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
3/29/18

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