associated with or preceded the last seven U.S. recessions, so a flattening yield curve raises alarm bells among stock investors.

We think the concerns over the flattening of the curve may be premature. There are several reasons for our thinking; 1) we think the Fed will be very reluctant to cause a yield curve inversion; 2) over time, higher growth rates and inflation expectations should result in some increase in long-term bond yields; 3) we believe the economy can function normally even if the yield curve remains flattish (but not inverted), i.e., a flattish yield curve should not necessarily constrain access to capital or shut down bank lending.

Given the fixed income background, we think equities can still do well as long as inflation remains moderate, which we expect, and corporate cash flow growth remains strong, which we also expect. One concern is that equity valuations may have peaked (the “as good as it gets” argument). We think there is room for further improvement in valuation based on what we believe will be 1) a longer-than-expected economic cycle thereby 2) supporting a sustained higher level of corporate cash flows. We expect stronger sustained corporate cash flows should result in rising dividends and share buy-backs, which increase the attractiveness of stocks.

With respect to changes in our investment models (and your holdings), we slightly reduced our allocation to equities primarily through moving to a slight underweight in international stocks from a previous overweight position. Within both U.S. and international equities, we continue to maintain a relatively balanced allocation to both value and growth. We continue to maintain targeted sector investments in three areas:  financial (XLF), health care (IHI), and the U.S. housing sector (ITB). We believe all three sectors still offer attractive growth potential. Within bonds, we continue to maintain our lowest possible allocation to long bonds and continue an overweight in short-maturity bonds as we believe this sector should actually benefit as short-term rates rise. Within intermediate bonds, we added a position in shorter-maturity floating rate bonds in order to further reduce overall duration of your bond holdings and thereby help to reduce portfolio volatility.

Have a happy and safe 4th of July holiday !

Robert E. Toomey, CFA/CFP
Vice President, Research




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