The Margin of Safety Quarterly Spring 2018
First Quarter 2018 Key Takeaways
- Volatility returned to the financial markets in the first quarter, for the first time in a long while.
- Developed international stocks got off to a strong start to the year, before suffering losses similar to U.S. stocks during the sharp correction in early February.
- European stocks (unhedged) lost a bit more than 1%.
- Emerging-market stocks held true to their higher-volatility reputation but also finished the quarter up 2.5%.
- Core bonds didn’t play their typical “safe-haven” role in the first quarter.
First Quarter 2018 Investment Commentary
Stocks surged out of the gates in January, then corrected sharply, before rebounding into mid March, clawing back much of their losses. They then dipped again into quarter end, buffeted by a potential trade war and a Facebook data scandal. When the dust settled, US large caps ended down 0.8% for the quarter, developed international stocks were down 1% and European stocks down slightly more at 1.2%. Emerging market stocks finished the quarter with a 2.5% return. Our portfolios’ overweight to emerging market stocks added to returns as they outperformed U.S. stocks for the period.
Core bonds did not perform well in the quarter and they posted losses during the sharp stock market correction in February and delivered a 1.5% loss for the quarter overall, as Treasury yields rose across the maturity curve. Our absolute return oriented, actively managed fixed income funds, floating rate loan fund and multi-strategy alternative fund all outperformed the core bond index for the period. In addition, our emerging markets bond manager continued to perform very well, up over 5% for the quarter.
At the end of last year, by some measures U.S. stock market volatility was the lowest it had ever been in 90 years of market history. While the 10% market correction this year was short lived, it provided a reality check for equity investors. However, the global economy still looks solid in the near term. Looking ahead, we have positioned client portfolios for further volatility and likely lower equity returns as the markets ride out what is already a longer than usual economic cycle.
Market and Portfolio Recap
Needless to say, it was a bumpy start to the year for financial markets—something we’d suggest getting used to in the months and years ahead. After years of record low volatility, the 10% market correction this quarter was a reality check for investors: Stocks can go down as well as up.
Equity investors should understand that stock market declines of 10% or more are normal. They’ve happened in over half of all calendar years since 1950. In exchange for their higher long-term expected returns, you must be willing and able to ride through these inevitable periods of decline.
It was a difficult quarter for most asset classes, as most equity asset classes had negative returns with the exception of US large and small cap growth, as well as emerging market stocks.
Our active fixed income positioning helped to support portfolios during a period when core bonds failed to play their typical “safe haven” role. Absolute return oriented and flexible bond funds were in positive territory for the quarter, and our floating rate loan fund gained around 1%. As noted earlier, our emerging market bond manager returned over 5% and our alternative strategy fund out performed core bonds and most global equity classes, providing some downside ballast versus stocks and core bonds.
Market and Portfolio Outlook
We have two primary observations about the quarter’s rocky ride. First, the declines witnessed serve as a good reminder that markets do not exclusively go up. Until the recent drop, the S&P 500 had rallied for more than 400 days without registering even a 3% decline from its high. That was the longest streak in 90 years of market history. So, from that perspective, the return of market volatility is a return to “normal” market form. We believe investors should be prepared for continued volatility rather than expect things will revert back to the unnaturally smooth markets we experienced in 2017.
Our second observation is that despite the dramatic news headlines and market volatility that might suggest otherwise, the global macroeconomic and corporate earnings growth outlook has not materially changed or deteriorated from what it was at the start of the year. In fact, the economic news that triggered the recent selloff was not a report of economic weakness but one that suggested the economy might be getting a bit too strong, with a tight labor market finally translating into higher wage growth and broader inflationary pressures. Fundamentally, even after the correction, the U.S. and global economies still look solid. Global growth may no longer be accelerating, but it remains at above trend levels and the likelihood of a recession over the next year or so still appears low (absent a macro/geopolitical shock).
The U.S. economy is getting later, if not late, in its cycle. We are experiencing the unwinding of an unprecedented period of global monetary policy influence, and geopolitical tensions fill the headlines—the latest being the potential for a trade war between the United States and China.
It is not in our nature to speculate on whether any of these factors will trigger more market volatility, and what their impact will be if and when markets react. However, it is in our nature to ensure we’ve properly assessed and managed risk in our client portfolios across a wide range of shorter term outcomes, while positioning them to capture longer term returns. With very little portfolio protection offered by core bonds in this flat to rising interest rate environment (i.e., returns more in line with this quarter’s losses), we continue to look to our positions in alternative strategies to behave more favorably during sustained equity market declines and generate returns independent of stock and bond markets.
We also remain defensively positioned in our equity risk allocation and tilted in favor of more attractive foreign market valuations. While not table pounding in an absolute return sense, the outcomes we see for European and emerging market stocks continue to be more relatively attractive than U.S. stocks.
Our analysis suggests the positive economic outlook has already been discounted to a meaningful degree in current U.S. stock market prices. So while the economy is strong, the stock market has been reflecting this for a while. The valuation of the S&P 500 is well above our estimate (and the estimate of other investment professionals that we respect) of its fair value range on a normalized (longer term) basis. As the valuation multiple comes down, it will be a significant drag on the total return of the market index over our five year investment horizon, regardless of the earnings outlook.
The Best Defense
As we reflect on the volatility levels we have witnessed so far this year, it’s worth reiterating why we emphasize a five year or longer time horizon as the basis for our expected returns analysis. It is over those longer term periods that valuation (i.e., what you pay for an investment relative to its future cash flows) is the most important predictor of returns. Over the shorter term, markets are driven by innumerable and often random factors (i.e., noise) that are impossible to consistently predict (although that doesn’t stop lots of people from trying).
There are a lot of paths financial markets and the economy can take to reach our base case scenario destination. And there is a wide range of reasonably likely outcomes around that base case. Simply put: markets and economies are unpredictable. But when it comes to the investment world, we are often our own worst enemy. We fall prey to performance chasing, our natural inclination to “do something,” and other behaviors that may have helped our ancestors, but hurt us as investors. We think Winnie the Pooh (typically not thought of as a great investor) had it right when he said, Never Underestimate The Value of Doing Nothing! The best defense is a sound, fundamentally grounded investment process like ours that you can have the confidence in to be able to stick with for the long term.
A Financial Plan – The Road Map For Your Financial Destination
We believe that a financial plan is a needed road map, to improve the odds of reaching your financial destination. We like to use the analogy, when a client starts developing their plan, of starting a road trip from Jacksonville, Florida to Seattle, Washington. It is a long trip and it will not always go to plan but even though we cannot predict, we can prepare the client for this journey. The client also needs to be flexible (“life happens”), patient and have a good advisory firm or navigator.
The first step is to decide on the goals, which need to be realistic, quantifiable and achievable. The sooner we finalize the plan (i.e. the earlier you start), the better as in the beginning of our journey, we just need to be directionally correct – for Jacksonville to Seattle, we need to be heading northwest.
For any trip, including a financial trip, a good, trusted navigator is needed. We are the trusted navigator for our clients: independent, objective, fee only with a professional staff of CPAs and CFP practioner’s, who check the coordinates along the journey and make necessary adjustments to the financial plan. Given the long trip, life will happen – on the financial journey, markets are unpredictable, volatility can spring up out of nowhere and emotions can threaten to move us off the directional path.
We develop globally diversified portfolio’s for our clients, to help withstand most of the expected pot holes that we will come across on the road trip. Our long trip to Seattle will not always be exciting and for large portions of the trip, it will be boring – however, the goal is not financial excitement but reaching the financial destination and achieving the goals. As the navigators, we will look to improve the efficiency of a journey by paying attention to investment costs, income taxes and liability protection.
As we get closer to our destination, not only do we need to be directionally right, but we need to start paying attention to the proper paths that lead to the financial goals. Distractions need to be avoided and there are many financial distractions that try to entice and take the journey off course – bitcoin, IPOs, annuity products that make all kinds of financial promises, freedom or free checks to name a few – this “noise” needs to be filtered out by the navigator.
As we get closer to the financial destination and have limited paths to take, we may find that we did not make as good of time as we had hoped, to reach the financial destination on a certain date. Flexibility may be needed to extend the trip time, take a different path or perhaps change the destination. For the financial plan, these may equate to working longer, working part time, saving more, spending less, or giving up on retiring to the South of France!
We work with our clients to help them become comfortable with the uncertainty that is inherit in a financial and investment plan. Proper preparation and planning are critical, as every possible outcome cannot be controlled. Even though we cannot predict, preparation can be done for the most likely outcomes and there are alternative choices if everything does not go exactly as planned.
For our portfolios, we always talk about the downside as the goal, not the upside – if an individual cannot live with the volatility and unpredictability of the financial markets that will occur in trying to reach their financial goals, then the goals need to change or the travel time needed will have to be extended.
There are many ways to get from Jacksonville to Seattle – each clients path is different, which means each journey is different. Also, the journey maybe from Jacksonville to Boise or San Francisco or British Columbia – every client has a different destination. As the navigator, we are prepared to plan out the different routes to address the challenges that will be met along the journey. In the end, we believe a trusted navigator is needed to stay on course and on target.
River Capital Advisor News
As you read this newsletter, the initial phase of the 2017 tax filing season has passed. We noted in last quarter’s newsletter the significant tax changes that are in effect for 2018. You can review these in detail here. A big item for our business clients is the qualified business income deduction and once we have regulations from the IRS, expected during the spring/early summer, we will be meeting with them to quantify the tax impact of this new area of the tax law.
We discussed last quarter the changes to our portfolio reporting, our reports and the new client portal. We have met with a number of clients already this year and all of the feedback we have received regarding these changes have been extremely favorable. We have recently advised clients of the steps needed to set up and access their investment portal, which provides additional data about their portfolio, updated in real time. Please let us know your thoughts about these significant changes and if you have any problems with the portal navigation.
RCA has been an independent, fee only advisory firm for over 20 years. We have been strong advocates of the benefits to individuals of working with a financial fiduciary like RCA and we are pleased to announce that the firm is now a member of NAPFA, The National Association of Personal Financial Advisors. NAPFA is the country’s leading professional association of Fee Only financial advisors—highly trained professionals who are committed to working in the best interests of those they serve.
We have updated our ADV and are including with our client quarterly performance package a Summary of Material Changes. If you would like a complete copy of our ADV, please contact Bradley Miller, CFP®.
Last but not least, thank you to all of our clients for the opportunity to work for you and your family. Our goal is to make a difference in your financial life. The referrals that we receive remind us of the trust our clients place in us and how we need to work hard everyday to continue to earn that trust. Please do not hesitate to contact us about any area of your financial life – investments, taxes, personal planning, risk management or any matter related to your financial life.