Investment Commentaries: Second Quarter 2018

Index Returns	2nd Quarter	Year to Date	Trailing 12 Months
S&P 500 US Large Cap Index	3.3%	2.6%	14.3%
MSCI All Country World Stock Index	0.0%	-0.8%	10.6%
Barclays Capital Aggregate Bond Index	-0.2%	-1.7%	-0.4%
US Core Consumer Price Index - (Inflation)	0.4%	1.2%	2.2%

Markets remained volatile during the second quarter, with mixed performance across asset classes leading to lower returns in most market-segments than investors have come to expect after a relatively longer period of historically higher returns and lower volatility. Our view in short, is that increasingly divergent economic and market indicators now suggest that a notable shift is under-way, requiring investors to choose between chasing the returns of the past and preparing for the uncertainty ahead. 

Primary US stock indices increased modestly during the second quarter, while benchmarks for bonds and non-US stocks both declined.  Markets continued to adjust to increasingly strong headwinds related to global trade tensions; the winding down of quantitative easing by global central banks; and tightening monetary policy in the form of increasing interest rates in the US. The few small pockets of market strength resting atop a weakening cyclical core suggest that vigilance and a focus on quality are more important now than ever.

The Economy: Moderate rates of economic growth both domestically and abroad continue. The Fed’s decisions to continue raising short term interest rates at 0.25% intervals with inflation now consistently trending above 2%, and unemployment below 4% signals that Fed governors believe the economy is strong enough to handle tighter financial conditions. We are encouraged to see most other indicators, such as consumer spending, corporate profits, housing inventory, and building permits continuing to flash green, but a few key indicators are beginning to reach levels that have historically indicated that an economic expansion is at-risk of becoming over-heated:

1. Gross Domestic Product (GDP) Output Gap: The output gap is a measure of potential GDP relative to actual GDP. Potential GDP is economists’ collective opinion of how productive the economy can be, given all its inputs. The theory is that an economy cannot sustainably exceed its potential without falling back to or below a more reasonable level at some point. The chart to the right demonstrates that the output gap usually turns negative prior to the end of an expansion/beginning of a recession (areas shaded gray). The timing of the recession is uncertain, but it has historically been a reliable indicator.
    
2. Employment Gap: Similar to the output gap, the employment gap measures actual unemployment against what economists collectively believe to be minimum unemployment. Although less reliable than the output gap, the employment gap also typically turns negative at the end of an expansion, signaling that the labor market may be over-extended.
    
3. Flattening Yield Curve: Economists and investors also view a negative spread between the 10-Yr and 2-Yr Treasury yield, a measure of yield curve steepness, as a leading indicator of recessions. While that figure is not negative yet, it is approaching zero, and we are watching it closely.

Anecdotally, in recent client meetings with business owners, we have also been asking about any notable changes at the micro-level that could indicate shifting dynamics in the broader economy. One client that operates a fleet of trucks that haul aggregate regionally informed us that orders of new trucks were projected to be delivered in early 2019 - a wait time of six or more months compared to eight weeks in 2012. This is good news for the truck manufacturers, but overall it is another possible indicator of overheating.  We have heard similar stories from several of our business-owner clients recently.

None of these indicators are fool-proof, and plenty of data-points suggest the economy is not currently headed for a recession. That said, the over-confidence of governments, large businesses, and markets largely detached from the dynamics of daily economic activity in the months preceding recessions contributes to their severity.

If recessions were reliably predictable, we would have learned how to avoid them by now.

Markets: As the chart below illustrates, aside from US Equities and Commodities, most asset classes have declined year-to-date. Emerging Markets stocks have been hit the hardest, falling -7.4% so far amid the combined impacts of the looming threat of US trade tariffs, and a strengthening dollar. Developed markets in Europe, Australia, and Asia have also declined, albeit less-so, for many of the same reasons.

The chart below demonstrates the direct impact of dollar-strength on the value of non-US stocks owned by US investors. The value of foreign stocks to US investors declines when the value of the dollar strengthens against other economies’ local currencies for the same reason it can be an advantage for US tourists to travel overseas when the dollar strengthens:  it takes less dollars to buy the same item, even if that item’s price has not changed in the local currency. The less-directly-measurable impact of the strengthening dollar will be its impact on emerging market economies to service dollar-denominated debt, which becomes more difficult as those countries must convert more of their local currency to dollars in order to make interest payments.

Most major categories of bonds have also declined this year, partially due to the Fed-driven rise in interest rates (when interest rates rise, bond prices decline), and partially due to investors’ over-reaction to the reality of continuing rate increases by the Fed.  While we have worked to limit portfolios’ exposure to longer-term bonds, which are more sensitive to rising interest rates, client-portfolios have been impacted by allocations across bond sectors. We believe bonds are an important part of balanced portfolios. They have historically exhibited less volatility than other asset classes, but they are subject to the same forces as stocks when it comes to investor-behavior. classes, but they are subject to the same forces as stocks when it comes to investor-behavior.     

As previously mentioned, US stocks are one of the few bright spots for portfolios so far this year. Yet, their moderately positive performance in aggregate masks the disparity of returns amongst specific market categories and individual companies. 48% of the companies and six out of ten sectors represented in the S&P 500 have delivered negative returns year to date. While the index’s return remains positive for the year, it has yet to return to levels from late January, prior to the start of the correction.

For the year so far, we have observed the emergence of “concentration” as a major theme that has gone mostly undiscussed. Positive return is concentrated in US stocks, with that performance in turn concentrated in a couple of sectors, within which returns are further concentrated in a handful of individual stocks. For example, the Consumer Cyclical sector represents 61% of the year-to-date (i.e. “YTD”) return of the S&P 500 index. Within that sector, 64% of the return is attributable to one stock: Amazon, Inc (AMZN).  The result is that Amazon, which represents approximately 2.5% of the overall S&P 500 index’s market capitalization, represents almost 40% of the index’s YTD return.

In such an environment, it can be difficult not to regret missing out on the rise of a stock like Amazon when it has driven so much of the market’s overall gain in the short term. While most of our clients’ diversified portfolios have exposure to Amazon through a Consumer Cyclicals sector ETF, it is not part of our individual large cap stock portfolio because it has not and does not meet our selection criteria. For example, while Amazon is experiencing significant growth, its Price-to-Earnings ratio based on analyst estimates (which are highly positively biased) is 134.9x compared to 16.1x for the S&P 500 in aggregate. Even considering top-line growth, Amazon currently trades at 4.4x’s its Revenue compared to an average of 3.2x’s for its sector.

No matter what valuation metric one chooses, Amazon’s price suggests it is either over-valued, less risky than a US Treasury bond, or able to grow at four or more times the rate of US GDP in perpetuity. But, if we hypothetically abandoned our process in order to buy stocks based on their recent performance, Amazon would still not be at the top of our list, as it has underperformed ten other stocks in the S&P 500 year-to-date.

The top performer is a medical device company named Abiomed (ABMD) that is up 118% so far this year. It is most likely not the topic of dinner conversations like Amazon is, yet it has returned over twice as much over the same time-period. Of the 11 analysts that follow it, nine currently rate it as a buy, even though their own price targets suggest upside of only 1.41%. While somewhat non-sensical, it could also be an indication of those analysts’ broader opinions on the market.

A significant challenge for us as portfolio managers in this type of environment is balancing short-term opportunities against exposure to a significant downturn in equity markets.  In a June 30th Barron’s article ominously titled “Why the bull market could end in 2020” the author offers "If nothing else, it’s time for investors to think about the types of companies they own, and to begin shifting away from the riskiest and most indebted toward those better-positioned to withstand a downturn.” We would argue that those characteristics are important at all times rather than just now, and that even stocks that are fundamentally strong can suffer as much if not more than the market if they are priced for perfection heading into a period of uncertainty.

As we have seen over the year to date, conditions can change quickly, and we strive as a team to be ready and able to make changes as quickly as necessary. That said, our primary concern now is that we adhere to our investment process that relies on systematic rebalancing of portfolios to keep allocations in-line; diligent research and analysis to evaluate and adjust positions when necessary, and frequent communication with you, our clients, to make sure we understand and stay updated on your objectives. We do not take lightly the trust you place in us as advisors and look forward to speaking with you soon.

Matt A. Morley, CVA, CEPA
Chief Investment Officer