Tuesday, December 26, 2017

First Quarter Investment Strategy Meeting Summary


We held our first quarter investment strategy meeting on December 20, 2017. As you know, at these meetings we discuss and analyze factors that affect our investment outlook and holdings in your portfolios. The primary outcome of the deliberations resulted in an increased weighting in small and mid-cap equities and a slight reduction in our macro allocation to bonds. There were no significant changes in the securities we are using for sector representation except for REITs in which we added two securities, a medical REIT and an industrial REIT, in order to further reduce exposure to the shopping mall category.

With respect to macro issues, we think the main drivers of the stock market remain positive looking into 2018. The U.S. economy, which is currently strong, appears poised for another strong year of growth. Employment and consumer spending remain strong. The consumer sector represents about 70% of the economy. The corporate sector is also in a strong position relative to both earnings and cash flow. We expect another strong year of corporate earnings growth in 2018 with potential for an acceleration in capital spending, which would add additional fuel to the economy. These factors are the positive underpinnings for stock prices. Continued low to moderate inflation, transparency of central bank policies, and a synchronized global recovery are also factors that support the positive outlook for stocks.

Despite these positives, there are some concerns or risks in our outlook. First, is the risk for an acceleration in inflation. As of now, we expect inflation could rise modestly in 2018 to potentially to 2.5% from less than 2% currently. We believe if we are wrong and inflation accelerates to the area of 3% or more, this could result in several problematic events: the Fed could accelerate its pace of interest rate increases; inflation concerns among investors could result in a decline in valuations for financial assets; and both of these events could precipitate a market correction. In addition, stock valuations are elevated: at about 18.5x forward earnings, the S&P 500 valuation is now about 23% above its long-term average valuation of about 15x. We would not be surprised to see some increased volatility in stocks in 2018 but as of now, we still expect stocks can continue to rise in 2018. We continue to believe returns for bonds will be below average due to rising interest rates.

Of course the new tax bill was a major topic of discussion at our meeting. I will not go into a detailed review of the bill but suffice to say that the bill does appear to be a net positive for both the consumer and corporate sectors. Most consumers should see some net benefit from the tax bill as all tax brackets were reduced by about 10%.There will certainly be situations where individuals have a tax configuration in which they do not benefit, but we think this will prove to be a relatively small portion. From the corporate side there are several features that are particularly positive in our opinion: a 40% reduction in the tax rate, elimination of the corporate AMT, and allowance of immediate expensing of capital expenditures. Not all of this benefit will be immediate. It will take a couple of years for the tax law changes to be fully felt; but net net, the new law should release material new capital into both the stock market and the economy which should be positive for growth. The downside to the bill, of course, is the potential risk of rising federal deficits. The two most recent examples of tax rate overhauls were in the Kennedy and Reagan administrations. In both cases, the several years following the tax overhauls resulted in strong economic growth, a rising stock market, and reduced federal deficits. Time will tell if this tax overhaul results in a similar outcome.

Robert Toomey, CFA/CFP
Vice President, Research

Thursday, December 14, 2017

Research Director Monthly Comment- December 2017


The Market Prediction Game

 It is that time of year and Barron’s magazine this week ran its annual “market forecast” issue in which the Wall Street brain trust (market strategists) makes their predictions about stock and bond returns for the coming year. Earlier in my career I used to consider this a very important and prescient article but over the years have come to discern that the accuracy of Barron’s group of strategist predictions are usually about in line with the broad averages of market predictions: about 50-50; or in other words, about the equivalent probability of a coin toss.
 
Given where we’ve been over the past nine years, the article seemed more like entertainment. This is not to put these folks down. They are all bright, highly credentialed, hard working, and have a high level of knowledge in their field. They are making reasoned educated guesses and some of those will be correct (or close). But the nature of the forecasting game is the markets have an uncanny way of fooling the great majority of investors (or investor “consensus”). And just because you are dying to know, here are the fearless consensus 2018 forecasts for several key market variables:

                Stock market total return: +7%

                Yield on 10-year U.S. Treasury on December 31, 2018: 2.8% (current: 2.35%)

                Corporate profit growth: +10%

                U.S. real GDP: 2.6%
Our take on all this? We generally agree that fundamentals for stocks remain positive for a number of reasons. There do not appear to be excesses in the credit or bond markets that would precipitate a major market adjustment. While aggregate stock valuation is elevated at about 18x forward earnings, we do not believe it is at such an extreme level that it would prevent the market from rising further. What are some of the risks? 1) that inflation is higher than expected; and 2) market sentiment is quite bullish now, which can be viewed as a negative “contrary” indicator.

 

Where do we put our energy? So what’s the point about market prognostications? It is the fact that over long-periods of time, it has been shown that both short-term market forecasting and market timing activity associated with this forecasting is difficult if not impossible and the best place for us to place our energy in managing our client’s capital is a) managing risk, b) setting appropriate portfolio allocations, and c) working diligently to select the best investments to achieve client financial plan objectives. It has been shown that diversified portfolios can and should deliver higher risk-adjusted returns than all-equity portfolios over time because they are inherently less volatile and, as a result, returns are more stable. This is extremely important for both financial planning and risk management and especially important for older clients who are not in a position to suffer a serious asset drawdown.

 

Robert Toomey, CFA/CFP

Vice President, Research

December 14, 2017