Q4-17 Strategy Meeting: More Goldilocks

We held our fourth quarter investment strategy meeting on September 27. I titled this commentary “Goldilocks” because right now we have a set of conditions in the financial markets that are positive for stocks….not too hot, not to cold, but just about right: stable economic growth, growing corporate profits, expectations for continued low inflation, and still highly accommodative global monetary policy. By implication, we believe this set of factors is supportive of higher stock prices in the near term. That said, there are some concerns in the overall picture such as above average valuations and geopolitical factors (e.g. North Korea); but at the moment, we do not view these as serious enough to offset the generally positive conditions for stocks.

 One factor on which we spent some time was the possibility of a policy mistake by the Federal Reserve. The Fed has gotten itself into a difficult position having reduced interest rates to a well below normal level; however, it did not anticipate that inflation would remain as low as it has. This raises a question of gauging how fast the Fed should raise rates: raising them either too fast or too slowly both raise some problems for the economy and financial markets. We believe the Fed is aware of these problems and we believe it will most likely pursue a gradualistic policy that should not destabilize the financial markets. We expect the Fed to raise the Fed funds rate in December and again in the spring of 2018.

We discussed the situation in North Korea and the broader issue of “black swan” events. The problem with geopolitical “black swan” events is that, by definition, they cannot be predicted and therefore hedging for a specific “black swan” event is virtually impossible. We did not take any hedging actions specifically related to North Korea but we did set a trigger which would require that in the event North Korea takes military action against another sovereign nation, we would reduce invested capital to its lowest allocation in our models. We also set a trigger in the event inflation goes higher than we expect: it is a “combination” trigger that would cause us to reduce investment exposure in the event  that 1) inflation measured by “core” CPI rises above 3% and 2) the yield on the 10-year U.S. Treasury bond goes above 3%.

With respect to changes in our investment holdings, we continue to maintain a tilt towards value stocks because we believe 1) valuations are high for “growth” stocks and 2) value stocks tend to be do better in a rising interest rate environment. We also maintain an overweight position in international equities in part because of their lower valuations relative to U.S. stocks, particularly Europe. Tilting our holdings toward value stocks also acts as a way of hedging against potential market volatility as “value” stocks tend to be lower volatility in nature due to their perceived stronger cash flows and higher dividend payouts.

In line with our tilt towards value stocks, we added positions in the health care and financial sectors. Health care remains a very positive secular growth story and financials should benefit from rising interest rates. Within fixed income, we continue to underweight long bonds and overweight short maturities in order to keep durations on the shorter end. In the long bond area, we added a position in preferred stocks as a way of increasing income in this sector.

 

Bob Toomey, CFA/CFP

Vice President, Research