Wednesday, February 6, 2019

Research Director Monthly Commentary – February 2019

Volatility And Its Role in Financial Returns

What a difference a month makes ! The stock market in December (2018), as measured by the S&P500, declined 9%; the stock market in January (2019) gained 8%. Now that’s some kind of volatility! As we mentioned in previous commentaries, there were both fundamental and technical issues that generated this volatility. Quick review, the primary fundamental issues were: concerns over the trade dispute with China; concerns that the Federal Reserve was out of touch with economic reality (i.e. would go too far in raising interest rates); and concerns over global economic and corporate earnings growth. The primary technical factor affecting volatility was program (or algorithmic) trading which now accounts for up to 75% of average daily volume in the stock market. Program trading is not fundamental or fundamentally driven, but it can and does have a material short term impact on volatility.

So where are we now? In January, a number of positive things occurred: early in the month, a couple of influential Federal Reserve Board members were commenting that the Fed’s stance on rates may be too draconian; a number of large companies reported better than expected profits; and later in the month following the FOMC meeting, Fed chief Jerome Powell made comments to the effect that the Fed was materially backpedaling on its 2019 interest rate policy. This provided relief to investors who were concerned the Fed was at risk of going too far in raising rates (which it was, in our opinion). This plus scuttlebutt mid-month that trade discussions with China would/could lead to a positive outcome were enough to generate a strong rally in January. As of now, we are relatively sanguine on the stock market outlook and believe the underlying fundamentals still support higher stock prices this year. We believe the biggest near-term risk is the trade deal with China. We think the risk of a recession in 2019 is low.

But what about volatility? Certainly downside volatility like we experienced in Q4 is not pleasant. But volatility is an important component of generating higher investment returns. As investors, we have to stomach occasional periods of volatility in order to generate higher returns. If we want zero volatility in our portfolios, we can expect essentially zero or very low returns. In support of this idea, Financial Planning magazine recently ran an interesting article entitled “You Can’t Win If You Are Afraid To Lose”. The article looked at the performance of 2500 mutual funds between 1998 and 2017 in order to analyze how volatility affected returns. The article’s findings support the idea that a) higher risk (volatilty) is positively correlated with higher return; and b) the best performing portfolios experienced negative returns (down years) 25-30% of the time, or roughly 4 or 5 years out of the 20. What does this mean for us as investors? Primarily, we need to be willing to stomach occasional (downside) volatility to generate higher long-term returns. We would also add that a diversified approach to investing, such as we do here at SRS, we believe is the best way to generate higher returns with lower risk. While the inevitable periods of volatility can make us feel upset, as long we take a long-term view towards investing, avoid market timing, and invest in quality diversified portfolios, we should have a greater probability of achieving higher portfolio returns over time.

Robert Toomey, CFA/CFP
Vice President, Research

Wednesday, December 26, 2018

1Q-19 Investment Strategy Review

We held our 1Q-19 investment strategy review on December 20, 2018. At these meetings, we discuss a wide range of factors that affect the financial markets and our investment strategy. As you are aware, the stock market has exhibited above average volatility over the past couple of months and actually entered “bear market territory” this week, having declined 20.4% from the intraday high in September to the intraday low on December 24. As we have stated previously, market corrections and mild bear markets are normal occurrences in a secular bull market. We would note that during the current secular bull cycle that began in 2009, we experienced a similar mild bear market in 2011, so swings of this magnitude are not unprecedented.

We believe the primary concerns for the market now are: 1) potential for slowing global economic growth; 2) Federal Reserve monetary policy; and 3) the trade dispute with China. Additionally, the “news” environment over the past several months has been unusually active. News about topics such as trade, immigration, government shutdown, White House staff changes, etc., we believe, has added to recent volatility. Not inconsequential also has been the impact of algorithmic (or computer-driven) trading, which now accounts for a large portion of daily market volume (we have heard estimates as high as 75% of daily volume). We believe the high level of algorithmic trading is materially amplifying the recent volatility.

Currently we believe the market appears to be disconnecting from the economic fundamentals. With respect to the global economy, we believe there will be some slowing in U.S. and global growth in 2019 but we believe it will still show good growth with the U.S. GDP now expected to grow about 2.5%. With regard to Fed policy, the Fed recently signaled it will most likely reduce the number of rate increases it expects in 2019 from four increases to two. This is a positive development and sends the message that the Fed is maintaining flexibility with regard to its policies. With respect to the China trade dispute, there appears to be some behind-the-scenes progress but it will take more time to see if the dialogue proves successful.

Let’s not forget there are some positives right now, to name a few: 1) Federal Reserve policy appears to have become a bit less aggressive; 2) investor sentiment has turned quite bearish; 3) valuations for stocks have declined significantly to about 14.5x forward P/E estimates and we believe there should be decent fundamental support for stocks at a forward valuation in the range of 13-14x; 4) based on the earnings yield, stocks still remain attractively valued relative to bonds.

With respect to changes in your portfolio, one of the key things to come out of the meeting was a review of all holdings which resulted in a reduction in the number of holdings in your portfolios. Within equities, our deliberations resulted in a slight 3.5% reduction in equity allocation while allocation to bonds remained the same. We again slightly increased our weightings in “value” stocks within both U.S. large cap and international equities. We maintained our sector investments in medical equipment and telecom stocks and added a small position in gold as a hedge against market volatility. Within the bond area, we continue to maintain a heavier weighting toward shorter duration bonds. We also changed our core bond holdings to U.S. Treasury bonds from U.S. corporate bonds as we believe Treasuries offer great stability in what we expect may be a more volatile market environment in 2019.

We want to emphasize that your portfolios are diversified across nine asset classes and that U.S. stocks are only a portion of your total holdings.  This is done primarily to reduce portfolio volatility particularly during times of above average market volatility. We don’t believe in timing the market; but rather, we believe remaining disciplined to an appropriate portfolio allocation along with some tactical allocation is the best way to provide long-term asset growth with lower volatility and higher risk-adjusted returns.

Robert Toomey, CFA/CFP
Vice President, Research

Friday, December 7, 2018

Comments on Recent Market Action

It has not gone unnoticed by us that it has been a rather tumultuous week for the stock market. We have a few thoughts on this that we’d like to share. What seems to be bothering investors most of all now, among an array of factors, is uncertainty over three things: Federal Reserve policy, the U.S.-China trade situation, and (near) inversion of the Treasury bond yield curve that many believe presages a recession. Add to this the impact of algorithmic (computer-driven) trading, and it all adds up to heightened market volatility.

With respect to the above-mentioned concerns, we offer the following thoughts: 1) We believe the probability is increasing that the Fed will materially curtail interest rate hikes in 2019, which should be positive for financial assets. 2) We believe there is a reasonably good chance there will be some positive progress made within the next 90 days on the U.S.-China trade dispute. 3) We believe the concerns over the yield curve possibly inverting may be overdone, but we are watching this. You might recall, we did set an action trigger at our September investment meeting which would cause us to take some protective action in the event the trigger is breached. The trigger is an inversion of the Treasury yield curve (meaning the spread between the yield on the 10-year and 2-year Treasury bond goes negative). As of today’s close this spread is positive, so it has not yet inverted, but we believe investors are concerned or projecting that it will invert.

The bottom line is the market is dealing with a little more uncertainty at the moment. As we stated in our previous commentary, we expect market volatility to remain elevated for a while longer, perhaps into early next year and we would not be surprised to see the stock market go a bit lower as part of a normal corrective process. As we move forward, there are a few key things we want to stress: 1) We have been through this before and corrections (and even mild bear markets) are normal parts of a secular bull market cycle. 2) Your financial plan and investment strategy take market volatility into account. We have selected a customized strategy for you that is diversified across nine asset classes. Only a portion of your assets are in U.S. stocks. The diversification of your portfolio is designed to dampen volatility. 3) We remain confident in the long-term strength and resilience of both the U.S. economy and the stock market and we do not believe there is a need at this time for any unusual or drastic action related to portfolio or investment strategy.

As always, if you have questions or concerns, please contact us.

S.R. Schill & Associates

December 7, 2018




Tuesday, November 20, 2018

Research Director Monthly Commentary, November 2018

Not A “Systematic” Correction

 Deep breath……aaahhh. As we’ve stated in the past, market corrections are normal and occur often. Looking back on the last 90 years, on average, corrections occur about once a year (we have been well below this average in the current 9-year bull cycle); the average correction is about 13% in magnitude (we are down about 10%); the average consolidation process following a correction lasts about 3-4 months (we are less than one month past the October 29 low).

We believe the current correction in stocks is due to a combination of factors, but primary among those are a valuation adjustment in tech stocks and concerns over the Federal Reserve getting too aggressive with raising interest rates. Secondarily, but also significant, have been concerns over the U.S. trade dispute with China and federal government policy uncertainty looking into 2019. The bulk of the correction has occurred in a fairly narrow area of the market, primarily the technology and energy sectors, so it does not appear “systematic”. Many sectors have held up well and the fact that the correction is fairly narrow in scope, at least up to now, is quite possibly a signal that this pullback is not something more serious. We also believe much of the selling is institutionally driven (hedge funds, bank trading desks, and computer-driven trading) which can  add significantly to intraday volatility. Algorithmic (computer-driven) trading is detached from fundamental investing and has led to greater market volatility.

As of now, the stock market as measured by the S&P500 is down about 10% from the September 20 all-time high, well within the bounds of a normal correction (a correction is defined as a pullback of 10-20%). We would not be at all surprised to see the market re-test the 2550 February and April lows, or even go a bit lower. This would be a normal technical re-test in a bottoming process. That said, we cannot, nor can anyone for that matter, forecast what the market will do in the short term. You will recall that we did take some steps to de-risk portfolios following our September 27 investment strategy meeting due to concerns primarily with tech stock valuations. We remain positive on the longer-term outlook for U.S. stocks, although we expect market volatility could remain elevated for a while longer. Looking into 2019, we believe the U.S. economy should remain healthy, corporate profits should grow in the range of 5-8%, inflation should remain moderate at around 2-2.3%%, and the Fed should move to a less hawkish stance on interest rates. One concern is the outcome of the trade dispute with China. We should have greater clarity on that after the G-20 summit in two weeks.

So what does this have to do with financial planning? Financial planning helps mitigate risk in a number of ways. It helps people identify and address personal financial risks. It helps people organize and better define their finances and financial goals. It also helps set an appropriate investment strategy. An appropriate investment strategy, which includes an appropriate allocation across several asset classes, helps to mitigate volatility and has shown to improve risk-adjusted returns. An example of how diversification benefits your portfolios is, over the past two months while the S&P500 is down about 10%, your short and intermediate term bond holdings have barely budged in price. Investment allocations should be set within the discipline of a financial plan in a rational and non-emotional way. Making sure your financial plan is up to date and re-balancing your portfolio to an appropriate allocation will go a long way towards helping to reduce risk and allowing one to sleep better during inevitable bouts of market volatility.

From all of us at S. R. Schill, have a very happy Thanksgiving !

Bob Toomey, CFA/CFP
Vice President, Research

Friday, September 28, 2018

Research Director Monthly Commentary: September 2018

Q4 Investment Committee Meeting Review

We held our Q4-2018 investment committee meeting on September 27. The key take-aways from the meeting are:  1) we continue to have a positive view towards equities; 2) we took some steps to modestly de-risk our U.S. equity exposure; and 3) our stance towards fixed income holdings remains unchanged.

The macro context for equities continues to remain positive due to a strong U.S. economy and continued strong corporate profit growth. The U.S. economy is showing broad-based strength across virtually all sectors. Consumer and business confidence remains strong and is driving healthy spending in those sectors. Employment is strong. Manufacturing is healthy reflected in rising orders and production and strong corporate cash flows are getting recycled into the economy by way of increased hiring and capital spending. We believe this bodes well for continued economic expansion. While the trade tariff issue continues to be a concern, the quantifiable impact of tariffs on the economy are modest and very small in actual dollar terms relative to total U.S. trade volume.

With respect the Federal Reserve’s recent increase in the Fed funds rate, this was expected and does not alter our assessment of Fed policy which remains essentially unchanged. At this point, Fed policy continues to remain gradualist and accommodative to the financial markets. At some point this may change, but we believe it is a ways off, especially if inflation remains low to moderate. We expect there will be some increase in inflation over the next year but we believe it will remain modest, perhaps 2.2-2.5%, and certainly not 1970s-style inflation. Low inflation should allow the Fed to remain gradualist in its policy and thereby should not be overly disruptive to the financial markets, at least near term.

On a relative basis, we still believe U.S. equities remain the most attractive of the major developed markets and we therefore continue to overweight our U.S. equity exposure and underweight international. While the U.S. economy is clearly in the most stable condition of major world economies, of late emerging market economies have suffered due to uncertainties surrounding the trade tariff issue.  The Eurozone economies continue to plod along at modest 2% growth and we do not see much upside to Eurozone growth.

We have become somewhat more concerned of late about stock valuation. Valuation is “high” by a number of measures. While a high valuation does not imply an imminent decline or rollover in the market, we believe it is prudent, given our concern, to address valuation risk in your portfolios. A couple of the steps we are taking this quarter to mitigate valuation risk include: 1) increasing weightings toward value stocks; 2) adding a position in the U.S. telecom sector ETF (IYZ) which we believe offers lower valuation and reasonable risk/reward. Taken together we believe these actions place more of your equity investments into sectors that offer lower valuations and lower downside risk in the event of a market decline. Within commodities, we added an investment in the metals and mining sector (XME) as an inflation hedge. Overall, our equity exposure was reduced very slightly. There were no changes in our bond holdings nor were there any significant changes in weightings within the three fixed income sectors. We expect interest rates will continue to rise gradually and we therefore continue to maintain the lowest possible exposure to long bonds while keeping overall bond duration at the low end.

Robert Toomey, CFA, CFP
Vice President, Research

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