Implementing Our Current Trigger To Reduce Equity Exposure

As you are aware, at our quarterly investment strategy meetings not only do we discuss market and economic factors that might impact investment strategy, we also set triggers that require us to take some action (either buying or selling) based upon some future possible event or occurrence. This is done to allow us to set action or policy in a non-emotional or knee-jerk fashion should the event actually occur and is also a way to manage investment risk. Normally, when we set these triggers, we do not expect the event to occur or believe there is low probability of it occurring; but if it does occur, it would have a material implication for investment strategy.

At our last quarterly investment meeting on March 27, one of the triggers we set was to reduce equity exposure to the low end of the investment range in our models in the event President Trump imposed the full 25% tariffs on imports from China. As of this morning at 12:01 a.m., those 25% tariffs went into effect. We have therefore, as of this morning, reduced equity allocations in all of our models to 90% of a normal allocation and have implemented this change in your accounts as of this morning. Of note, we have only implemented (“pulled”) an action trigger perhaps once or twice before in the history of the firm, so these events are very rare.  

We had been of the belief that there would be some sort of trade agreement and still believe there very well may be one in the not too distant future. As you know, a lot of this is “posturing” on the part of both Trump and the Chinese and we believe Trump’s implementing the increased tariffs is a negotiation ploy. Both sides are engaging in negotiating ploys and neither side wants to appear weak. Our concern with the higher tariffs is that it would have a dampening effect on economic growth and therefore, it would have a negative impact on U.S. corporate profits which is the key fundamental driver of stock prices. We will be following the trade situation closely.

S.R. Schill & Associates

May 10, 2019

Research Director Monthly Comment For March/April 2019

2Q Investment Strategy Meeting Summary

 

We held our Q2-19 investment strategy meeting on April 2. The meeting was of particular significance for a couple of reasons: 1) update to our investment strategy, 2) important changes in how we utilize and invest our investment models (more about that later).

In terms of the investment landscape for U.S. stocks, it has improved in the past few months. Why? Largely because investors are feeling more positive about Federal Reserve policy and the prospects for some sort of trade agreement with China. As you recall, the market experienced a severe pullback in the fourth quarter of 2018 driven by concerns that Federal Reserve policy would remain too restrictive and that trade negotiations with China were falling apart. The stock market actually experienced a “bear market” (a 20% decline measured by intraday high and low) in Q4, officially marking the fourth “bear” market pullback in this cycle (which began in 2009). While your portfolio may have experienced a (temporary) decline in this market pullback, diversification of your investments across several asset classes helped to reduce the drawdown in your accounts.

So far this year, the stock market has risen about 15% and appears to be poised to reach new highs in the near term driven by improved sentiment around Fed policy, the China trade deal, and higher second half corporate profits. Our concerns in the last quarter over an inverted yield curve appeared premature; not only has the ratio we were watching (10-yr/2-yr Treasury) not yet inverted but also the yield curve (which measures interest rates along the entire maturity spectrum) appears to be steepening of late. While we believe interest rates have probably bottomed near term, we do not believe an overheating economy or Federal Reserve policy will cause rates to rise dramatically. This is supporting a positive environment for stocks and helps to support our continuing positive outlook for stocks. Short of a dramatic increase in interest rates, which we do not expect, we believe returns on bonds will remain below historic averages for the foreseeable future.

As a result of our deliberations, our overall allocation to equities increased by about 4.5% due largely to higher allocations to small cap stocks and REITs. Overall allocation to bonds increased very slightly due largely to reduced exposure to intermediate maturity bonds and increased exposure to shorter maturity bonds to capture the income potential of rising short term yields. Within equities, we continue to maintain sector investments in health care technology through IHI (iShares Medical Devices ETF), telecommunications, and medical-related real estate through our holdings of Medical Properties Trust (MPW). We put considerable effort and time in this quarter’s meeting into improving our investment model by simplification and streamlining of holdings and sector investments. We expect this effort should improve the efficacy of our investment process with the objective being improved performance in your accounts and in achieving your investment goals.

Robert E. Toomey, CFP/CFA

Vice President, Research

 

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

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

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

 

 

 

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

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
9/28/18