Q3 Investment Committee Meeting Summary

We held our third quarter Investment Committee meeting on June 27. There was general agreement on a number of issues following our meeting, namely: we believe the U.S. economy continues in a slow but stable recovery; we believe inflationary pressures remain low; we continue to hold a positive view towards equities; we believe equity market leadership is shifting from a value/yield focus to growth; and general agreement that investor psychology toward interest rates is shifting to the view that a more sustained rise in rates is increasingly probable.   

Our longer-term view towards equities remains positive. We believe stocks should continue to perform well in a rising interest rate environment as long as 1) inflation remains moderate and 2) Fed policy remains gradualistic. We think leadership in stocks is shifting away from yield-oriented or value, to growth.  We think growth stocks can do better in a rising interest rate environment because of their perceived ability to grow both earnings and dividends at an above average pace.

Within equities, we meaningfully changed our allocation in favor of growth. We eliminated our holdings of higher yield stocks and added new positions in technology and dividend achiever stocks. These groups have the attributes of very large cash positions, attractive valuations, and large growing cash flows which place them in a position to grow dividends at an above average rate. We also increased allocations to small and mid-cap growth, which have historically delivered higher returns than large caps and we expect should do well in an environment that favors growth.

Within bonds, we reduced our exposure to intermediate bonds, slightly increased our exposure to short-term bonds, and repositioned our long-term bonds by substituting preferred stocks for long corporates. The preferreds provide a significant boost in yield and have demonstrated lower volatility. Our allocations to intermediate and long-term bonds are now at the low end of our allocation range while our allocation to short term bonds is neutral within our allocation range.  

Rising Interest Rate Concerns

Of increasing concern for the stock market of late has been anxious focus on the potential wind-down of the Federal Reserve’s long-standing monetary policy known as quantitative easing, or “QE”. QE has involved massive bond purchases by the Fed to keep interest rates low and stimulate economic growth. Some investors are concerned that ending this program would result in a rapid rise in interest rates which would be damaging for the valuations of financial assets, especially bonds.

While there is a clear and visible risk for bonds in a rising interest rate environment, history shows this is  not necessarily the case for stocks. Historically, stocks have been able to overcome rising interest rates and continue to appreciate in the face of rising interest rates. We recently analyzed seven (rising) interest rate cycles going back to 1967. What we found was that, on average over these seven rate cycles, the stock market was up 7.7% in the twelve months and up 17.7% in the twenty-four months following the bottom in rates. 

Why would stocks go up during a period of rising interest rates? There are several reasons for this:

1.       In most of the periods analyzed, the economy was either strong or recovering and, therefore, corporate earnings were rising.

2.       Stocks are viewed as a hedge against inflation because corporations can raise prices for their products and pass some of this on to investors via growth in earnings and dividends.

3.       Growth companies have greater potential to increase their book value faster than inflation and thereby provide better return potential relative to fixed income investments (i.e. bonds).

From a financial planning perspective, the analysis leads us to believe that this cycle should probably not be much different from earlier cycles. There may be a period of market “turbulence” or even a market correction as the Fed begins to taper its QE program; however, as of now, the economy appears to show little sign of recession, we believe corporate earnings will continue to grow, and we expect inflation will remain moderate. This leads us to conclude that equities, particularly growth stocks, should continue to remain an important component of a diversified portfolio.