Fourth Quarter Investment Strategy Highlights

We held our Q4 investment policy meeting on September 21, 2015. There were some meaningful changes in our policy following this meeting, which will be reflected in your portfolios.

One of more significant considerations at our meeting was the recent decision by the Federal Reserve to postpone its long-anticipated increase in its Fed funds target range, a decision which has numerous implications. The primary reason for the Fed’s “non-move” was concern over the pace of global growth, which does appear to be slowing due to the slowdown in the Chinese economy. The implication of this is that both interest rates and inflation may remain lower for a longer period than we and other investors expected. In its deliberations, the Fed also reduced its forecast for inflation, estimated global growth rates, and pace of future interest rate increases. All of this implies further continuation of what some have dubbed the “new normal”, a euphemism for an extended period of low growth and low inflation. Other key considerations in our meeting revolved around relative exposure to “growth” versus “value” sectors of the market as well as U.S. versus international exposure.

We now expect an increased level of volatility in the equity markets over the near term primarily due to heightened concerns over global growth, risk of associated slowing in corporate profit growth, and lingering uncertainty over Federal Reserve policy. We believe these factors have increased the near-term risk of some further downside in the stock market and we have taken action to address this risk, discussed below. We continue to remain positive about the long-term outlook for the U.S. economy and stock market and we do not believe this derails the secular bull thesis; however, we felt it prudent to make these adjustments in managing risk in your portfolios.

With respect to changes in your portfolio, we reduced equity exposure by about 5%, on average, reflected in a lower allocation to all equity sectors, both domestic and international. Within equities we raised our allocation to growth stocks versus value stocks because we believe growth companies can maintain stronger relative earnings growth in a slower economy and maintain a higher relative valuation. Our real estate and commodity/natural resource exposures were also reduced slightly; however within natural resources we increased exposure to energy (primarily oil) as we believe it offers good relative value. We maintained exposure to health care, financials, and home builders as we believe they still represent attractive secular growth opportunities. Within the fixed income sector, we slightly increased our overall exposure while increasing our effective duration (time-weighted average maturity). As we now believe rates will stay lower for a longer period than we previously expected, we believe this implies better returns for longer-maturity bonds than we previously expected warranting some lengthening of duration. 

Q3 Outlook and Meeting Summary……”Transition Period”

We held our third quarter investment strategy meeting on June 26. We see the financial markets in a transition period as we move into a new phase of Federal Reserve policy. A new regime of rising interest rates, when that occurs, would change the investment landscape somewhat. Based on the history of previous rate cycles, we believe stocks can continue to rise in an environment of rising interest rate.

Uncertainty over the timing of the Fed rate increase and a slowing in corporate earnings growth have kept a lid on the stock market so far this year. As of this writing (June 29), the stock market as measured by the S&P500, is flat year-to-date on a price basis. As we have mentioned previously, we expect stock market returns going forward will be lower than the past 5-6 years largely due to lower expansion in equity valuations. A resumption of corporate profit growth later this year and in 2016 should support higher stock prices despite less tailwind from valuation expansion.

A big question now is what would a Fed rate increase mean for stock and bond prices? Based on history, stocks should do OK, in our view. Looking back on five previous Fed tightening cycles, stocks outperformed bonds. Stocks rose on average by 14% during the first year of the cycle and 16% over the entire cycle. We believe a gradual tightening should not be an impediment to further rise in stock prices assuming reasonable earnings growth and continued moderate inflation. Bonds typically underperform in a rising interest rate environment.

In term of meeting outcomes, we have maintained an overweight exposure to stocks in all major categories. One significant change in the large-cap sector was the sale of technology stocks (XLK) and replacing them with a position in financial stocks (XLF, primarily large banks and insurance companies), which we believe offer attractive relative value. Within the developing equity sector, we added a position in U.S. homebuilder stocks (ITB) as we believe the sector is poised to show above average growth over the next several years. Within fixed income, our allocations remain essentially unchanged (underweighting long bonds), however we introduced a position in the PIMCO Total Return actively managed bond ETF.

A note on Greece: As of today, it appears negotiations on Greek debt payments (to meet a June 30 deadline) have failed, and it now appears Greece will default on its debt. Greece represents a very small portion of the developed world debt and economy and, therefore, we do not believe a Greek default would have significant repercussions in other larger economies. The greater concern is that Greece could pull out of the Eurozone and set a precedent that could be repeated by other Euro area countries. As of now, we believe the probability of both a Greek exit (from the Eurozone) and that event being repeated by other Euro are countries is very low. Therefore, as of now, we have not taken specific steps to hedge an event such as this. We believe the situation with Greece will eventually be settled and as of now, we do not see sustaining ramifications that would cause us to materially alter our strategy.

June 29, 2015

 

 

Q2 Investment Strategy Meeting

We held our second quarter 2015 investment strategy meeting on March 24. The most notable changes following the meeting were an increase in exposure to European stocks and modifications to our fixed income strategy.

We remain constructive on the outlook for U.S. stocks but recognize volatility has increased in 2015 and we expect volatility will most likely remain elevated in the near term for a number of reasons. The reasons for the increased volatility so far this year include heightened uncertainty over Federal Reserve policy, a temporary slowdown in corporate earnings growth, and uncertainty over the health of the global economy. Going forward, we think returns on U.S. stocks could be more moderate (mid to high single digits) compared to the 15% annualized returns experienced over the past five years.

U.S. economic fundamentals remain constructive. We expect another year of moderate 2.5-3% real GDP growth in 2015 with continued moderate inflation. With improving job growth, lower oil/gas prices and strong dollar, we believe U.S. consumers are in a stronger position to increase spending, which should support economic growth and an acceleration in U.S. corporate profits in 2H-15.

Investors were highly focused on the March FOMC meeting for indications of future direction of Federal Reserve policy. In our view, the meeting supported continuation of the Fed’s gradualistic policy and it now appears any rate increase by the Fed may be pushed out. We expect the Fed will attempt at least one rate increase in 2015, most likely in the fall; however we do not expect this rate increase to have a lasting impact on stocks as it is highly anticipated and, historically, the first few rate increases in a tightening cycle have not derailed a cyclical bull market.

The primary change to your portfolio this quarter was a slight increase in allocation to equities through increased exposure to international stocks. We introduced a holding in large European stocks as we believe Europe is undergoing an improvement in economic and monetary conditions, both of which should support higher valuations for quality European stocks.

Our macro allocation to bonds remained essentially unchanged. Our current strategy in bonds is to underweight long-maturity bonds and overweight short-maturity. We believe it is prudent to position your portfolios for the eventual rise in interest rates which, typically causes more volatility in long bond prices, thus our underweight in this sector. Our overweight in short bonds reflects the fact that short bonds tend to be less sensitive to rising rates and currently present an opportunity to capture a rising income stream as maturing bonds get rolled into higher yielding bonds once interest rates begin to rise.

 

3/27/2015

Summary of our 1Q-15 Investment Committee Meeting

We held our first quarter 2015 investment committee meeting on December 18. We continue to “stay the course” in maintaining a fairly full exposure to stocks. We believe U.S. stocks continue to offer the most attractive risk/reward among global markets. This is based on our positive outlook for the U.S. economy and corporate earnings and continued low inflation. Growth of the U.S. economy remains the strongest of the developed world economies. We expect U.S. real GDP growth in 2015 of about 3%, compared to virtually zero growth in the Eurozone. Both China and many emerging markets are experiencing slowing in growth. Relative growth of U.S. corporate earnings should remain a positive factor in 2015.

The Federal Reserve continues to remain accommodative of economic growth. While we expect the Fed to begin raising interest rates in 2015, we expect this increase will be a) later in the year and b) gradual and well telegraphed. We do not share the concerns of some that a change in Fed policy will cause a significant upset to financial markets,  particularly if inflation remains low and corporate profit growth remains sound, both of which we expect as of now.

With respect to recent stock market volatility, we note that volatility is a normal element of all financial markets. The mid-December pullback in the stock market was about 5% and well within the normal range of day-to-day, week-to-week volatility going back many years. It seemed worse because of the coincident plunge in oil prices. That said, we think the cyclical bull market is maturing and we do not expect stock market returns going forward to be as strong as the past 5-6 years. Valuation, for one thing, is now above the long-term average and will not be the tailwind it has been for the past six years. We expect market growth going forward will mostly be driven by earnings.

We spent more time this quarter in deliberating our bond investment strategy. As we’ve explained previously, the conundrum (balancing act) facing bond investors is maintaining income in a very low rate environment while protecting against capital risk associated with rising interest rates. We have implemented a structure that underweights the long end of the curve and overweights shorter duration while also holding bonds or bond substitutes (such as utility stocks) that support portfolio income. With respect to equity investments, within U.S. exposure, we increased our weightings to large and mid-cap value (higher dividend-paying) stocks and also increased exposure to real estate. We slightly reduced aggregate exposure to international stocks and held steady our exposure to commodities, primarily in the areas of energy and forest products.

Daily Bullets…..for October 7, 2014

·         IMF again reduces growth outlook…The International Monetary Fund today reduced its global growth outlook with most of the weakness centered in Europe, particularly Germany, Italy, and France. The announcement also had some rather alarming language pertaining to potential for a stall in the recovery, acceleration in deflationary trends, and risks of market plunge once the U.S. Federal Reserve starts raising interest rates.

What’s the point? We believe today’s announcement by the IMF is the primary factor contributing to today’s stock market weakness. As we have mentioned in previous posts, the European economy remains in a deep funk and the IMF report just confirms this. Deflation continues to be a major risk for the Eurozone economy. Japan went through a period of sustained deflation, so it can certainly happen. While Eurozone monetary policies might be highly accommodative, the mechanisms to transmit the policy to the economy (such as credit) are highly stunted to non-existent in Europe currently. A key concern for investors is renewed possibility of recession in Europe which could act as a drag on the entire global economy, and thereby slow corporate earnings growth, a key driver of stock prices. The good news is U.S. companies generally remain in excellent condition financially and are generating record levels of free cash flow. This should be an important factor in supporting U.S. stocks, along with the prospect of a strengthening U.S. dollar.

Link: http://www.reuters.com/article/2014/10/07/us-imf-economy-idUSKCN0HW15Y20141007

 

 

Daily Bullets……for September 29, 2014

·         Steady outlook for economy……..The latest National Association for Business Economists (NABE) forecast was released today. The results point to continued steady economic growth led primarily by business and government investment and growing export trade activity.

What’s the point? The NABE survey is a good one because it reflects the views of private sector economists at large businesses, and not Wall Street economists. This is good, in our view, because NABE economists are closer to what is really happening in the economy through their businesses. The article in the link discusses the outlook for various sectors, but a key point is there appear to be no big surprises in the general outlook, which is in line with our view: moderate real GDP growth of 2.5%-3%, with inflation of around 2% (what we’ve dubbed the “3+2” economy). In general, this scenario remains a positive backdrop for financial assets, particularly stocks, and is probably more neutral for bonds.

Link: http://money.msn.com/business-news/article.aspx?feed=AP&date=20140929&id=17967495

 

·         Evans comments assuring on Fed policy……Chicago Fed president Charles Evans spoke this morning at a meeting of economists and reiterated his belief that the Federal Reserve will remain patient and restrained in raising interest rates, even if it involves the risk of inflation running modestly above the Fed target of 2% for period.

What’s the point? We think Evans’ comments most likely reflect the current majority view of the FOMC, and echo recent comments of Fed Chairwoman Janet Yellen. While the U.S. economic growth does appear to be accelerating somewhat, as the above comments on the NABE survey indicate, moderate growth is still expected and Europe remains in a severe funk with deflationary implications. The Fed thinking is probably that the economy gives them the latitude to keep monetary policy more loose than they otherwise might at this point in an economic recovery and, in fact, this may still be of necessity. The point for financial markets is essentially “more of the same”: an accommodative Fed policy is positive for stocks, in particular. The big questions concerning investors now are “how fast does the economy accelerate?” and “to what extent does the Fed accelerate the reduction of accommodation?” Our thought is gradualistic changes in policy accomodation, which we expect, should not be overly disruptive to the financial markets. Under this scenario valuations should hold up if not increase somewhat.

Link: http://money.msn.com/business-news/article.aspx?feed=OBR&date=20140929&id=17968890

Q4 Investment Strategy Meeting: More “3+2”

We held our Q4 investment strategy meeting on September 16, 2014. The environment for the financial markets has not changed significantly since our last meeting in June and we believe the stock market outlook remains favorable for the longer term.

Economic growth in the U.S. remains steady and, while we expect the pace of growth to accelerate, we do not expect a level of growth that would cause significantly higher inflation or interest rates. The bond market has confounded predictions this year, with 10-year Treasury yields actually declining about 20% due to slower than expected growth in Europe and emerging markets and foreign capital seeking higher returns in U.S. bonds. The European economy remains weak which is contributing to slower-than-expected global growth.

Within this backdrop, we believe Federal Reserve policy will continue to remain accommodative. This was confirmed at the Fed’s recent FOMC meeting in which the Fed voted to maintain a “highly accommodative” monetary policy and reiterated its guidance to maintain very low interest rates for an extended period. Fed policy continues to be a positive for financial assets.

U.S. stocks remain in a stable uptrend. The current “3+2” environment (3% GDP growth, 2% inflation) is favorable for U.S. stocks which we believe remain positioned for further gains over the longer term. In the short term, we remain of the view that risks of a market correction are elevated due to increased bullish sentiment, narrowing breadth, and increased valuation. We have taken actions following our past two strategy meetings to hedge this risk by slightly reducing our equity exposure.

With respect to investment strategy, there were no major changes in our sector allocations following the meeting. Within equities, we slightly increased exposure to large cap stocks. Within this sector, we continue to favor quality dividend-paying stocks as well as health care and technology due to their strong secular growth prospects. Our exposure to developing equity (small and mid-cap stocks) remained essentially flat and slightly underweighted due to high relative valuations. Our exposure to international equities was reduced slightly in favor of a higher U.S. allocation, while exposure to REITs and natural resources remained virtually unchanged.

Our allocations within fixed income were essentially unchanged. We remained at the low end of our allocation with respect to long bonds as these remain most sensitive to a rise in interest rates. We increased our exposure to intermediate maturity bonds, mostly through increased utility stock exposure. Our exposure to short-term bonds remains above normal due to increased risk of an increase in interest rates or unexpected change in Federal Reserve policy.