THE MARGIN OF SAFETY QUARTERLY FALL 2017
Third Quarter 2017 Key Takeaways
- Despite its reputation as the worst seasonal period for stocks, global stock markets rallied again during the quarter
- The U.S. market delivered strong returns in the third quarter, extending its winning streak to eight consecutive quarters and a remarkable 18 out of the last 19 quarters.
- U.S. larger-cap growth stocks—technology stocks in particular—continued their year to date dominance over smaller cap and value stocks, a sharp reversal from what we saw last year
- One indicator of how calm the stock market has been this year is that its largest decline (drawdown) has been a loss of 2.8% (from March 1 to April 13).
- In fixed income markets, core investment grade bonds inched up 0.7% for the quarter
- Credit sensitive (higher risk) sectors of the fixed income market outperformed core bonds for the quarter
Third Quarter 2017 Investment Commentary
For the quarter, our globally diversified portfolios generated attractive returns as all the major asset classes registered gains for the period. Our portfolios particularly benefited from our tactical overweighting and meaningful exposure to emerging market and European stocks, both of which had strong absolute returns and also beat U.S. stocks. Active equity manager performance versus the benchmark was mixed. Fixed income allocations continued to beat the benchmark and our emerging market bond allocation had another good quarter. Our alternatives position outperformed bonds but lagged equities, which is expected given the current equity market environment.
Emerging market stocks were strongest, surging 8%, followed by European stocks, which gained 6.2%. More broadly, developed international stocks rose 5.5%. For the third consecutive quarter, the U.S. dollar depreciated against foreign currencies, boosting dollar based investor returns in these markets. The S&P 500 Index closed at an all time high, gaining 4.5%.
Our portfolios have benefited over the past year from the very strong relative and absolute performance of international and emerging market stocks. Yet foreign stocks continue to look very attractive relative to U.S. stocks and offer solid absolute expected returns.
The 10-year Treasury yield (which moves inversely to bond prices) ended the quarter flat, but this masked intra-quarter shifts. It bottomed in early September as fears over North Korea, hurricanes, and political events peaked. But the yield shot up into month end, closing the quarter right about where it stood three months earlier. The high yield bond index gained 2% and floating-rate loans were up 1%. Our portfolios have also benefited from exposure to actively managed, absolute return oriented bond funds, which again outperformed core bonds overall this quarter. Our emerging market local currency bond manager returned over 3.50% in the quarter, benefiting from dollar weakness.
Hope and Luck Are Not Successful Investment Approaches
Mike Tyson famously said (and we are paraphrasing), everyone has a plan when they enter the ring, until they get hit in the mouth! For twenty years, we have worked with RCA clients in developing a financial and investment plan that will help them achieve their financial objectives in good and not so good markets. We talk with many people and we are noticing more and more that with the equity markets being unusually calm (this year the largest decline (drawdown) has been a loss of 2.8%, from March 1 to April 13 and according to Ned Davis Research, since 1929, there has been only one calendar year when the largest drawdown was smaller), many individuals have forgotten the benefits of having a well defined investment plan.
When markets are turbulent (and they will be again), particularly when stocks fall unexpectedly, resisting the urge to start looking for reasons to bailout of the market can be a tall order. Yet the future is inherently uncertain; there are no guarantees in life or when it comes to investing. Anything can happen, as always, and there are significant uncertainties and “unknowables” when it comes to economic forecasting.
If you have a sound investment strategy though, we know those are the times when you really need to stick with it, remaining disciplined and consistent in executing it. Otherwise, you will be at the whim of both your emotions and the market’s random moves. It’s possible to get lucky once or twice by exiting the market right before a big drop or jumping in just before an extended rally. But hope and luck are neither sustainable nor successful investment approaches.
Asset Class Performance & Investment Outlook
U.S. Stocks: Based on our research, discussions and reading, US economic fundamentals, the backdrop for stocks, still looks pretty solid. But U.S. stocks have high valuation risk. Across almost every absolute valuation metric, U.S. stocks look expensive relative to history. In our assessment, this argues for caution when it comes to U.S. stocks, looking out over the next five plus years. That is why we remain underweight to U.S. stocks, despite what may continue to be a supportive economic backdrop for them over at least the next few quarters. Although the US market looks expensive, we are not buying “the market” via an index. Our active, disciplined value managers invest in individual stocks that meet their buy criteria. This means that their portfolios are very different from “the market” and benchmarks (you beat a benchmark by investing differently than the benchmark). However, our managers are telling us that they are not finding as many attractively priced stocks today. This means that cash will build in their portfolios, which does provide downside protection and “dry powder” for when stock prices decline. This is a significant benefit of active management, and one not frequently discussed. A market index stays fully invested and keeps buying stocks that become ever more expensive. A question we believe passive investors should ask is, how much of your portfolio are you comfortable having in stocks that no one is watching and analyzing? Our readers and clients know that we believing in both passive and active strategies, but for our passive strategies, they are also focused on value stocks, those that are not as expensive as “the market”.
Foreign Stocks: International and emerging market stocks have generated strong relative and absolute performance over the past year. Part of this performance can be explained by the euro’s sharp 12% appreciation against the U.S. dollar in 2017. Consequently, the euro/dollar exchange rate now looks to be in a broad fair value range, with the euro now only slightly undervalued. Therefore, looking ahead over a multiyear time horizon, we wouldn’t count on additional meaningful gains from the currency.
However, based on our analysis, foreign stocks still look very attractive relative to U.S. stocks, and offer solid absolute returns, in the mid- to upper single digit range, at least, over the next 3-5 years. Generally, we think US stocks will have returns in the low single digits. Therefore, we remain overweight to European and emerging market stocks.
In Europe and the emerging markets, we are seeing the corporate earnings (and stock market) recovery we have been expecting. Yet, earnings remain far below their pre-crisis highs and also below what we view as their normalized (longer term) trend growth level. Absolute valuations remain reasonable if no longer depressed.
The relative strength chart below shows that U.S. stocks’ large return advantage since the financial crisis has only begun to reverse. As we’ve written before, and financial market history demonstrates, asset classes go through cycles of relative performance—driven not just by their underlying economic fundamentals but by human herd behavior and market sentiment that swing to excess. We may be in the early stages of the pendulum swinging back in favor of foreign stocks. While we can’t predict short-term swings in sentiment, our forward looking analysis of the fundamentals and valuations certainly supports that view.
Fixed Income: Within the fixed income portion of our balanced portfolios, our long established positions in several flexible and absolute return oriented bond funds, in place of roughly half of our strategic core bond exposure, added value again for the quarter. We have also maintained a meaningful allocation to emerging market bonds (local currency), which we think is still attractively prices. These funds are also ahead of the core bond index for the year.
Alternative Strategies: Our alternatives position, which includes a number of different strategies, posted positive returns for the quarter. These diversifying strategies outperformed core bonds but lagged the strong U.S. stock market. For the trailing year, ended September 30, the strategy is up over 5% as well.
Closing Comments on Asset Class Outlook
Despite the U.S. economy’s rather healthy economic indicators, it’s worth noting that a typical 5% to 10%-plus stock market correction can happen at any time, triggered by any number of unpredictable and/or unexpected events. Historically, the U.S. market has dropped at least 5% roughly three times a year and declined 10% or more about once a year. We are at 330 days and counting since the last 5% drop; this is the longest such streak in 26 years. Given that historical reference, the U.S. market seems long overdue for a correction.
However, a true bear market in U.S. stocks (a sustained 20%-plus decline) is almost always associated with an economic recession. Absent a recession, a bear market is unlikely. Recessions, in turn, are typically caused by excessive Fed tightening, usually in response to inflationary pressures, an overheating economy, or financial market excesses, none of which seem imminent in the U.S. or global economy. So although this is now the third longest economic expansion and second longest bull market in U.S. history, neither appears ready to die of old age just yet.
If that’s the case, then we expect to continue to benefit from our exposure and overweight to international and emerging market stocks as their performance “catches up” to U.S. stocks. We also expect our flexible fixed income and floating rate loan funds to outperform the core bond index, due to their yield advantage and lower duration (which mitigates the negative price impact from rising interest rates). Alternative strategies should also perform well in that environment, although they may lag U.S. stock returns.
But as the cycle turns, the likelihood of a recession increases. We’d say one is very likely within the next five years, and a bear market as well. Our portfolios will have exposure to risky assets that will be hit hard by a recessionary bear market—although the degree of exposure depends on the individual portfolio’s risk objective (i.e. the percentage of the portfolio invested in stocks). Investors must be prepared—psychologically and financially—for market dips and drops along the way. They are inevitable and may be unsettling, but they are also temporary.
It’s also important to remember that the next bear market will surely create some table pounding tactical investment opportunities, as many risky asset classes will get excessively beaten down in price relative to their longer term fundamentals. Given our positioning in lower risk asset classes, we expect to be able to take advantage of such opportunities.
In the meantime, we have built balanced portfolios that are resilient across a range of scenarios; diversified across investment strategies, asset classes, and risk exposures; and tilted to the areas our analysis indicates currently have the most attractive risk/return profiles, such as European stocks, emerging market stocks, absolute return oriented and flexible bond funds, floating rate loan funds, and lower risk liquid alternative strategies.
General Tax and Planning Comments
With the year end fast approaching, we are working with clients to adjust or update their tax and financial planning. Although this is a year round endeavor, year end is always a time to look for opportunities to save income taxes. President Trump and Congressional Republicans recently released a framework (i.e. no details) for tax reform in September. The framework proposes three individual tax rates (12, 25 and 35 percent) and a 20 percent corporate tax rate. The framework leaves open the possibility that “an additional top rate may apply to the highest-income taxpayers.” The framework also calls for eliminating most individual and business tax breaks, raising the standard deduction, repealing the federal estate tax and abolishing the alternative minimum tax (AMT). A special 25 percent tax rate for non-corporate businesses, with yet undetermined provisions to prevent “gaming” that benefit, has also been proposed. Some groups are already lobbying against restricting the state and local tax itemized deduction, as well as any restrictions on the mortgage interest deduction. Without meaningful legislation to review, however, we are hesitant to make significant financial decisions based on the framework recently released. We are monitoring the tax reform discussions closely and will advise our clients once more becomes known. In the meantime, traditional tax saving strategies such as maximizing employer retirement plan contributions, looking for “back door” ROTH contribution opportunities, maximizing Health Savings Account contributions (while paying medical costs if at all possible with non Health Savings Account money), making nondeductible IRA contributions (to defer income on the dollars contributed), harvesting tax losses, deferring income and accelerating deductions continue to make sense at this time. Please contact our office to discuss your particular tax situation and related tax projection.
Hurricane Irma left a lot of destruction here in Northeast Florida and with the designation in place for the surrounding counties as a Federal Disaster area, individuals who sustained hurricane damage can potentially deduct out of pocket casualty costs on their 2016 or 2017 tax return. The IRS has waived the normal 10% of adjusted gross income floor and has also indicated that for those taxpayers who do not itemize, they can still get a tax benefit via an enhanced standard deduction.
We are also looking at financial products that may help certain clients, such as hurricane deductible insurance and short term long term care insurance. As our clients and readers know, we do not sell any financial products but can help our clients evaluate products. We then work with the appropriate sales person to buy the right product at the best cost.
As always, we remind our clients to contact us with any tax, investment or financial topic or matter so that we can help them in all areas of their financial life.
River Capital Advisors News and Final Comments
Year end is always a busy time of year. We continue to work hard with our clients to ensure that we address and discuss the various financial and tax matters impacting their life. We continue to receive steady referrals from clients, as many individuals want to work with someone who is independent, objective and a financial fiduciary firm.
The RCA team is also focused on a major upgrade to our website – it is long overdue and we hope to have it live in the next month or two. Our goal is to have a website that provides not only information about RCA and its services, but also educational and helpful information about a wide range of financial topics. We continue to receive very positive feedback on our financial and life planning software, a centralized tool that summarizes our clients financial information, planning and related important financial documents. Lastly, we are in the middle of a major change in our quarterly performance reporting. We expect to have the updated reports available at the end of the first quarter of next year – we will update you again with our next newsletter – stay tuned!
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