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.
3/29/18
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