1st Quarter 2019: Quarterly Recap and Near-term Outlook

After a rough 2018, and a historically bad December, I am happy to post this information following a day certain to make all quite happy. Aside from enjoying much improved investment performance in the first quarter, yesterday saw markets close at new all-time highs. What a wild six-month round trip it has been!

This link is to a PDF containing our Q1 2019: Quarterly Recap and Near-term Outlook.  It follows the form of (1) What is it that we are most thinking about right now, (2) What happened during the past quarter from a big-picture perspective, and (3) How might, if at all, recent events change strategy. This Recap incorporates a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by Morningstar. This tabled data will, hopefully, help each reader evaluate their own performance in proper context with just a few numbers.

As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions with all clients. Until then, be well, enjoy your week, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC


4th Quarter 2018: Quarterly Recap and Near-term Outlook

Hello Friends!

Following you will find, once again quite late this quarter, Lake Jericho’s look back at the prior quarter, some commentary about 2018 in total, and a bit about improvements to our process given tough lessons learned during the period. Once again, I might be an old dog. But I can learn new tricks.

This link is to a PDF containing our Q4 2018 Quarterly Recap and Near-term Outlook.  It follows the form of (1) What is it that we are most thinking about right now, (2) What happened during the past quarter from a big-picture perspective, and (3) What are we doing about it. Also, this Recap incorporates a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by Morningstar, Inc. This tabled data will, hopefully, help each reader evaluate performance in proper context with just a few numbers.

As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions with all clients. Until then, be well, enjoy your week, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

3rd Quarter 2018: Quarterly Recap and Near-term Outlook

Hello Friends!

Following you will find, although very late this quarter, a much-changed performance reporting format.

Given how late it is, perhaps this quarter-end I bit off more than I could reasonably chew. But I think you will like what I’ve done. Gone is the 4,000-6,000 word, granular, and largely institutional-focused, blog post. While writing that level of detail is an important part of my own process, almost without exception, individual clients had told me that it was tough to make it through, and that it was exceedingly difficult to see how it all applied to their unique situation. I was giving a lot of different benchmark information that, while appropriate to all of the various market sectors in which we invest, was largely impossible for people to distill down to what was directly comparable to their own portfolio performance. Most asked for something more simple, more easily absorbed, and that just hit the highlights of what was going on. They also wanted something physically easier to read than a blog post.

I might be an old dog. But I can learn new tricks. It takes me a minute, or two, but I get there.

This link is to a PDF containing our new-form 3rd Quarter 2018: Quarterly Recap and Near-term Outlook.  It is easily ¼ to ½ the length of our prior Outlooks. It follows the form of (1) What is it that we are most thinking about right now, (2) What happened during the past quarter from a big-picture perspective, and (3) What are we most watching during the coming quarter. Also, this new reporting incorporates a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by Morningstar, Inc. This tabled data will, hopefully, help each reader evaluate performance in proper context with just a few numbers, rather than the both hands and feet worth of numbers that I had been providing.

As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions with all clients. Until then, be well, enjoy your weekend, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

2nd Quarter 2018: Quarterly Recap and Near-term Outlook

Is the New Normal just the Old Normal?

In a 2014 “A Wealth of Common Sense” post, Ben Carlson, CFA said “diversification is about accepting good enough, while missing out on great, but avoiding terrible.”  If forced to summarize Q2, those would be my words of choice. I am not going to attempt an overly positive spin on what was a tough quarter, or on what remains among the most challenging socio-political investment environments that I have experienced in a nearly 30-year career. Objectively speaking, some of our investments performed greatly. Some performed terribly. On average, which is the point in the long run, our investments finished the quarter better than “good enough” on a relative basis. Of course, anyone that knows me also knows that “good enough” is not my normal, personal or professional, standard. Unfortunately, we are not in normal times. Or are we? Perhaps we have returned to normal times after enjoying years of abnormally high returns. Perhaps, even, we (meaning me) have been lulled into a sense of security, if not entitlement, by the post-financial crisis run. Regardless of our frame of mind, market performance for 2018 is far more typical than atypical. It is important that we adjust our expectations to align with 2018’s type of market in the near term, rather than anchoring our expectations on prior experience.

Q2 Review

During Q2, Trump’s escalation of trade tariffs moved from nascent threat to the forefront of investor concern. The tariffs enacted thus far have been China-oriented, micro-focused, and affecting sectors sufficiently small that they are estimated to have little (0.2% of U.S. GDP) macro effect on U.S. growth. Impacts upon employment and inflation are also expected, thus far, to be minimal. However, fear is growing that the opening salvos, rather than simply Trump’s unsettling negotiating style, could be just the tip of the spear that ultimately kills the global recovery.

China announced retaliation on a similar scale, about $50 billion (USD). Trump indicated that, if China does retaliate, he would ask the Office of the U.S. Trade Representative to expand tariffs to an additional $400 billion (USD) of imports, and separately threatened to impose additional tariffs on about $360 billion (USD) of automobile imports from both China and the European Union. Additionally, the U.S. is threatening investigations into China’s alleged misappropriation of intellectual property, and to block acquisitions in domestically sensitive industries. The latest actions raised investor fear of an all-out trade war between the world’s two largest economies, one likely to spread to the EU, Japan, Canada, and Mexico.

Investors fear the impact of escalating trade tension on global economic growth and the resulting hit to corporate earnings. The prospect of a protectionist driven slowdown follows what has been an extended period of rising economic optimism for the world. In January, the International Monetary Fund (IMF) upgraded its global growth forecasts for 2018 and 2019 by 0.2% to 3.9%. The most recent announcement from the IMF suggests that if the current trade threats are realized, and business confidence falls as a result, global output could be about 0.5% below that projection. Others have published opinions that a global trade war could result in a negative shock to global GDP of perhaps 1% to 3% in the next few years. That is not a 1%-3% reduction in the rate of growth, that is an actual reduction in the absolute level of global GDP. By comparison, the damage done by the great financial recession caused a drop in global GDP of about 5%.

Lake Jericho’s process of investing in domestic and global markets is fundamentally built upon stable, long-run, expected, global economic growth rates. Our investment horizon, except for client-specific or portfolio-specific exceptions, is similarly long-run (10+ years). Although we do make tactical adjustments within that long-run framework, we are not a “trading” type of company. It is better to think of the tactical moves made as a method to “nudge” portfolios in desired directions, rather than making reactionary, dramatic changes. There is minimal incentive in our process, within our long-run investment horizon, to react to short-term dislocations caused by threats to expectations of long-run, global economic growth rates. Yet in Q2, escalating trade fears did exactly that: undermine expectations in what has been an extended period of rising long-run, global economic growth rates. The result was a large divergence between domestic and international investment markets. During a quarter that saw meaningful underperformance in international markets, especially emerging markets, our significant positions in those markets overwhelmed positive U.S. market influences. By any technical definition, international markets, and particularly emerging markets, entered “correction” territory during Q2.

Despite rising trade fears, since topping out in late January, U.S. equity indexes have bounced about quite a lot, but have modestly advanced on a year-to-date basis. While at the end of Q2 the S&P 500® Index (a broad measure of large-sized U.S. companies) was down roughly 5% from late-January highs, the Index is once again positive for the year. Small- and mid-sized U.S. companies, represented by the Russell 2500™ Index, have fared significantly better, leading their large-company counterparts for most observation periods since inception of our Firm. The unchallenged leader amongst U.S. equity indexes continues to be the technology and consumer-cyclical heavy NASDAQ Composite Index.

Chart 1: U.S. Equity Returns Since Firm Inception

Small beats big, but the NASDAQ continues to lead.

Growth of the S and P 500, Rusesell 2500 Total Market Index, and the Nasdaq Composite index, from 2014 to 2018

During 2017, the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) index, a common measure of stock market volatility, averaged just 11.1%, the lowest annual average on record. Volatility has increased during 2018. The VIX is running at a 16.3% average for the year. Higher? Yes. But merely more in-line with the long-run average of 18.5%.

Chart 2: CBOE Volatility Index

Volatility representing more historically average risk.

CBOE Volatility Index: VIX

Turning to international markets and bonds, what 2017 gave us, 2018 is whittling away. For the U.S., exports account for a relatively small percentage of GDP. There are some sectors that are more reliant on trade than others, but for the most part, the U.S. economy is not heavily dependent on exports. Other countries, however, are heavily dependent on exports. It is that heavy dependence upon international trade that has so rattled international markets, and particularly emerging markets. The strengthening U.S. dollar is further exacerbating the problem, turning otherwise strong home-currency returns into negative returns once converted into U.S. dollars. With international allocations in our typical client portfolio running as high as 30%, even the small amount of 2017’s strong returns given back thus far in 2018 are having a meaningful impact.

Chart 3: Asset Class Returns

Following 2017’s significant lead, international markets trail significantly.

Novel Investor Asset Class Returns TableSource: novelinvestor.com

Bond funds gave us negative returns for the second consecutive quarter. The Federal Reserve raised interest rates another 0.25% during its June policy meeting, increasing the federal funds rate to a range between 1.75% to 2.00%. This was the second rate hike during 2018, and the seventh since the Fed started moving toward a more restrictive monetary policy in December, 2015. Consensus is that the Fed will raise rates two more times this year, and three times in 2019.  The difference between U.S. short- and long-term bond yields narrowed to the lowest level since 2007. Of particular concern to investors is that short-term rates continue to rise while long-term rates remain stable. Market participants are holding down long-term interest rates, another indication of the potential threat to U.S. growth from the increasing threat of trade protectionism. A flat yield curve has traditionally been viewed by markets as a signal of a weaker economic outlook, while an inverted curve, where long-term bonds yield less than short-term bonds, is considered a harbinger of recession. We are not prepared to make that leap, but we are watching the relationship closely.

Chart 4: U.S. Treasury Yields

Interest rates are moving steadily higher, particularly short-term rates.

Image of US Treasury yields from 2012 to the beginning of 2018

Summarizing the various market forces during the quarter:

  • The S&P 500® Index finished Q2 with a total return of  3.43%, for a 2018 year-to-date return of  2.65%.
  • The more concentrated, and more interest-rate sensitive, Dow Jones Industrial Average finished Q2 with a total return of 1.26%. For the first half of 2018 the return was -0.73%.
  • The bright spot in the U.S. during Q2 was the technology and consumer-cyclical heavy NASDAQ Composite Index with a total return of 6.61%. For the first half of 2018 the return was 9.37%.
  • Small- and mid-sized U.S. companies, as measured by the Russell 2500™ Index, outperformed large-company counterparts during Q2 with a total return of 5.71%, and a year-to-date return of 5.46%. Small- and mid-sized U.S. companies are less affected by the increasing threat of tariffs and trade-wars as less of their earnings depend upon overseas transactions. For Q2, the Russell 2500™ Index returned 5.71%, besting the S&P 500® Index return by 2.82%.
  • International, developed markets portfolios as measured by the MSCI World (ex US) Investable Market Index finished Q2 with a total return of -0.77%, for a year-to-date return of -2.57%. Emerging markets as measured by the MSCI Emerging Markets Investable Market Index, after being a bright spot during Q1, finished Q2 with a loss of -8.02%, leaving the index with a year-to-date return of -6.86%.
  • Bond markets, in the face of rising global interest rates, provided little shelter for investors. Interest rates and bond prices are inversely related, so as interest rates increase, bond prices fall. The Bloomberg Barclays U.S. Aggregate Bond Index finished Q2 with a total return of -0.16% leaving the year-to-date return at -1.62%. The Bloomberg Barclays US Aggregate Bond Index is a broad-based benchmark that includes U.S. Treasuries, government-related, and corporate securities.
  • For context within broadly balanced portfolios, as most Lake Jericho client portfolios are some balanced average vehicles managed to the above indexes, the Morningstar, Inc. Moderate Target Risk Allocation category total return during Q2 was 0.56%, for a year-to-date return of -0.31%. Morningstar, Inc.’s Aggressive Target Risk Allocation category total return during Q2 was 1.14%, for a year-to-date return of 0.46%. Novel Investor’s (novelinvestor.com) Asset Allocation Portfolio detailed in Chart 3resulted in a year-to-date loss of -0.40%.

Getting to the specific decisions that influence Lake Jericho client portfolios, I will briefly cover the quarterly results of each of the five levels of our portfolio construction process. As a reminder, no client portfolio will match perfectly target portfolio allocations, sector allocations, or percentages in each, as every client portfolio is unique. Unique factors (portfolio start dates, timing of asset transfers, timing of individual contributions or distributions, overall risk profile, etc.) impact strategic and tactical decisions and the performance attribution of each. However, what follows will generally inform you of the influences upon your portfolio. Clients should carefully review their individual portfolio information to understand how their portfolio is impacted.

International versus U.S. ( Contribution)

For Q2, international equity versus U.S. equity strategy decisions versus an all-equity, U.S. market-neutral portfolio detracted from performance for the typical Lake Jericho client by about 2.11%.

Our overweights to international investments, particularly small-company developed market and emerging markets served as a meaningful contributor to client portfolio performance during 2017 and during Q1, 2018. With the view that foreign equities remained undervalued, trading at discounted valuations versus U.S. equities, we continued to increase portfolio exposures throughout 2018. That decision proved to be a bit premature given the impacts of rising trade worries. However, international markets continue trade at an average of 13.6X forward earnings, versus U.S. equities currently trading at an average of 17.1X forward earnings. It remains difficult to deny the value represented by international markets.

Bonds versus Stocks ( Contribution)

For Q2, bonds versus stocks strategy decisions versus an all-equity, U.S. market-neutral portfolio detracted from performance for the typical Lake Jericho client by about 0.10%.

Interest rates are on the move higher. As long as the move is reasonably paced then that move over time can be deftly managed. Lake Jericho managed portfolios are defensively positioned against the impact of rising interest, in terms of lower allocations to bonds than is considered typical, in how we constrain allocations to equity investments with high negative correlation with interest rates (real estate, utilities, consumer staples, heavily leveraged sectors), and in how we position the bond investments that we do hold. We believe that this defensive position is best in the current environment as yields provide little protection from sudden and large adverse price movements should rates move quickly higher.

Small Versus Big ( Contribution)

For Q2, small- and mid-sized company strategy decisions versus an all-equity, U.S. market-neutral portfolio contributed about 0.24% of additional performance to the typical Lake Jericho client.

One of Lake Jericho’s fundamental portfolio convictions is that investors should maintain an exposure to, if not an ongoing overweight towards, small- and mid-sized company equity investments across time. While on average, over the long-run, the space can provide superior investment returns versus large-company peers, much of the excess performance can occur in short, unexpected time periods. We are not in the business of predicting these patterns or trading these patterns, rather we hold as efficient of an exposure to this space as possible over time. This pattern of return, and our persistent holdings, can result in extended periods of underperformance. Our approach to manage this trade off is to employ across time three different strategies, simultaneously, that best expose portfolios to persistent factors of return within the space. This strategy works well across time.

Value versus Growth ( Contribution)

For Q2, value versus growth strategy decisions versus an all-equity, U.S. market-neutral portfolio detracted from performance for the typical Lake Jericho client by about 0.84%.

As with small- and mid-sized company exposure, Lake Jericho managed portfolios maintain a constant bias towards value-oriented investments. The basic premise of value investing is that certain securities are underpriced bargains and are likely to outperform once their “real value” is fully appreciated by investors. “Value plays” can also be implemented for defensive positioning in certain sectors and markets. If for no other reason, it is a bit of common sense supported by the statistics that if you remain mindful of not overpaying for your investments then you are more likely to achieve superior returns over the long-run. Value-oriented investing is one method that helps investors achieve this objective. A gross over-simplification of an entire field of financial study, but that is the basic idea.

Like our decisions in the small versus big category, performance patterns in the value versus growth category demonstrate “clumpy” patterns of return. While on average, over long-run periods value-oriented strategies provide superior investment returns versus growth-company peers, extended periods of meaningful underperformance can persist. We are currently in an extended period of meaningful underperformance. But leadership does turn, and the relationship normalizes over time. Patience is the watchword here, and we remain patient.

To fairly represent value versus growth factors in the markets we use Morningstar, Inc. measurements. During Q2, the U.S. Value Index trailed the Total U.S. Market Index by 2.38%. The rolling one-year difference in total return advantage of the Total U.S. Market Index over the U.S. Value Index has been 5.46%. That difference is among the greatest spreads in value underperformance in such a compact time frame in measurement history. That degree of performance differential, though rare, certainly feels painful in the short-run. Our strategy and implementation in the space has suffered more so than the Index, but we look at the current valuation differences as an opportunity for future outperformance more than just as a negative for recent performance. All one need do is look back to 2016, a period in which the spread of value over growth extended to 17.63%, to understand how these patterns can reverse in meaningful ways.

Sector Overweight/Underweight Decisions ( Contribution)

For Q2, sector overweight/underweight strategy decisions versus an all-equity, U.S. market neutral portfolio contributed about 0.17% of additional performance to the typical Lake Jericho client, and has contributed about 0.39% of additional performance for the year-to-date.

Strategic and tactical sector weighting, the fifth aspect of our portfolio construction process, is an important part of how we add real, long-term value for our clients. Our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting those sectors that we expect to outperform the market average has been a meaningful tailwind for client portfolios over time. Our sector overweights are currently materials, financials via regional banks exposure, and healthcare via medical devices and technology. We are in the early stages of adding to our technology sector holdings due to upcoming changes in sector classifications, and the resulting impact upon sector valuations. We will comment more on that in coming quarters.

  • While the materials sector has had a rough 2018 due to global macro concerns (finishing down by 3.01%) it had been a strong performer for the last couple of years. We erred when double-guessing ourselves on a standard sell-signal during 2017, believing that we should continue to hold the positions due to our continued outlook for global economic expansion and what we expect to be resulting commodity price inflation. Post Q1-end, materials was among the market leaders in terms of recovery for just those reasons. However, now with trade concerns continuing to suppress global growth expectations, and the U.S. dollar strength continuing to burden commodities and their emerging markets producers, it is possible that we could reverse course on this position sooner rather than later.
  • While the financial sector generally struggled during Q,2 finishing down by 3.16%, our overweight is specific to the smaller regional banks. Regional banks added 1.39% in return during Q2, for a year-to-date contribution to return of 4.38% and besting the S&P 500® Index by 1.73%. We believe that regional banks in the U.S. are best positioned to benefit from a combination of lighter regulation, and higher loan growth rates loan particularly in the energy field as U.S. capacity once again ramps up in response to rising crude prices.
  • The healthcare sector was a reasonably strong performer during Q2 with a positive return of 3.06%. But our overweight is specific to the Medical Device and Technology industry sector which provided a 8.51% in total return during Q2, for a year-to-date return of 15.72%

By necessity, when we apply sector overweights in the U.S. to industries such as materials, regional banks, and medical technology we are as well imbedding underweights to those sectors that we believe will perform poorly in the near term: real estate, utilities, and similar sectors that struggle under inflation and rising interest rates.

Near Term Outlook

As economic and financial professionals, we have it drilled into our collective conscious that trade wars are always damaging. As a student of economic history, I am keenly aware that even seemingly innocuous tit-for-tat trade spats serve only political theater and base mobilization. History shows us that trade conflicts, of any type, are rarely good for workers, consumers. or investors. Not in the long run. Negotiation tactics aside, my default reaction is dismissive disbelief that any rational person would support or enact protectionist trade policy, outside of bonafide national security interests, as an actual economic plan. As a free-market purist, my worldview is heavily informed by lessons learned across time, economy, and market. From the macroeconomic: the Smoot-Hawley Tariff Act of 1930, under which retaliatory reactions deepened and extended our own Great Depression. From the microeconomic: Bush, Jr.’s 2002 short-lived experiment with steel tariffs resulting in domestic job-losses numbering by some estimates of 200,000 in a single industry.

Nonetheless, we are continuing with our long-run, global economic growth estimates for both U.S. and international markets. Our targets remain, for now, the same as those we have held for the past two years (higher growth rate expectations for both foreign developed and emerging markets than for the U.S. market). As such, we will maintain our current allocations to international investments and our value bias. But in a slight attitudinal shift, we do so now more because of the recent period of significant underperformance. For historical relationships to remain intact, either international markets are significantly oversold, or the U.S. market is now overvalued. The same must be assumed of the value factor: it is now dramatically oversold, or growth oriented strategies are dramatically overvalued. We believe, in both cases, that it is the former, rather than the latter. We expect the relationships to normalize, which should lead to a period of significant outperformance at some point. But for the near term, as trade negotiations remain in the forefront of investor minds, we expect continued volatility in both domestic and international markets. We are not alone. Trade worries are giving investors, both individuals and institutions, reason to pause. Like most investors, we have a wait-and-see attitude until we can better determine what might be next in the Trump agenda.

We remain watchful and ready to respond should we see signs on the horizon sufficiently impactful to change our near term outlook. As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions. Until then, be well, enjoy the rest of your week, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

1st Quarter 2018: Quarterly Recap and Near-term Outlook

Jockeying for Position Before the Final Turn.

Less than two weeks until the call to post for the 144th running of the Kentucky Derby! If ever a time existed to use thoroughbred racing analogies for investment markets, that time is now. If you are betting with the financial media pundits, then your money is on the race having made the final turn, that this market is thundering down the final stretch. But are we really down to the wire? I do not believe we are. The measures by which Lake Jericho evaluates long-term strategic decisions indicate that while the track is currently muddied, the fundamentals have not changed in a material way. Markets have merely returned to normal levels of volatility, fundamental factors such as global economic growth remain positive, corporate earnings are strong and rising, and after a 10.0% February correction stock prices became more reasonable than before. Our view is that global economies, markets, and investors still have the wind at their back. The market has not yet made the final turn, so we have more distance yet to run.

Q1 Review

2018 picked up as 2017 left off: low volatility and rising stock prices. During 2017, the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) index, a common measure of stock market volatility, averaged just 11.1%, the lowest annual average on record. For context, the 10-year rolling VIX average is about 18.0% meaning that 2017 demonstrated nearly 40.0% lower volatility than the average post-financial crisis experience. During 2017, the S&P 500® Index (a broad measure of large-sized U.S. companies) posted significant gains every quarter to produce a total annual return of 21.8%. During January, the S&P 500® increased 5.73%, the biggest gain for a January since 1997. January’s close saw markets set another milestone: more than 400 trading days without a drawdown of 5.0% or more.

Friday morning, February 2, the U.S. Department of Labor released the Employment Situation Report for January. The report showed solid job growth, a bit larger than expected though not surprising given preliminary data. But the focal point was a 0.3% jump in average hourly earnings. When combined with revisions to previous data the average hourly earnings were up 2.9% year-over-year, the highest wage growth rate since May 2009. There had been a burgeoning assumption that the strengthening economy and a tightening labor market would invite higher wages and wage-based inflation pressures dormant for years. That report gave data-centric life to that assumption, and offered a reasonable basis for the U.S. Federal Reserve to move forward with a more aggressive pace of interest rate increases. Anticipation caused bond prices to fall, pushing U.S. Treasury yields to multi-year highs. The U.S. 10-year Treasury yield, the yield upon which much debt in the U.S. is benchmarked, rose 50 basis points to 2.90%, hitting its highest point since late 2013. Negative headlines warning of rising interest rates that would slow global growth, undermine corporate earnings despite tax reform measures, and insure a ballooning U.S. budget deficit was all that trading algorithms needed to queue up the sell orders. But, the day was still young, and there was more drama to come.

Chart 1: U.S. Treasury Yields

Interest rates are moving steadily higher.

2YR, 10YR, 30YR Constant Maturity Treasury Yields

When wrapping up the Q4 2017 Outlook I stated that if we do discover a fly in the ointment with respect to this market, it will come through one of three windows: interest rates, currency values, or commodity prices. Though on-the-money about interest rate risk, I did leave off one important item: domestic political risk. That same Friday was also the day that Trump authorized the release of a GOP House Intelligence Committee memo alleging bias at both the FBI and the Justice Department. The release and the associated headlines accelerated Friday’s sell off given that it compounded political uncertainty in front of the following week’s federal government spending deadline.

Although upon release of that Employment Situation Report markets experienced a 29% spike in the CBOE VIX Index, the most meaningful volatility shock would not come until the following Monday. Having had the opportunity to digest the weekend headlines, programmatic trading drove markets down fast and hard. The VIX experienced a single-day spike of 116%, the largest one-day spike ever recorded. That day also saw the largest single-day point decline ever recorded for the Dow Jones Industrial Average. Over the course of February’s first few trading sessions investors watched the first drawdown of more than 10% since early 2016.

Chart 2: CBOE Volatility Index

A return to historically average volatility following a tranquil 2017.

CBOE Volatility Index: VIX

Although markets quickly rebounded, recovering about 8% of the lost ground, volatility remained elevated. In stark contrast with historically tranquil 2017, markets spent the balance of Q1 alternating between episodes of relief and panic. It was a pattern of strong moves to advance, only to then stumble in field packed with distractions. Those distractions would once again, at the end of Q1, cause markets to weaken and give back much of February’s recovery. In the end, for the first quarter in ten quarters, most market indexes finished in the red.

  • The S&P 500® Index finished Q1 with a total return of  -0.76%.
  • The more concentrated, and more interest-rate sensitive, Dow Jones Industrial Average finished Q1 with a total return of -1.96%.
  • Small- and mid-sized U.S. companies, as measured by the Russell 2500 Index, outperformed large-company counterparts with a total return of -0.24%. Small- and mid-sized U.S. companies were less affected by the increasing frequency of Trump tweets threatening tariffs and trade-wars as less of their earnings depend upon overseas transactions.
  • The bright spot in the U.S. during Q1 was the technology and consumer-cyclical heavy NASDAQ Composite Index with a positive total return of 2.59%. For the NASDAQ, the story was not so much that it was hit less hard by the downturn, rather it had such a large head start during the month of January that when the downturn hit there was more cushion to keep the index from turning negative.
  • Foreign market performance during Q1 was comparable to the U.S. market performance. Foreign, large-company portfolios as measured by Morningstar, Inc. finished with a  total return of -0.86%. Foreign, small-company portfolios as measured by Morningstar, Inc. finished with a total return of -0.38%. Emerging markets were a bright spot during Q1, finishing with a positive total return of 2.01% as measured by Morningstar, Inc.
  • Bond markets, in the face of rising global interest rates, provided little shelter for investors. Interest rates and bond prices are inversely related, so as interest rates increase, bond prices fall. The Bloomberg Barclays U.S. Aggregate Bond Index finished Q1 with a total return of -1.46%. The Bloomberg Barclays US Aggregate Bond Index is a broad-based benchmark that includes U.S. Treasuries, government-related, and corporate securities.
  • For context within broadly balanced portfolios, as most Lake Jericho client portfolios are some balanced average of these various asset classes, the Morningstar, Inc. Moderate Allocation category total return during Q1 was -1.26%. Morningstar, Inc.’s Aggressive Allocation category total return during Q1 was -1.14%. Given the differences in allocations, yet with somewhat similar returns, it is easy to see that in times of heightened market volatility most asset classes do tend to move with a high degree of positive correlation.

Chart 3: U.S. Equity Returns Over Time

The NASDAQ continues to pace the field.

Graph tracing the growth of the S and P 500, Russell2500 total market index, and the Nasdaq index.

Getting to the specific decisions that influence Lake Jericho client portfolios, I will briefly cover the quarterly results of each of the five levels of our portfolio construction process. As a reminder, no client portfolio will match perfectly target portfolio allocations, sector allocations, or percentages in each, as every client portfolio is unique. Unique factors (portfolio start dates, timing of asset transfers, timing of individual contributions or distributions, overall risk profile, etc.) impact strategic and tactical decisions and the performance attribution of each. However, what follows will generally inform you of the influences upon your portfolio. Clients should carefully review their individual portfolio information to understand how their portfolio is impacted.

International versus U.S. ( Contribution)

For Q1, international equity versus U.S. equity strategy decisions versus a market neutral portfolio contributed about 0.03% of additional performance to the typical Lake Jericho client.

Our overweights to international investments, particularly small-company developed market and emerging markets served as a meaningful contributor to client portfolio performance during 2017. The contribution during Q1 was much more subdued, but still positive. Foreign equities remain undervalued in our view, trading at significant discounts to U.S. equities.

On a total return basis the S&P 500® lost 0.76% during Q1, but the rolling one-year total return of 13.99% still bests any reasonable long-term return expectation. The Dow Jones Industrial Average (DJIA), on a total return basis, lost 1.96% during Q1, but remains higher by 19.39% on a rolling one-year basis. The largest Q1 and rolling one-year gains among U.S. diversified funds were among large-company, growth-oriented funds. The NASDAQ Composite Index supports this showing a total return of 2.59% during Q1. On a rolling one-year basis, the NASDAQ continues to outperform with a total return of 20.76%. The rolling one-year results for each of these three major U.S. large-company indexes remain among the best numbers seen in fifteen years, a reminder that keeping a long-term perspective is always best.

The MSCI All-country World Index Ex-US (a measure of large- and mid-sized companies throughout the world’s developed and emerging market economies, excluding US equity securities) finished Q1 largely inline with U.S. counterparts with a total return of -1.18%. The rolling one-year total return was 16.53%. Our foreign, small-sized company exposures fared even better with a positive return of 0.04% for Q1 and a rolling one-year total return of 19.60%. Emerging markets, as measured by Morningstar, Inc. bested all with a Q1 total return of 2.01% and a rolling one-year return of 22.90%.

Bonds versus Stocks ( Contribution)

For Q1, bonds versus stocks strategy decisions versus a market neutral portfolio contributed about 0.11% of additional performance to the typical Lake Jericho client.

Interest rates are on the move higher. As long as the move is reasonably paced then that move over time can be deftly managed. Lake Jericho managed portfolios are defensively positioned against the impact of rising interest, in terms of lower allocations to bonds than is considered typical, in how we constrain allocations to equity investments with high negative correlation with interest rates (real estate, utilities, consumer staples, heavily leveraged sectors), and in how we position the bond investments that we do hold. We believe that this defensive position is best in the current environment as yields provide little protection from sudden and large adverse price movements should rates move quickly higher.

While certain elements of our defensive position might not add to portfolio returns in many environments, our positioning provides relatively inexpensive volatility insurance. While our bond positions were a headwind for clients during 2017’s outstanding equity market performance, the way in which we construct exposure was less costly to portfolios than the way in which more traditional managers might implement bond investments. During the volatility of Q1, a period in which bonds provided little cover, our bond construction performed exactly as designed and was a net contributor to positive performance in the typical Lake Jericho managed portfolio.

Small Versus Big ( Contribution)

For Q1, small- and mid-sized company strategy decisions versus a market neutral portfolio detracted from performance for the typical Lake Jericho client by about 0.07%.

One of Lake Jericho’s fundamental portfolio convictions is that investors should maintain an exposure to, if not an ongoing overweight towards, small- and mid-sized company equity investments across time. While on average, over the long-run, the space can provide superior investment returns versus large-company peers, much of the excess performance can occur in short, unexpected time periods. We are not in the business of predicting these patterns or trading these patterns, rather we hold as efficient of an exposure to this space as possible over time. This pattern of return, and our persistent holdings, can result in extended periods of underperformance. Our approach to manage this trade off is to employ across time three different strategies, simultaneously, that best expose portfolios to persistent factors of return within the space. This strategy works well across time. However, one of the three strategies embedded in our approach is particularly sensitive to market momentum, and as a result underperformed other small- and mid-sized strategies in the recent downturn.

To fairly evaluate our process in the small versus big category, we look to the Russell 2500 Index for comparisons. The Russell 2500 Index is a broad measure of blended strategies in both small- and mid-sized U.S. company stocks. For Q1, the Russell 2500 Index returned -0.24%, besting the S&P 500® return by 0.52%. Due to the breakdown of the momentum factor during Q1, our strategy somewhat lagged not only the Russell 2500, but also the S&P 500®.

Value versus Growth ( Contribution)

For Q1, value versus growth strategy decisions versus a market neutral portfolio detracted from performance for the typical Lake Jericho client by about 0.39%.

As with small- and mid-sized company exposure, Lake Jericho managed portfolios maintain a constant exposure to, and ongoing overweight towards, value-oriented investments. The basic premise of value investing is that certain securities are underpriced bargains and are likely to outperform once their “real value” is fully appreciated by investors. If for no other reason, it is a bit of common sense supported by the statistics that if you remain mindful of not overpaying for your investments then you are more likely to achieve superior returns over the long-run. Value-oriented investing is one method that helps investors achieve this objective. A gross over-simplification of an entire field of financial study, but that is the basic idea.

Like our decisions in the small versus big category, performance patterns in the value versus growth category demonstrate “clumpy” patterns of return. While on average, over long-run periods value-oriented strategies provide superior investment returns versus growth-company peers, extended periods of meaningful underperformance can persist. Leadership does turn, and the relationship normalizes over time.

To fairly represent value versus growth factors in the markets we use Morningstar, Inc. measurements. During Q1, U.S. value funds trailed U.S. growth funds by 6.97%. The rolling one-year difference in total return advantage of U.S. growth funds over U.S. value funds has been 16.01%. That 16% difference is among the greatest spreads in value underperformance in such a compact time frame in measurement history. That degree of performance differential, though rare, certainly feels painful in the short-run. Our strategy and implementation in the space held up well, and we look at the current valuation differences as an opportunity for future outperformance more than as a negative for recent performance. All one need do is look back to 2016, a period in which the spread of value over growth extended to 17.63%, to understand how these patterns reverse in meaningful ways.

Sector Overweight/Underweight Decisions ( Contribution)

For Q1, sector overweight/underweight strategy decisions versus a market neutral portfolio contributed about 0.32% of additional performance to the typical Lake Jericho client.

Strategic and tactical sector weighting, the fifth aspect of our portfolio construction process, is an important part of how we add real, long-term value for our clients. Our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting those sectors that we expect to outperform the market average have been a meaningful tailwind for client portfolios over time. Our sector overweights are currently materials, financials via regional banks exposure, and healthcare via medical devices and technology.

  • While materials had a rough Q1 due to global macro concerns (finishing down by 5.45%) it has been a strong performer for the last couple of years. We continue to hold the positions due to our continued outlook for global economic expansion and what we expect to be resulting commodity price inflation. Post Q1-end, materials is among the market leaders in terms of recovery for just those reasons.
  • While the financial sector generally struggled during Q1 finishing down by 0.98%, our overweight is specific to regional banks which added 2.94% in total return during Q1. We believe that regional banks in the U.S. are best positioned to benefit from a combination of lighter regulation, and higher loan growth rates loan particularly in the energy field as U.S. capacity once again ramps up in response to rising crude prices.
  • The healthcare sector generally struggled during Q1 finishing down by 1.29%. Our overweight is specific to the Medical Device and Technology industry sector which provided a 6.64% in total return during Q1.

By necessity, when we apply sector overweights in the U.S. to industries such as materials, regional banks, and medical technology we are as well imbedding underweights to those sectors that we believe will perform poorly in the near term: real estate, utilities, consumer staples, and similar sectors that struggle under inflation and rising interest rates.

Near Term Outlook

Economic and political headlines continue to whip up anxiety like a photo finish between an odds-on favorite and the long shot. No denying that the headlines are cause for concern; monetary tightening by central banks around the world, rising global interest rates, late-cycle fiscal stimulus in the U.S., media pundits volleying around terms like “stagflation”, budget deficits, tariffs, and trade wars. Concern is a natural and expected reaction. But it is too early to be whipping these anxieties across what is still an imaginary finish line. Among our primary measures of economic and market health (global growth, corporate earnings outlook, asset pricing multiples), each indicate that equity markets on average have more room to run.

  • The U.S. economy continues to grow, and the full impact of the Tax Cut and Jobs Act of 2017 is expected to enhance the rate of growth in the near term. The injection of two rounds of budgetary stimulus are more difficult to evaluate in the near term. Forecasting the outcome of the U.S. tax cuts and fiscal stimulus measures combined so late in an economic cycle is, frankly, a guessing game. If anyone tells you otherwise, smile politely and change the subject.
  • Global economies continue to grow, despite some weak data reported during Q1 that caused concern. Emerging economies are showing particular strength.
  • The U.S. Federal Reserve’s plans to slowly increase interest rates has been well communicated and implemented accordingly. The same cadence is being followed by central bankers across the globe. While in the midst of handwringing over rising rates, we should not forget that interest rates remain at historically low levels.
  • First quarter corporate earnings are expected to increase 20.0% or more from Q1 2017. Of the companies in the S&P 500 Index that have reported earnings to date for Q1 2018, 79.3% have reported earnings above analyst expectations. This is above the long-term average of 64% above, and also above the prior four quarter average of 72% above. Admittedly, estimates peg 8% of the 20% as a direct consequence of tax-law changes rather than improved corporate performance. But even a significantly reduced earnings growth number still means positive earnings growth, and the ability to grow into the price multiples.
  • Equity values might generally be considered stretched, if not expensive. But they are certainly less so than they were at this point last quarter. By the most commonly used measure of value, the trailing price-to-earnings (P/E) multiple, U.S. stocks are at least fully priced. However, if companies can grow corporate earnings 20% in 2018 (like they did in Q1), or even the lower 12% estimated once removing tax implications, then equities appear modestly attractive at that multiple. Sure, certain sectors remain a bit too rich for our taste. Some of the technology sector and the consumer cyclical space is priced more like Millionaire’s Row while we prefer to pay Granstand admission prices. But great value, and winning payouts, are still to be had.
  • On the geopolitical front, concerns have increased about tariffs and trade wars. But the smart money is betting that the media circus is more of a stare-down tactic than it is a willingness to tear up the track so no one else can win.

The critical consideration for investors is deciding if this increased volatility is just a normal adjustment in an otherwise healthy market or is it a symptom of something more serious? No denying that we are late in the current economic cycle and that being late-cycle does call for increasing cautiousness. But for each of the concerns listed above, the reality is that the risk is more subdued than the fevered pitch of the crowd indicates. Neither the data, nor market sentiment, support a claim that this record market run is over. At Lake Jericho, we believe the winning strategy from this point forward is to remain in our lane, running our race. If that means that we run the home stretch wearing blinders, so we will not be distracted by the noise and flash of the field, so be it.

We remain watchful and ready to respond should we see signs on the horizon sufficiently impactful to change our near term outlook. As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions. I will also be in touch with each of you in the coming weeks to follow up on Lake Jericho’s rollout of its financial planning platform and capabilities. Until then, be well, enjoy the rest of your week, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

To Be Worried, or Not To Be Worried, That is the Question.

I am not worried about Friday’s 666-point drop of the Dow Jones Industrial Average (DJIA). I feel better about the health of the market with the past week’s retreat than I would otherwise feel had it not occurred. Taking a bit of pressure off of a rapidly heating market is not a bad thing. But people tend to worry. Or at least people tend to express concern. I did field a lot of calls and messages on Friday. The great thing about calls and messages from clients was that they were all reasonable, even-keeled, and well-informed. That makes me feel great about the work I do with clients, or at least feel great about the way clients feel about the work I am doing on their behalf. Calls and messages coming from folks that are not clients? Not quite so reasonable, even-keeled, or well-informed. If for no other reason than times like these, I wish everyone would, or could, work with a professional advisor.

So I had an internal debate raging all weekend. Should I comment publicly about the market’s weekly decline? Should I let it slide as normal market behavior, comfortable that Lake Jericho clients “get it”? Honest client concerns aside, it has become increasingly difficult to tell when some folks are genuinely worried about market conditions versus when some folks are simply glomming to market conditions as a type of political wedge. Thus the internal debate; what are Lake Jericho clients, my friends, my family, truly concerned about, versus what is it that I see in market sentiment that is just hyperbole, and what, if anything, should I state professionally?

First, my primary concern is with Lake Jericho clients. And to address client concerns, why am I not worried? Easy answer. Perspective. Some investors are focusing on the eye-popping 666-point, one-day decline alone. Humans are built of inherent biases, mental short-cuts, among which is our conditioning to evaluate absolute numbers quickly and short shrift the relative analysis. It is a type of anchoring bias in which we hear a number and react, often without an appreciation for what the number itself might currently mean. Headlines (or Facebook posts) fuel those biases, shouting “worst day since Brexit”, “biggest weekly drop in 9 years”, “my 401(k) lost thousands”. But the headlines are intended only to grab your attention, not intelligently inform. So the headlines flame feelings, people seek no further insight, and all perspective is lost. In proper historical perspective, the Brexit impact reversed in less than 48 hours, the DJIA has doubled in 9 years, and it is likely that your 401(k) has far more than doubled in recent years. Absolute headlines are not reflective of relative experience.

So let us add some perspective. When the DJIA dropped 508 points on October 19, 1987 it amounted to a drop of 22.6% on one day. When the DJIA had its worst single-day decrease of 679 points on October 9, 2008 in the midst of the nation’s financial crisis, that was a 7.3% one-day drop. By comparison, Friday’s 666-point drop was a 2.5% decrease because the absolute value of the Index has climbed so much in the post-crisis recovery. For the week, the DJIA declined 4.1%, the S&P 500 shed 3.9% from its all-time high last Friday, and the Nasdaq Index fell 3.5%. To geek out on the statistics a bit, with a 10-year standard deviation of 14.2%, Friday’s 2.5% drop might be less-than-common but it certainly should not be considered abnormal. What has been abnormal is the lack of meaningful pullback during the past 18 months. When last week opened, the market had run 400 days without a pullback of 5% or more. Friday’s 2.5% drop should be taken more as a sign of return to normalcy than a worrisome deviation from the norm. Even so, one trading day does not mean that the nine-year bull market in stocks is dead.

A 100-year history of the Dow Jones Industrial Average: 

When we picture last week’s move in historical perspective, we can see that it is hyperbole that drives our perception. In reality, Friday’s move barely registers on the scale of  historical volatility.

A graph of a 100-year history of the Dow Jones Industrial Average

100 Years of Daily Moves in the DJIA: Source Macrotrends

Second, and as I’ve been saying in quarterly Recap’s for a while, the fundamental factors that have driven stocks higher — improving global economic growth and rising corporate earnings — remain intact. It is widely expected that corporate earnings will continue to grow by double digits, especially now that the U.S. tax reform plan has cut the federal corporate tax rate to 21% from 35%. Market internals (those measures market professionals use to evaluate the health of markets themselves) showed no signs of panic selling. General market consensus, and our own internal view, is that this pullback represents a good buying opportunity rather than a reason to sell. And buy, where able, is exactly what we were doing on Friday.

Third, about hyperbole and political wedges? I mention the third-rail of politics in this discussion because one can hardly assess market sentiment these days without a grasp of the narratives that drive particular views. If it is true that politics makes for strange bedfellows, then it must be true that objectivity about politics makes for no bedfellows at all. But if I can’t be objective, then I cannot do my job. I am fond of saying that “the truth is typically somewhere in the middle”. Given the tribal polarization of media coverage today, that saying has rarely been so true as it is now. To properly evaluate current market conditions, I must filter out the biases and objectively evaluate facts. It seems that if I am widely reviled by both sides of the political spectrum, then I am capably doing my job. I encourage everyone else to attempt the same.

So what is happening? Why did Friday happen? If you will recall from Lake Jericho’s Q4 2017 Recap posted just last week, we speculated that were there to be a metaphorical fly in the ointment of this market that it would come in through the window of interest rates, currency rates, or commodity values. Last week’s main sell-off trigger was growing concern about inflation rising more quickly than expected and therefore interest rates more rapidly increasing, and both of their impact on stock values going forward. The economy’s growth already has pushed up market interest rates. The yield on the U.S. Treasury’s 10-year note hit 2.84% on Friday, its highest level since 2014. Lake Jericho has defensively positioned client accounts against gradual movement higher for some time. Rapid, unanticipated movements in rates are exceedingly difficult to defend against.

Concerns about rising inflation and a corresponding increase in interest rates were heightened by the Labor Department’s U.S. jobs report released Friday showing the largest year-over-year percentage gain in average hourly wages, 2.9%, since June, 2009. The report also showed sustained low unemployment in January at 4.1%, and that employers added 200,000 jobs last month. All of that data further fuels the narrative that inflation is picking up. This has always been the market’s concern with the Trump administration’s myriad of pro-growth strategies; though enthusiastically welcomed by corporate America and investors alike, it might simply be too much and lead to overheating of the economy. Rapidly rising inflation could lead the Federal Reserve to move more quickly in lifting interest rates to keep inflation in check. Increases in interest rates puts upward pressure on business and consumer borrowing, where rates could trend higher for home mortgages, auto loans, business loans, and other personal and business big-ticket purchases requiring debt financing. Despite rising corporate earnings, rapidly rising interest burden costs could offset those gains and cause investors to rethink the long-term value of the stocks they own. Further, if interest rates in the U.S. were to increase at a faster rate than those in other developed economies around the world, a resulting impact could be a rapidly rising value of the U.S. dollar. A stronger U.S. dollar could also negatively impact the earnings of large, multinational U.S. companies as they translate those earnings back into dollars. A stronger dollar could also make it more difficult for smaller U.S. companies to sell goods and services overseas.

To wrap all of this up in a tidy little package, I will remind folks of stuff that I talked about a great deal during late 2015 and early 2016. The predominant theme then was that as markets adjust to new or changing expectations there will be price dislocations and market distortions. The market is wise and all-knowing, but it takes a while to figure itself out in the light of new information. This past week has been a process of assimilating new information. What we experienced was natural volatility. And frankly, a return to some natural volatility that we knew would be coming back eventually. As I said in the Q4 2017 Outlook, I see nothing yet on the near-term horizon that meaningfully changes my expectations. I expect to see last week’s volatility fall a bit throughout Monday’s market and settle lower into Monday’s close. If this happens, it will prove to be an excellent opportunity to put more money to work. If I am wrong, and volatility continues to increase during the week then we will have a different set of decisions to make.

Regardless, rest easily knowing that I am watching all of this and ready to act when necessary. If necessary.

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

4th Quarter 2017: Quarterly Recap and Near-term Outlook

Lather. Rinse. Repeat. Continued.

When opening last quarter’s Recap I commented about the Groundhog Day type of experience that had been 2017’s investment market through the end of Q3. And when closing Q3’s Outlook I encouraged investors to relax, to enjoy the market’s calm and persistent upward trajectory. With no meaningful roadblocks on the horizon, and with few meaningful exceptions to the market’s push higher, Q4 was a welcome continuation of 2017’s lather, rinse, repeat theme. However, I am not wholly confident that clients were able to wash away worry that what goes up potentially comes back down. The two conversations clients initiated the most during Q4 were (1) is it time to sell everything and wait for a pullback, and (2) should I be buying Bitcoin? I will get to the first in a couple of paragraphs. I will not touch the second. Here at least.

Q4 Review

2017 was a great year for investors, with Q4 the strongest of the four quarters for U.S. markets. The persistent upward trajectory of markets pushed U.S. stocks repeatedly to new all-time highs. For the first time since its inception, the S&P 500 Index (a broad measure of large U.S. companies) was positive for each of the 12 months during the year, providing a total return of 21.8%. Although small company stocks (as measured by the Russell 2000 Index) lagged their large company counterparts, they too delivered a better than historical average total return of 14.6% for 2017. As forecast in prior Quarterly Recaps and Near-term Outlooks, most regions across the globe are exhibiting some degree of economic expansion, and on average international economies exceed the rate of growth in the U.S. In its most recent update, the International Monetary Fund projects that the U.S. economy will grow 2.7% in 2018 (up from prior projections of 2.1%) and that the world economy will grow 3.9% (up from prior projections of 3.7%). Rising global economic growth helped to fuel strong equity performance across most major indices for both U.S. and international markets during 2017. And despite a bit of weakness in international developed markets during Q4, both international developed markets (+25.6%) and emerging markets (+37.8%) outperformed U.S. markets over the full year.

Interest rates in the U.S. and internationally had a meaningful mid-year reversal from falling bond yields/higher bond prices back towards higher bond yields/lower bond prices (bond yields and bond prices have an inverse relationship). Even so, most U.S. bond sectors posted gains for 2017 despite a challenging Q4 during which U.S. Treasury yields climbed steadily. The U.S. dollar, as measured by the ICE Futures U.S. Dollar Index (DXY), ended the year lower by about 11.4% despite rising Treasury rates. Corporate bonds capped a good year with positive total returns. International bonds also experienced healthy performance.

Another supportive factor of the improving global growth theme, the Bloomberg Commodities Index (a price index based upon a broadly diversified basket of commodity items) posted a robust return in Q4 of +4.7% that finally pushed 2017’s Index return into positive territory at +1.7% for the year. While a 1.7% total return might seem paltry, after many years of commodity price deflation Bloomberg commented that while commodity values were still compressed, they are now “less depressed” and “on sound footings for 2018”. West Texas Intermediate crude traded above $60 per barrel in December, extending that push to a three-year high in early January. Normalizing oil prices are certainly a harbiner of better things to come for the energy sector.

The fine folks at Novel Investor provide for us the box charts that follow. We thank them, greatly! The first, immediately below, demonstrates the annual relationship of returns across broad asset categories, both stocks and bonds, in the U.S. and internationally. I like to include this chart when updated as it provides an easy-to-understand visual representation of how the relationships between broad asset categories and markets change over time. The chart also includes a box for an Asset Allocation Portfolio that is broadly diversified, balanced, and fairly indicative of the types of one-size-fits-all portfolios built by other firms for the most typical investor. I have often heard feedback that the level of detail that I provide is nice, but that clients struggle to understand exactly how it should inform their performance expectations. The Asset Allocation Portfolio provided by Novel Investor gives clients an independent, broadly diversified, and balanced benchmark against which to evaluate their own portfolio performance. The Asset Allocation Portfolio described by Novel Investor aligns with Morningstar, Inc.’s Moderate Risk Target Portfolio total return and proves informative for most investors.

Click on the chart to embiggen and activate features.
Right-click to open in a new window. We don’t judge.

Novel Investor Asset Class Returns TableSource: Novel Investor.

The box chart above illustrates 2017’s positive performance adding to what is the second longest bull market on record, helped by a domestic economic expansion now in the 103rd month (making it the third longest in U.S. history). These strong returns have been amid an environment of historically low volatility as measured by the Chicago Board Options Exchange, Inc.(CBOE) Volatility Index (VIX). And while the length of the current expansion, the length of the current bull market, and so many new market highs may unnerve some investors, it is worth noting that bull markets have not historically ended suddenly at historical highs or simply due to advanced age. Rather, unsustainable policy action, extreme valuations in one or more market sectors, or macro shocks (like geopolitical events) typically bring about the end of bull markets runs and economic expansions. Although market expectations are high, they do not appear to be extreme. Rather than describing market expectations as euphoric or irrationally exuberant describe the current market environment as “amiable”, having or displaying a friendly and pleasant manner.

The Chicago Board Options Exchange, Inc (CBOE) Volatility Index (VIX)

Getting to the specific decisions that influence Lake Jericho client portfolios, let’s briefly cover each of the five levels of our portfolio construction process. And as a brief reminder, no client portfolio will match perfectly typical/target allocation decisions, or sector allocation percentages, as every client experience is unique. These unique factors (such as portfolio start dates, timing of asset transfers, timing of individual contributions or distributions, overall risk profile, etc.) certainly impact exact performance attribution of our strategic and tactical decisions. However, what follows will generally inform you of the nature and direction within your own personal portfolio. Clients should carefully review their individual performance information provided to determine and understand how their particular portfolio is impacted by these decisions and performance versus appropriate benchmarks.

U.S. versus International

On a total return basis the S&P 500 Index gained 6.6% during Q4, 21.8% for all of 2017. The Dow Jones Industrial Average (DJIA) gained 10.9% during Q4, 28.1% YTD. These are among the best quarterly numbers seen in fifteen years. The biggest YTD gains among U.S. diversified funds was among large-company growth-oriented funds thanks to red-hot, mega-cap technology stocks. Technology ended the year as the top performing industry sector. The tech-heavy NASDAQ clearly demonstrates this fact having returned 29.6%.

Improving international economic growth, increasing foreign interest rate expectations, the weaker U.S. dollar, and some uncertainty surrounding U.S. economic policy, drove the outperformance of international equity markets during 2017.  The MSCI All-country World Index (a measure of the world’s developed markets performance) finished 2017 higher by 25.6%. If excluding the U.S. from that developed markets index, then the measure of international stocks improves to 27.2%. Even better, the MSCI Emerging Markets Index finished 2017 higher by 37.8%. Our overweights to international investments (with small-company developed market and emerging market overweights imbedded in those investments) served as a meaningful contributor to client portfolio performance during 2017.

Stocks versus Bonds

Interest rates are on the move higher. As long as the move, or the trend in the move, is reasonably paced then the move over time can be deftly managed. Lake Jericho managed portfolios have been defensively positioned against the impact of rising interest rates since 2015, in terms of lower allocations to bonds than is considered typical, in how we constrain allocations to equity investments (real estate, utilities, heavily leveraged sectors) with high negative correlation with interest rates, and in how we position the bond investments that we do hold. We continue to believe that this defensive position is best in the current environment as current bond yields provide little protection from sudden and large adverse price-movements should rates move unexpectedly higher. While certain elements of our defensive position might not add to portfolio returns in many environments, our positioning provides relatively “cheap” risk insurance for a small piece of client portfolios that does not detract meaningfully from portfolio returns in the long run. While our bond positions have been a head-wind for clients during 2017’s outstanding equity market performance, the way in which we construct exposure has been less costly to portfolios than the way in which more traditional managers might implement bond investments. But our lower overall allocation to bonds (and higher allocation to equities) than is typical has been a positive contributions to client portfolio performance during 2017.

Small Versus Big

The small- and mid-sized company space was one that widely outperformed most other sectors immediately after 2016’s election cycle. That the space lagged most other sectors during 2017 is not entirely surprising. However, the persistence of that underperformance post tax reform in the U.S. is somewhat perplexing. Traditional wisdom tells us that tax reform in the U.S. would most benefit small- and mid-sized companies as those companies tend to pay most/all of their corporate earnings tax inside the U.S. (versus large multinationals that are able to shop the world’s most advantageous tax jurisdications). Significant tax savings should fuel significant earnings growth, leading to meaningful outperformance of those company’s stock prices. This has not been the case. We shall see during Q1 2018’s earning season if the weaker U.S. dollar and rising commodity prices are putting a strain on input costs and thereby suppressing earnings.

To fairly evaluate our process regarding the “small versus big” question, we look to the Russell 2500 Index for comparisons. The Russell 2500 Index is a broad measure of blended strategies in both small- and mid-sized U.S. company stocks. For Q4, the Russell 2500 Index returned 5.2% (16.8% for 2017). With the S&P 500 Index return of 6.6% for Q4 (21.8% for 2017), our “small versus big” strategy underperformed large-company peers by 1.4% for Q4 (-5.0% for 2017). And as we do tend to hold larger allocations than is typical in the small- and mid-sized company space, this was a significant drag on client portfolio performance during 2017.

Value versus Growth

U.S. value-oriented equity strategies also wildly outperformed growth-oriented strategies during 2016. As a value-biased portfolio manager, Lake Jericho clients certainly benefited from that differential during 2016. But with the overwhelming outperformance of value-biased strategies during 2016 and of certain elements of value-oriented strategies during Q1 2017, that value strategies began to lag growth-oriented strategies during 2017 is again not surprising. But our focus is on maintaining long-term, strategic positions and not on attempts to time trading patterns. As with small- and mid-sized company exposure, we also believe that investor portfolios should maintain exposure to, if not an ongoing overweight towards, value-oriented investment strategies. The basic premise of value investing is that certain securities are underpriced bargains and are likely to outperform once their “real value” is fully appreciated by investors. If for no other reason, it is a bit of common sense supported by the statistics that if you remain mindful of not overpaying for your investments then you are more likely to achieve superior returns over the long-run. Value-oriented investing is one method that helps investors achieve this objective. A gross over-simplification of an entire field of financial study, but that is the basic idea.

To fairly represent value versus growth factors in the markets we use Morningstar, Inc. measurements. During Q4, U.S. value funds as a group were up 6.3%, right on the heels of the S&P 500 Index return of 6.6%. However, for the full year U.S. value funds as a group were up 14.2%, trailing the S&P 500 Index total return of 21.8% by 7.6%. If we isolate large-company growth strategies within the S&P 500 Index during 2017, return increases to 31.1% and the differential swells to 16.9%. That degree of performance differential, though rare in the long run, surely feels painful in the short-run. But the tide will turn and the relationship will normalize. Luckily (or smartly) our value bias is constructed both domestically and internationally. During most of 2017, international markets simply outperformed U.S. markets. Putting both exposures together, our value bias internationally was essentially a wash for client performance returning a comparable 21.5% to 23.9% depending upon the manner of implementation versus the S&P 500 Index’s 21.8%.

Sector Allocation Decisions

Finally, strategic and tactical sector weighting, the fifth aspect of our portfolio construction process, is an important part of how we add real, long-term value for our clients. Our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting those sectors that we expect to outperform the market average have been a meaningful tailwind for client portfolios over time. If you look at the 2017 column of sector returns in Novel’s box chart below, you will see the S&P 500 Index return for 2017 sitting at #6. The 11 sectors that make up the S&P 500 Index are strewn about, above or below depending upon the sector finish relative to the Index. Our sector overweights are currently materials (#2), financials (#4), and healthcare via medical devices and technology (#5), each besting the S&P 500 Index for 2017. Finishing in second place behind technology was the materials sector at 23.8%. Finishing in fourth place among the 11 sectors was the financials sector at 22.2%. And in fifth place, the healthcare sector finished at 22.1%. Since we were overweight sectors outperforming the S&P 500 Index, and underweight to all of the other sectors underperforming the S&P 500 Index , our underweighting of the high-flying technology sector was muted at bit.

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Novel Investor Sector Returns TableSource: Novel Investor

Near Term Outlook

Amiable , admittedly, is a strange word to describe a market or to describe the expectations of market participants. But it fits for two reasons widely discussed in the financial media. First, analysts feel that the lingering impact of the global financial crisis caused market expectations during the past decade to be generally so depressed that proper attitudes are only now returning. So, have market expectations been unnecessarily low for so long that our new and proper expectations feel euphoric in contrast? Perhaps say the pundits. I say yes, absolutely. Second, and more tangible than “feelings”, increasing growth expectations are now seen in consensus forward looking estimates for domestic and international real GDP growth, meaning that market participants view global economic growth as supportive of higher equity prices. Further, the consensus among market participants is that room remains for yet more upside. And while domestically the U.S. has had a big run-up in the markets due to the growth impact of tax cuts, markets are continuing to climb higher because those tax cuts are already beginning to show up in household and corporate earnings. In even simpler terms, the economy is growing into these higher stock prices. And that is the historical norm. The stock market has been, and is now, a leading indicator of the health of the underlying economy. This first-mover behavior of equity markets is the market behavior that professional investors expect to see.

So there has to be something, right? Something for us all to fret about, and to wonder if now is the time to sell everything and wait on the sidelines for the reckoning that must come? If you are going to twist my arm and force me to say something unfriendly about this very amiable market then I am going to say that we need to watch the value of the U.S. dollar. The softening U.S. dollar (currently at about a 3-year low) has been a supporting factor for rising commodity prices, a supporting factor for rising international equity returns, and certainly has been a goal of the Trump administration with his focus on the trade deficit. The cheaper the dollar the more we can sell overseas, right? So a weaker dollar has some upside. In past quarter’s we have described our mindful process, carefully watching for imbalances between interest rates, currency values, and commodity prices. In 2015 and early 2016 we talked a lot about what happens when things get too expensive or too cheap. “Too” anything is never a good thing in markets. We might be getting close to a dollar that is “too” cheap. The small-company stocks might be the early warning signal. And if interest rates continue higher without a corresponding increase in the value of the U.S. dollar, then we might actually have a perception problem internationally related to government policy and impacts upon market stability. We shall see. If we do discover a fly in the ointment with respect to this market, it will come through one of the three windows; interest rates, currency values, or commodity prices.

We remain watchful and ready to respond should we see signs on the horizon of something awry. I encourage you once again to take a bit of time and enjoy what this market is providing. There will be time for worry later. As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions. I will also be in touch with each of you in the coming weeks as Lake Jericho rolls out its new collaborative and interactive financial planning application. Until then, be well, enjoy the rest of your week, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

 

3rd Quarter 2017: Quarterly Recap and Near-term Outlook

Lather. Rinse. Repeat? Maybe Bill Murry’s experience in the movie Groundhog Day is the appropriate comparison. Either way, I am writing about the same themes, if not the same things, this year. But portfolio gains continue to roll in, so I do not want to jinx this groove. Economic growth continues to expand across the globe. Expansion is improving corporate earnings throughout the world’s economies. Improving corporate earnings are providing fundamental support for global equity market’s steady grind higher. Low interest rates, geo-political stability (despite puerile rhetoric and media induced anxiety), normalizing energy/commodity prices, and normalizing currency relationships persist. Despite investor’s behaviorally-biased anxiety associated with notching repeated new market highs, there is calmness in the markets evidenced by historically low levels of volatility. When volatility does appear, it is short-lived and in a short-list of market sectors (if not a short-list of individual stocks) from which investors rotate out of and directly into other investments. At no point this year has there been a wholesale liquidation of broad market holdings. Will this last forever? Absolutely not. Does there exist any clear, fundamental signal that this will end today? Not really. Will there be some type of pull-back in the near-term? History tells us that there will be. What should we do about it? The math tells us to keep doing what we are doing.

Q3 Review
Despite a painfully slow start and now a mind-boggling eight years old, the global economic recovery is well under way. Finally, after years of continuous monetary stimulus major developed economies (U.S., Europe, Japan, et. al.) are seeing firm growth and inflation data. The U.S. is now slightly weaker compared to developed market peers, but more meaningfully so compared to emerging market economies where growth has outpaced the U.S. for some time. While some in the U.S. may lament “too low” of growth and inflation data, I view data continuing slightly below central banker’s targets and well below the White House’s targets, and the resulting measured pace of policy responses, to be a terrific thing for Lake Jericho clients. History has proven, repeatedly, the ill-effects of boom-to-bust cyclical swings made worse by heavy-handed political action or central bank policy intervention. While market speculators and Wall Street insiders might benefit from big brother’s thumbs-on-the-scale tilting market forces in their favor, it comes at a cost to Main Street investors and long-term savers. So I am perfectly comfortable with a measured pace of recovery, a slow pace by policymakers as they remove monetary accommodation over a period of years supported only by underlying economic fundamentals. In past commentary I have gone into excruciating detail about the market mechanisms that make important economic variables (growth rates, interest rates, currency exchange rates) inextricably intertwined and their effects upon client portfolios. I will spare you the halloween-season horror of that level of discussion. I will simply remind everyone that a boring path is a good path. A boring path means that economic growth can be reasonably forecasted, inflation is of the expected variety, interest rate movements and long-run relationships in currency exchange rates can be signaled and managed.

We began our Q2 Review with a lengthy discussion of volatility. Volatility, or rather the lack of volatility, is also important in the Q3 story. The current low level of volatility, and the long-run downward trend in market volatility, is partially an outcome of “boring” paths and the benefit of a soft-handed approach to market intervention. Again, in the U.S. there were a few pockets of sector weakness and market volatility during Q3 as measured by the Chicago Board Options Exchange (CBOE) Market Volatility Index (VIX). But it remains important to view these few, short-lived periods of volatility within the context of what continues to be a period of the lowest market volatility in the history of the measure. The few, short-lived periods of volatility have largely been due to transitory issues rather than fundamental problems, and have resulted in investor rotation amongst markets or market sectors rather than broad-based market sell-offs. Whereas the VIX spiked by 40% during the final week of Q2 before settling back to historic lows, that Index spiked again by about 76% during August only to fall back to even lower marks not seen since January, 2007. The graphs below is included for a bit of historical perspective on that 76% August jump in volatility; a 76% jump from a historically low level does not even register as a blip in the long-run trend. As a bit of forward-looking insight, we see historically a slow turn higher in volatility before significant events occur. It is for a reversal in trend we most watch for, rather than transitory events. In a time of attention-spans that last no longer than a daily news cycle, it might be difficult to recall mid-August from mid-October. But mid-August saw the saber-rattling between the U.S. and North Korea, the fallout from President Trump’s comments about the Charlottesville protests, and heavy flood damage in Houston and Florida from hurricane activity. To borrow another’s analogy, August came in like a lamb, turned into a lion, and then left like a lamb. If you looked only at the market numbers from the beginning and the end of Q3 you would never know that anything of consequence had occurred.

CBOE Volatility Index (VIX) through Q3 2017

CBOE Volatility Index (VIX) through Q3 2017

Generally speaking, nearly all industry sectors and portfolio strategies are positive thus far during 2017. Big companies, little companies, U.S. companies, foreign companies, emerging market companies, growth-oriented strategies, value-oriented strategies, are all up solidly. The U.S. sectors and strategies that most benefitted from the post-election “Trump-bump”, excelling in terms of relative performance during 2016 (small company stocks, banks, infrastructure, cyclical/value-oriented strategies), that had lagged in the first half of 2017 managed to close much of the YTD performance gap during Q3. Professional investors look to these types of “participation” measures, tests of both the breadth and depth of market performance, to measure market health. With continued wide and deep participation in the current market rally, most consider equity markets to be healthy. With the exception of the Energy, Real Estate, and the Consumer Staples sectors, the YTD return numbers for most major sectors and strategies are relatively close by historical standards. As the forward-looking performance of these three sectors is somewhat tied to interest rate outlooks, it is no surprise that these three sectors might somewhat lag in the current environment as rates are slowly trending higher.

Getting to the specific decisions that influence Lake Jericho client portfolios, let’s briefly cover each of the five levels of our portfolio construction process. And as a brief reminder, no client portfolio will match perfectly typical/target allocation decisions, or sector allocation percentages, as every client experience is unique. These unique factors (such as portfolio start dates, timing of asset transfers, timing of individual contributions or distributions, overall risk profile, etc.) certainly impact exact performance attribution of our strategic and tactical decisions. However, what follows will generally inform you of the nature and direction within your own personal portfolio. Clients should carefully review their individual performance information provided to determine and understand how their particular portfolio is impacted by these decisions and performance versus appropriate benchmarks.

U.S. versus International
On a total return basis the S&P 500 Index gained 4.48% during Q3, 14.24% YTD. The Dow Jones Industrial Average (DJIA) gained 5.58% during Q3, and 15.45% YTD. These are among the best quarterly numbers seen in five years. The biggest YTD gains among U.S. diversified funds are large-company growth-oriented funds, in large part thanks to the red-hot, mega-cap technology stocks. Technology is now the top performing industry sector YTD despite experiencing pockets of market volatility during the year. The tech-heavy NASDAQ clearly demonstrates this fact having returned 21.67% YTD. The healthcare sector, and especially certain sub-sectors within the healthcare space, are a close second in terms of YTD performance. While technology is up about 23% YTD, healthcare is up about 20% YTD with several sub-sectors within healthcare up by 25% to 30% YTD. The only sector in the red for 2017 is the Energy sector, down almost 7% YTD. Energy has yet to fully recover from the early-year sell off in crude and the impact of the Q3 hurricane season in the U.S. gulf region. However, improving crude prices thus far in Q4 could go a long way to reversing that energy slide heading into year-end.

Aside from improving local growth, international markets continue to get a bit of help from a generally weaker U.S. dollar. Due in large part to improving international economic growth, corresponding increases in foreign interest rate expectations, and surprisingly even due to uncertainty surrounding U.S. economic policy, a weaker U.S. dollar is driving a good portion of the outperformance of international equity markets this year. Although the U.S. dollar as measured by the DXY increased in value by about 0.45% during Q3, YTD the dollar is lower by about 7%. Supported by a weaker dollar, the Morgan Stanley All-country World Index (excluding the U.S.) is up by 21.13% YTD. Even better, emerging market indices are up by about 26% YTD. Our overweights to international investments (with small-company, and emerging market overweights imbedded in those investments) have served as a meaningful tail wind for clients thus far during 2017.

Stocks versus Bonds
Interest rates are on the move higher. As long as the move, or the trend in the move, is reasonably paced then the move over time can be deftly managed. Lake Jericho managed portfolios have been defensively positioned against the impact of rising interest rates since 2015, in terms of lower allocations to bonds than is considered typical, in how we constrain allocations to equity investments with high negative correlation with interest rates, and in how we position the bond investments that we do hold. We continue to believe that this defensive position is best in the current environment as current bond yields provide little protection from adverse price-movements should rates move quickly higher. While certain elements of our defensive position might not add to portfolio returns in many environments, it is relatively “cheap” risk insurance for a small piece of client portfolios that does not detract meaningfully from portfolio returns in the long run. While our bond positions have been a head-wind for clients during 2017’s outstanding equity market performance, the way in which we construct exposure has been less costly to portfolios than the way in which more traditional managers implement bond investments. And our lower overall allocation to bonds (and higher allocation to equities) than is typical has certainly been a tail wind for clients during 2017.

Rising Interest Rates/Flattening Yield Curve

Rising Interest Rates/Flattening Yield Curve

Small Versus Big
The small- and mid-sized company space was one that widely outperformed most other sectors immediately after 2016’s election cycle. That the space has lagged most other sectors throughout most of 2017 is no surprise. Mean reversion is real. Nonetheless, one of our fundamental portfolio convictions is that investors should maintain an exposure to, if not an ongoing overweight towards, small- and mid-sized company equity investments at all times. Among the reasons that we hold this belief is the tendency for small- and mid-sized company stocks to demonstrate “clumpy” patterns of return. While on average, over the long-run, the space can provide superior investment returns versus large-company peers, much of the excess performance can occur in short, unexpected time periods. This pattern can then leave longer time periods of underperformance. We are not in the business of predicting these patterns, much less trading these patterns, rather we are in the business determining and holding as efficient of an exposure to this space as possible over time.

The first eight months of 2017, as well as all of 2015, are time-period examples of a market rotation away from small- and mid-sized company investments. 2016, especially post-election 2016, is an example of why you always want to maintain exposure to the space. During 2016, the way we construct small- and mid-sized company exposure bested large-company U.S. equity investments by 8.60%. But none of these time-periods support a position, statistically, that market-timing or risk taking simply for risk’s sake is its own reward. Statistically, there exists in our determination an approximated optimal allocation of small- and mid-sized company exposure to be held in investor accounts that adds value over time without exposing portfolios to unnecessarily high levels of variability. Our answer to best manage this trade-off over time without engaging in unnecessary trade execution is to maintain a fairly constant exposure to the space, and to employ three different strategies simultaneously that best gain exposure to persistent factors of return within the space. This strategy was once again rewarded during Q3. Having trailed significantly throughout 2017, sinking to the widest depths of the year in August, immediately following the announcement of Trump’s tax reform plan and potential for outsized benefit to small U.S.-based companies the small- and mid-sized company space significantly outperformed large-company counterparts to pull ahead for Q3.

To fairly evaluate our process in the “small versus big” space, we look to the Russell 2500 Index for comparisons. The Russell 2500 Index is a broad measure of blended strategies in both small- and mid-sized U.S. company stocks. During Q3 the Russell 2500 returned 4.74%, 0.26% ahead of the S&P 500 for the Quarter. While slightly ahead for Q3, the small- and mid-sized U.S. company space is behind the S&P 500 YTD but essentially even for the rolling one-year period.

Value versus Growth
As with small- and mid-sized company exposure, we also believe that investor portfolios should maintain exposure to, if not an ongoing overweight towards, value-oriented investment strategies. The basic premise of value investing is that certain securities are underpriced bargains and are likely to outperform once their “real value” is fully appreciated by investors. It is a bit of common sense, supported by the statistics, that if you remain mindful of not overpaying for your investments then you are more likely to achieve superior returns over the long-run. Value-oriented investing is one method that helps investors achieve this objective. A gross over-simplification of an entire field of financial study, but that is the basic idea.

Last year, U.S. value-oriented equity funds as a group were up 20.79%, according to Morningstar, while U.S. growth-oriented equity funds as a group rose only 3.16%. As a value-biased portfolio manager, Lake Jericho clients certainly benefited from that differential during 2016. But with the overwhelming outperformance of value-biased strategies during 2016, and of certain elements of value-oriented strategies during Q1 2017, that value strategies lagged growth strategies by a wide margin during Q2 is not a great surprise. Again, our focus is on maintaining long-term, strategic positions and not on attempts to time trading patterns. As with the small- and mid-sized company space, Q3 provided some relief for the 2017 performance differential in value versus growth.

Sticking with Morningstar measurements, during Q3 2017 U.S. value funds as a group were up 4.48% to equally match the return of the S&P 500. However, those red-hot mega-cap technology stocks did lift U.S. growth funds as a group by 5.33%. While better, with the continued type performance differential for YTD 2017, how could the Lake Jericho managed portfolio compete? Again, I offer a gross oversimplification, but there are two ways in which we managed to offset that performance gap. First, a large part of our value-biased positions increased in value significantly during 2016 (particularly post-election) meaning they begin to exhibit, statistically, more growth-oriented characteristics. Over time, due to portfolio turnover, our positions will return to a more typical value-oriented performance profile. Second, our value bias is constructed both domestically and internationally. During both Q2 and Q3, international markets simply outperformed U.S. markets. Putting both factor exposures together, our target value bias remains a tail wind for client performance. For YTD 2017 and on a rolling one-year basis, our target value bias with both domestic and international exposures has contributed positively to performance.

Sector Allocation Decisions
Finally, strategic and tactical sector weighting, the fifth aspect of our portfolio construction process, was an important part of how we added value during Q3. Our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting higher expected growth sectors (currently materials, medical devices and technology, pharmaceuticals, biotech/genomics, and early additions to regional banks and emerging markets) were a mixed bag for the quarter. Two of our most meaningful contributors during Q1 and Q2, medical devices and pharmaceuticals, reversed trend and actually detracted from client portfolio performance during Q3. Medical devices (4.11% behind the S&P 500), pharmaceuticals (0.17% behind the S&P 500), and regional banks (0.78% behind the S&P 500) all served to detract from client performance. Materials (1.72% ahead of the S&P 500) and biotech/genomics (4.85% ahead of the S&P 500) served to add to client performance. Direct emerging market exposures are too new to objectively quantify attribution as of yet. In summary, for Q3 our sector allocation decisions served to reduce the average client portfolio by about 0.03%. It was really a non-event in terms of comparison with a market-weighted portfolio. However, for YTD 2017 our sector allocation decisions have added 1.33% in additional returns versus a market-weighted portfolio to the average Lake Jericho client account.

Near Term Outlook
Let’s first lay out a few current market realities.

  • The S&P 500 passed through 2500 recently, and the DJIA just this week overtook the 23,000 mark.
  • We are at 40+ new market highs this year, and closing in on 50.
  • Market volatility is at all-time lows.
  • Market internals, things like short-interest and call-option purchases, all indicate upside expectations abound.
  • Q3 earnings season is off to a strong start and thus far is reinforcing market valuation levels.
  • Macro data continues to support growth expectations, if not upward revisions of growth estimates.
  • The unemployment rate sits at 4.3%, yet inflation is subdued at just 2.2%.
  • The 10-year treasury bond yield is still well below 3%.
  • We haven’t had an economic downturn since the last one ended in mid-2009, making this one of the longest recoveries in history.

These are all great things, right? Of course they are. I would be the first to sound the warning should I see something worrisome in these data points. It is always my full-time job to evaluate the data, to understanding risks, and to execute efficient ways of managing those risks. It is also part of my full time job to occasionally reassure investors that times do exist when we can take a breath and simply enjoy a ride. They are few and far between, so enjoy what the market it giving us. In the mean time know that I am watching events on the horizon that could create bumps in this smooth ride. There are a few matters (the tax-policy debate, a potential change in the Federal Reserve chair, currency shocks due to unforeseen policy events) that create potential for upset, but nothing that I see on the horizon as immediately problematic. For the near-term, at least through year-end, I plan no meaningful changes in strategy or execution.

Having said that, I am keenly aware that it is closing in on two years since stocks have seen a 10% correction, and I don’t recall without looking when the last 5% correction occurred. And tomorrow just happens to be the 30th anniversary of “Black Monday”. I know that it is this type of market reality that is causing the greatest amount of investor concern. I also know that this concern is rooted in historical context and not conditioned by the current data. And that is OK. That is human nature. I follow Ben Carlson’s blog, and in a recent post he stated “This is why understanding yourself is the most important part of the investment process. If you don’t understand yourself — your reactions, your personality traits, your biases, your limitations — it doesn’t matter which type of investor you’re supposed to be. It matters which type of investor you are.” I like that blurb because it best informs me why I am here, and what the most important element of my responsibility happens to be. My responsibility is to be the voice of evidence-based reason, to align the type of investor each of my clients is supposed to be with the experience that each achieves. In short? I must be a capable technician, but I must be an even better investing “coach”.

As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions. I will also be in touch with many of you in the coming weeks to conduct needed reviews of goals and objectives, make any needed changes as a result, and to walk through a few administrative tasks that we might need to tackle. Until then, be well, enjoy the rest of your week, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

2nd Quarter 2017: Quarterly Recap and Near-term Outlook

Along with the end of Q2, the first half of 2017 has come to a close. An elementary observation, of course. Nonetheless, it has been tough for me to wrap my head around this reality. To look at my calendar and see that we are moving into August is befuddling to my perception of time. Yes, the timing of the July 4th holiday pushed back most of the street’s reporting cycles, and I am as well behind my typical schedule in posting this commentary. Most likely, perhaps, I am disoriented because 2017 has been packed with distraction, but somewhat devoid of negative investment catalysts. Despite the constant noisy-gong and clanging-cymbal drama arising from our nation’s capital, the lack of any pro-growth policy progress from the White House, and a Congress recently called the least effective in 164 years, little of consequential market impact has been integrated into public consciousness. While the news cycle is 100% hyperbole, 100% of the time, professional investors seem to have turned away from Washington’s, and the media’s, inflammatory rhetoric and instead refocused itself on old-school, fundamental macro-economic analysis and corporate valuation work.

Q2 Recap
Fundamental investment work has been rewarded this year as market volatility remains at, or near, record lows, as persistently low interest rates at home and abroad have sustained equity market’s reasonable pace to record highs, and as global economies have joined the U.S. in a broad-based recovery. Sure, there have been a few pockets of sector weakness and market volatility. The Chicago Board Options Exchange (CBOE) Market Volatility Index (VIX), one measure of equity market volatility, spiked by 40% during the final week of Q2. But it is important to view these few, short-lived, and far-between periods of volatility within the context of what has been a period of the lowest market volatility in the history of the measure. The few, short-lived periods of volatility have largely been due to transitory issues, and have resulted in investor rotation amongst markets or market sectors rather than broad-based market sell-offs. To fully understand equity volatility at the end of Q2 one must turn attention away from equities to look at what was going on with interest rates and currencies.
The end of Q2 saw global bond yields rise suddenly following comments from European Central Bank (ECB) president Mario Draghi that the ECB was prepared to reduce its monetary stimulus prior to year-end. Knowingly an oversimplification of the comments, the ECB basically said it is time for interest rates and asset intervention by the central bank in Europe to normalize. Comments not so dissimilar from recent guidance from our own Federal Reserve, so why the impact? Draghi’s comments surprised investors who were thinking that the ECB, much like the U.S. Federal Reserve, would react more slowly to signs of improving economic conditions. No doubt, should the ECB move this year it will be, relatively, at a faster pace than the U.S. Fed has dared move under similar signals. While it is good news that global economic conditions are improving, investors worry that too rapid of a move towards monetary policy normalization could dampen global growth and slow rising corporate earnings before sustainable growth has the opportunity to gain sure footing. The sudden change in investor expectation caused global bond yields (including some interest rates in the U.S.) to shift higher. Although U.S. interest rates had moved a bit lower throughout Q2 pushing domestic bond returns higher, the sudden move towards higher interest rates at the very end of Q2 did take back some of those gains. The impact on global (ex-U.S.) bond funds was more dramatic, with many finishing in the red for Q2. These sudden interest rate movements and the resulting impact on global currencies played a hand in U.S. equity market volatility at the end of Q2.

Despite the short-lived volatility, on a total return basis the S&P 500 Index gained 3.09% during Q2 while the Dow Jones Industrial Average (DJIA) gained 3.95%. For the year-to-date through June 30 (YTD), both the DJIA and the S&P 500 Index gained more than 9.0%, at 9.35% and 9.34% respectively. The tech-heavy NASDAQ soared more than 14% during the same period. Even better, international equity markets have out-paced the U.S. market YTD, with the Morgan Stanley All-country World Index (excluding the U.S.) also up by more than 14%. In fact, most stock and bond market indexes have posted solid gains YTD. All but a few dozen funds in the Morningstar 500 (Morningstar’s field of 500 highly-rated, actively managed, diversified mutual funds) finished 2017’s first half in the black. Generally speaking, most industry sectors and portfolio strategies are positive for the first half of 2017. Big companies, little companies, U.S. companies, foreign companies, emerging market companies, growth-oriented strategies, value-oriented strategies, all up solidly thus far on the year. As one would expect, a couple of U.S. sectors and strategies that most benefitted from the post-election “Trump-bump”, excelling in terms of relative performance during 2016 (small company stocks, banks, infrastructure, cyclical/value-oriented strategies), have lagged during 2017 as other sectors and strategies played catch-up. But even with differences in timing of returns, the one-year return numbers for most major sectors and strategies are relatively close by historical standards. Professional investors look to these types of “participation” measures, tests of both the breadth and depth of market performance, to measure market health. With continued wide and deep participation in the current market rally, most consider equity markets fairly or fully valued at this time. I am in the “fairly” camp with most, but I do consider some areas of the market to be “fully” valued and am more conservative when making new investments.

The biggest gains YTD among U.S. diversified funds have been had by growth-oriented funds, in large part thanks to red-hot, mega-cap technology stocks and significant recovery in the biotechnology/genomics space. These sectors were negatively impacted by 2016’s election cycle rhetoric and outcome. With the lack of any resulting policy impact it is no surprise that these 2016 under-performers have overachieved this year. “Technology” itself has been the second best performing industry sector YTD despite itself experiencing a couple of pockets of market volatility during the year, including the final week of Q2. However, the technology sector rebounded quickly and meaningfully in the early days of Q3 and as of this posting sits at or near record index levels. The only better place to be this year has been the healthcare sector. Healthcare, and especially certain sub-sectors within the healthcare space. The healthcare sector has been 2017’s big performer despite domestic policy noise regarding the Affordable Care Act and attempts to repeal, replace, or simply save face. While technology is up about 14% YTD, healthcare is up about 16% YTD with several sub-sectors within healthcare up more than 20% YTD.

With only one sector serving as an exception, the remaining eight of the eleven S&P 500 industry sectors have all performed within 1% – 2% of the S&P 500 Index’s total return YTD. The lone exception for 2017 is the energy sector. Despite the energy industry growing more diversified within the U.S., the energy sector remains heavily linked to the price of oil. Having started 2017 at about $54 per barrel, crude fell by more than 20% to a 2017 closing low of about $42.50 per barrel, taking down with it share prices of energy sector companies. Energy sector stocks are down, on average, about 13% YTD. Some mega-cap, commonly known names with the greatest oil exposure have been off by about 40% from their 52-week highs experienced during 2016’s crude-oil rebound. However, oil has rebounded somewhat thus far during Q3 as crude is up to about $46-$48 per barrel, and sector stock prices (and expected earnings) are improving. Even with 2017’s lull in crude, this year is shaping up to be far superior for the industry overall compared with the shake-out that resulted from 2016’s sub-$30 bottoming out in the price of oil.

Getting to the specific decisions that influence Lake Jericho client portfolios, let’s briefly cover each of the five levels of our portfolio construction process. And as a brief reminder, no client portfolio will match perfectly typical/target allocation decisions, or sector allocation percentages, as every client experience is unique. These unique factors (such as portfolio start dates, timing of asset transfers, timing of individual contributions or distributions, overall risk profile, etc.) certainly impact exact performance attribution of our strategic and tactical decisions. However, what follows will generally inform you of the nature and direction within your own personal portfolio. Clients should carefully review their individual performance information provided to determine and understand how their particular portfolio is impacted by these decisions and performance versus assigned benchmarks.

U.S. versus International
With limited exceptions, the global recovery in economic activity continues and in many regions is gaining steam. Aside from improving growth, international markets are getting a bit of help from from the U.S. in unanticipated ways. At multiple points in the last couple of years I have talked about things that get too expensive and things that get too cheap, and how those pricing distortions stand in the way of economic recovery. The end of 2015 and the opening weeks of 2016 were times when the prices of various assets were distorted and caused all sorts of mayhem in the markets. One of the things that got too expensive during that time period was the U.S. dollar. Due in large part to improving international economic growth, corresponding increases in foreign interest rate expectations, and surprisingly even due to uncertainty surrounding U.S. economic policy, a weakening U.S. dollar is driving a good portion of the outperformance of international equity markets. The U.S. dollar was down 3.45% for Q2, down 6.44% YTD, and with post-Q2 softening now sits near at a year-long low of the Dollar Index (a measure of the U.S. dollar value versus a basket of major world currencies). Supported by a weaker dollar, international equities led the global stock market rally for the second quarter in a row. Emerging-market equities continue to outperform U.S. large-company stocks on a one-year basis. Our overweights to international investments (with small-company, and emerging market overweights imbedded in those investments) served as a meaningful tail-wind for clients. Our method for building international exposure bested aggregate U.S. equity exposure from 1.7% to 3.0% during Q2. Having increased international exposure in client portfolios during 2017 to as much as 30%, this added up to 0.70% of additional return to client performance during Q2 versus an all U.S. equity portfolio.

Stocks versus Bonds
Lake Jericho managed portfolios have been defensively positioned against the threat of rising interest rates since 2015, both in terms of lower overall allocations to bonds and in how we have positioned bond holdings where they exist. We continue to believe that a defensive position is best in the current environment. However, the way in which that defensive position is constructed is the most important part of the decision to be defensively positioned. By design, our approach in the fixed income space is statistically disconnected from standard benchmarks in this particular part of client portfolios (again a gross over-simplification). The purposeful disconnect has been a benefit to client portfolios during the past two years, but did adversely impact client returns during Q2. Versus the Barclays U.S. Aggregate Bond Index, our typical client bond allocation underperformed by about 0.2% during Q2. On a YTD basis, client portfolios are essentially even with that index at +0.02%.

Small Versus Big
As stated above, the small- and mid-sized company space was one that widely outperformed most other sectors immediately after 2016’s election cycle. That the space has now lagged many other sectors YTD while other sectors played catch-up is no surprise. Nonetheless, one of our fundamental portfolio convictions is that investors should maintain an exposure to, if not an ongoing overweight towards, small- and mid-sized company equity investments at all times. Among the reasons that we hold this belief is the tendency for small- and mid-sized company stocks to demonstrate “clumpy” patterns of return. While on average, over the long-run, the space can provide superior investment returns versus large-company peers, much of the excess performance can occur in short, unexpected time periods. This pattern can then leave much longer time periods of underperformance. We are not in the business of predicting these patterns, much less trading these patterns, rather we are in the business determining and holding as efficient of an exposure to this space as possible over time.

The first half of 2017, as well as the entire year of 2015, is an example of short-run market performance rotating through sectors. 2016, especially post-election 2016, is an example of why you always want to maintain exposure to the space. During 2016, the way we construct small- and mid-sized company exposure bested large-company U.S. equity investments by 8.60%. But none of these time-periods support a position, statistically, that market-timing or risk taking simply for risk’s sake is its own reward. Statistically, there exists in our determination an approximated optimal allocation of small- and mid-sized company exposure to be held in investor accounts that adds value over time without exposing portfolios to unnecessarily high levels of variability. Our answer to best manage this trade-off over time without engaging in unnecessary trade execution is to maintain a fairly constant exposure to the space, and to employ three different strategies simultaneously that best gain exposure to persistent factors of return within the space.

To fairly evaluate our process in the “small versus big” space, we look to the Russell 2500 Index for comparisons. The Russell 2500 Index is a broad measure of blended strategies in both small- and mid-sized U.S. company stocks. During Q2 the Russell 2500 returned 2.13%, 0.96% behind the S&P 500 for the Quarter. Our approach to the space returned 1.60%, 1.49% behind the S&P 500 for the quarter. On a YTD basis, the Russell 2500 has returned 5.97% while our approach has returned 4.87% (3.37% and 4.47% behind the S&P 500). While lagging both the S&P 500 and the Russell 2500 for both Q2 and YTD, our approach to the small- and mid-sized company space has bested both the S&P 500 and the Russell 2500 on a one-year basis. On a one-year basis, our small- and mid-sized company positions returned a weighted average of 19.86% while the Russell 2500 Index has returned 19.84% and the S&P 500 has returned 17.90%. In this regard, our sector allocation decisions have outperformed the S&P 500 by nearly 2.00% during the last year, adding about 0.44% of additional return to the average client portfolio.

Value versus Growth
As with small- and mid-sized company exposure, we also believe that investor portfolios should maintain exposure to, if not an ongoing overweight towards, value-oriented investment strategies. The basic premise of value investing is that certain securities are underpriced bargains and are likely to outperform once their “real value” is fully appreciated by investors. It is a bit of common sense, supported by the statistics, that if you remain mindful of not overpaying for your investments then you are more likely to achieve superior returns over the long-run. Value-oriented investing is one method that helps investors achieve this objective. A gross over-simplification of an entire field of financial study, but that is the basic idea.

Last year, U.S. value-oriented equity funds as a group were up 20.79%, according to Morningstar, while U.S. growth-oriented equity funds as a group rose only 3.16%. As a value-biased portfolio manager, Lake Jericho clients certainly benefited from that differential during 2016. But with the overwhelming outperformance of value-biased strategies during 2016, and of certain elements of value-oriented strategies during Q1 2017, that value strategies lagged growth strategies by a wide margin during Q2 is not a great surprise. Again, our focus is on maintaining long-term, strategic positions and not on attempts to time trading patterns.

Sticking with Morningstar measurements, during Q2 2017 U.S. value funds as a group were up a meager 0.24% while U.S. growth funds as a group rose 5.86%. With that type of performance differential during Q2, how could the Lake Jericho managed portfolio compete? Again, I offer a gross oversimplification, but there are two ways in which we managed to offset that performance gap. First, a large part of our value-biased positions increased in value significantly during 2016 (particularly post-election) meaning they begin to exhibit, statistically, more growth-oriented characteristics. Over time, due to portfolio turnover, our positions will return to a more typical value-oriented performance profile. Second, our value bias is constructed both domestically and internationally. During Q2, international markets simply outperformed U.S. markets. Putting both factor exposures together, our target value bias was far more competitive and in the end resulted in only -0.15% of composite performance attribution underperformance for the typical client portfolio versus a 100% U.S. core strategy. For YTD 2016 and on a rolling one-year basis, our target value bias has contributed positive composite performance attribution of 0.09% and 2.20% versus a 100% U.S. core strategy.

Sector Allocation Decisions
Finally, strategic and tactical sector weighting, the fifth aspect of our portfolio construction process, was an important part of how we added value during Q2. Our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting higher expected growth sectors (currently materials, medical devices and technology, pharmaceuticals, biotech/genomics, and early additions to a regional banks exposure) contributed from 0.38% to 0.72% in excess weighted-average return to client portfolios during Q2. Medical devices (+7.78% over the S&P 500), biotech/genomics (+5.44% over the S&P 500), and pharmaceuticals (+4.02% over the S&P500) all contributed to quarterly performance, while materials (-0.40% behind the S&P 500) trailed slightly. Regional bank exposures trailed the S&P 500 by 2.10% at the end of fairly volatile Q2 for the banking industry. During the early weeks of Q3, our regional bank exposure recovered strongly but continues to bounce between gains and losses. We will continue to hold existing positions and likely add them for other clients as banking sector equity investments position us even more defensively against movements higher in interest rates.

Near-term Outlook
So where does that leave us heading into Q3? We continue to see upside in our long-term global economic growth estimates, with continued higher expectations for both foreign developed markets and emerging markets than for the domestic U.S. market. Client portfolios with limited exception are fully invested and at long-term strategic targets. We foresee little activity for Q3 unless unforeseen events cause meaningful changes in long-term outlook. Other than period reviews and any necessary rebalancing trades, we maintain our “wait and see” approach. I know, due to a few phone calls, that this approach has a few of you worried. If the Washington D.C. claptrap keeps telling us how bad the U.S. economy is doing, where is all of this equity upside coming from? And if equity markets have been in this long, eight-year bull-market move to the upside why am I not getting nervous about valuation levels? Three things make me comfortable with the current level of equity prices. And by comfortable I mean believing that, generally, current equity prices are fair; not cheap but also not too expensive.

First, it is important to pay attention to the data and the data’s time-tested interpretations rather than biased rhetoric attempting to spin data to fit political narratives. Following the global financial crisis, world economies and investment markets were forced to restart from such low levels that even after eight+ years into the recovery there is still room to run. The U.S. economy is strong and growth is accelerating. Global economies are strengthening after nearly a decade of trailing the U.S. and are most likely to lead in the near-term. And one important thing that history teaches us about recoveries is that they don’t tend to die in early acceleration phases, rather they tend to fade after some period of full- to over-employment begins to drive higher than expected inflation. And although growth is happening, deflation in the world’s economies remains a bigger fear than inflation. So yes, we still have some room to run.

Second, along with economic growth, corporate earnings are accelerating. Even better, earnings are accelerating under improving corporate investment in productivity. This is an important positive signal directly linked to corporate economic outlook and indicates that further multiple expansion (how much investors are willing to pay for each dollar of forward looking corporate sales, revenue, earnings, etc., or in layperson terms “rising stock prices”) can be supported. Admittedly, a few sectors were trading at prices that could have only been justified by companies reporting higher earnings during this earnings reporting cycle. Some of these trades got a bit dodgy at Q2-end, and helped contribute to some of the volatility discussed above. However, after some dismal corporate earnings results in early 2016, Q1 2017 saw average earnings growth of nearly 14%. Q2 2017 has seen, thus far, about a 10% improvement in corporate earnings over last. Both of these have been well above consensus expectations and for the 10% average improvement forecast for the full year 2017. Luckily, these earnings reports did help support trades that had gotten ahead of themselves. I doubt that professional investors will get themselves caught up in this dynamic again during 2017. So while I don’t expect the back half of 2017 to enjoy the same market upside as the front half, I don’t see any obvious signs of a reversal that would wipe out the gains we have enjoyed thus far. I would be surprised, and it would have to be the result of some surprise catalyst, if we ended 2017 too terribly far from where we are now.

Third and finally, both current low inflation and the resulting low interest rates remain as a catalyst for growth. As long as inflation remains low as expected, or at least lower than the rate of inflation targeted by central bankers, then moves towards higher interest rates will be slow. Low inflation and slow movements higher in interest rates are both wonderful things to spur economic and corporate investment over time without overheating global economies. I believe that this will be the environment at least through Q2 2018, and should be a good environment for global equities and provide a rather uneventful environment for bond investments.

As always, I am available at any time, any day of the week, to discuss specific portfolio performance questions. I will also be in touch with many of you in the coming weeks to conduct needed reviews of goals and objectives, make any needed changes as a result, and to walk through a few administrative tasks that we might need to tackle. Until then, be well, enjoy the rest of your weekend, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

1st Quarter 2017: Quarterly Recap and Near-term Outlook

The thing about crafting a useful Recap at each quarter’s end? There are times when everyone needs a break from my idea of “useful”. After that weighty tome that I posted as Q4 2016 Commentary? I owe everyone a break for Q1 2017. Never mind that recent shoulder surgery has also rendered me a one-fingered, hunt-and-peck, kind of communicator. For your benefit, and the benefit of my much needed healing, this quarter I am providing a more brief summary to inform you of the factors influencing client portfolios during Q1.

Q1 Review.
Q1 2017 started with high expectations that the incoming Trump administration would deliver on fiscal (spending) stimulus and regulatory relief, both then allowing the Federal Reserve’s FOMC to normalize monetary (interest rate) policy. Economic data, employment, and consumer confidence, were generally strong during Q1, contributing to the Federal Reserve’s March decision to raise short-term interest rates for the second time in four months. Improving economic data served to bolster business and consumer confidence in the strength of U.S. economic growth. Investors remained generally upbeat that a Donald Trump presidency would result in pro-growth policy changes, even though doubts began to mount, and pockets of trouble with select “Trump trades” emerged, after the failed efforts to reform both immigration and healthcare in the first attempts.

A sell-off in energy markets driven by a surge in North American production led investors to question all of the reflationary trades. A 6.58% sell-off in energy, and similar action in select commodity investments, lead to a mid-quarter flight away from risk assets (cyclical equities) and into safe-haven assets (counter-cyclical equities and bonds). This flight to safe-haven assets helped push to interest rates down again even though the FOMC was moving to raise rates. The darlings of the immediate post-election period (small company stocks, financial stocks, infrastructure stocks) all stalled during Q1. Otherwise, U.S. stocks generally continued their trend higher during Q1 with the S&P 500 (measure of large-company U.S. stocks) up 6.07% on a total return basis. The Russell 2000 Index (measure of small- and mid-sized company U.S. stocks) was up 2.47%. International equities bested U.S. counterparts as measured by the MSCI All Country World Index (ex-US) returning 6.37% for Q1. U.S. bonds, despite a lot of news coverage of the FOMC’s policy moves regarding interest rates, did not really do much during the quarter. As measured by the Barclay’s U.S. Aggregate Bond Index, U.S. bonds added about 0.82% for Q1.

All of our client portfolios can generally be categorized as moving along one of three paths during Q1.

(1) With meaningful growth in new relationships and significant new deposits from existing clients during Q4 2016 and Q1 2017, many client portfolios were in a purposeful and steady process of moving towards full investment. Our decisions here were less about macro-strategy structure than they were about taking advantage of market opportunities when presented to execute that strategy.
(2) For many existing client portfolios with more aggressive risk positions, prior to the 2016 Presidential election we had put in place an investment constructed purely for downside protection. We talked a great deal about this in the last two quarters. During the post-election period and throughout Q1 2017 we were methodically reducing, and ultimately eliminating, this protective position as President Trump’s early agenda came into focus. As the protective position was reduced we moved these client portfolios back towards full investment. Our tendency for these portfolios, however, was when moving back towards full investment to dial back unique sector exposures and towards our core target portfolio. Our preference is to be more focused on targets while waiting to see how actual implementation of Trump’s agenda progresses.
(3) For all other client portfolios, Q1 was a fairly uneventful time period in which we executed a number of rebalancing transactions to maintain full investment, but did not undertake significant changes in long-term strategy.

Getting to those long-term, strategic positions that influence Lake Jericho client portfolios, let’s briefly cover each.

U.S. versus International.
The worldwide recovery in industrial activity continued to drive global expansion. While political uncertainty surrounding U.S. economic policy caused a few reversals in post-election, policy-related trades, that uncertainty helped drive down the value of the U.S. dollar. Supported by a weaker dollar, international equities led the global stock market rally for the first time in several years. Emerging-market equities outperformed U.S. large-company stocks on a one-year basis. Our overweights to international investments (with small-company, and emerging market overweights imbedded in those investments) served as a meaningful tail-wind for clients. Our method for building international exposure bested aggregate U.S. equity exposure by 2.22% to 3.82% during Q1. With international exposures of approximately 25% of client portfolios, this added from 0.55% to 0.95% of additional return to client performance during Q1 versus an all U.S. equity portfolio.

Stocks versus Bonds.
Lake Jericho managed portfolios have been defensively positioned against the threat of rising interest rates for the last two years. At times this has hurt performance, and at times it has helped performance. We continue to believe, on balance, that a defensive position is best. However, the way in which a defensive position is constructed is the most important part of the decision to be defensively positioned. Because we structure our fixed income exposure in a statistically somewhat disconnected relationship to standard measurements (again a gross over-simplification) we were able to best the U.S. Aggregate Bond Index by 1.90% during Q1, returning 2.72% for the typical client fixed income position.

Small versus Big.
During 2016, our small- and mid-sized company positions bested large-company U.S. equity investments by 8.60%. As stated above, the Russell 2000 Index returned 2.47% for Q1, 3.03% behind the aggregate U.S. market for the Quarter. For Q1, our small- and mid-sized company positions returned a weighted average of 3.21%. Our construction bested the Russell 2000 Index by 0.74%, but still lagged the aggregate U.S. market by 2.70%.

Investor portfolios should maintain an exposure to, if not an ongoing overweight towards, small- and mid-sized company equity investments at all times. The basic premise is that, although small- and mid-sized companies are inherently more risky in the sense that more of them fail than do big companies, those that do succeed are sufficiently successful such that the return distribution for broadly diversified holdings (mutual funds, ETF’s) is skewed towards superior returns in the long run. So why would one not simply invest 100% of their portfolio in small-company equities and call it a day? Investors are often misinformed, thinking that all risk translates directly into extra reward in the long-run. There is no evidence to support that position. We attempt to coach this often misled belief away from client’s cognitive biases and replace that with a belief in and trust in broadly diversified and efficient risk exposures.

Q1 is an example that in the short-run market leading performance rotates through sectors. 2016’s market-leading performance is an example of why you always want to have some exposure to the space. But none of these time-periods support a position, statistically, that risk taking simply for risk’s sake is its own reward. Statistically, there exists an approximated optimal allocation of small- and mid-sized company exposure to be held in investor accounts that add value over time without exposing too great a level of variability in portfolios. Our answer to best manage this trade-off over time without engaging in unnecessary trade execution is to maintain a fairly constant exposure to the spaces, and to employ three different strategies in the space to best gain exposure to persistent factors of return within the space.

Value versus Growth.
Investor portfolios should maintain exposure to, if not an ongoing overweight towards, value-oriented investments. The basic premise of value investing is that certain securities are underpriced bargains and are likely to outperform once their “real value” is more appreciated by investors. It is a bit of common sense, supported by the statistics, that if you remain mindful of not overpaying for your investments then you are more likely to achieve superior returns over the long-run. Value-oriented investing is one method that helps investors achieve this objective. A gross over-simplification of an entire field of financial study, but that is the basic idea.

Last year, U.S. value equity funds as a group were up 20.79%, according to Morningstar, while U.S. growth equity funds as a group rose only 3.16%. As a value-biased portfolio manager, Lake Jericho clients certainly benefited from that differential during 2016. But with the overwhelming outperformance of our value-biased strategy during 2016, and of certain elements of value-oriented strategies during Q1 2017, one must naturally question the current wisdom of this strategy. Is there a point when the very success of value-biased strategies take away their promise? The reality is that, in the investment arena, all things are cyclical. As our focus is on long-term, strategic positions and not on attempts to trade timing patterns, it is the manner in which we execute our value-bias that is most important.

Sticking with Morningstar measurements, during Q1 2017 U.S. value funds as a group were up 2.58% while U.S. growth funds as a group rose 8.58%. With that type of performance differential during Q1, how could the Lake Jericho managed portfolio compete? Again, I offer a gross oversimplification, but there are two ways in which we managed to offset that performance gap. First, our value-biased positions had increased in value so significantly during 2016 (particularly post-election) that they began to behave statistically more as growth-oriented counterparts. This is a natural outcome of such price appreciation combined with a tendency to buy and hold long-term investments. Second, much of our value bias is represented by both domestic U.S. equities and international market equities. During Q1, international markets simply outperformed U.S. markets. Putting both factor exposures together, our target value bias was able to best the aggregate U.S. market by between 1.8% and 3.4% in client portfolios.

Sector Allocation Decisions.
Finally, strategic and tactical sector weighting, the fifth aspect of our portfolio construction process, was an important part of how we added value during Q1. Few portfolios will match all sector allocations, or sector allocation percentages exactly, or the timing of investments perfectly, and these factors certainly impact exact contribution to performance of our sector decisions. However, our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting higher expected growth sectors (currently materials, medical devices and instruments, pharmaceuticals, biotech/genomics, and early additions to a regional banks exposure) added between 0.46% and 0.53% in excess return to client portfolio during Q1. Materials, medical devices, and biotech/genomics contributed to performance, while the pharmaceutical sector overweight has not performed as expected (but does continue to close its historical performance gap). For portfolios where we began to add exposure to regional banks (after the sector began a price-breakdown late in the quarter) those allocations were very late in the quarter and the overall impact was minimal. We will cover this sector decision in the coming quarters.

So where does that leave us heading into Q2? We continue to see upside in our long-term global economic growth estimates, with higher expectations for both foreign developed markets and emerging markets than for domestic markets. But simply put, client portfolios with limited exception are now fully invested and at long-term strategic targets. We foresee little activity for Q2 unless unforeseen events cause meaningful changes in long-term outlook. Other than period reviews and necessary rebalancing trades, Lake Jericho is in a profound period of “wait and see”. The French election this weekend, along with further international elections this year, and a bit of breathe holding regarding the pace of policy implementation in the U.S. causes us pause to make any strategic changes in client portfolios, near-term.

I am available at any time to discuss specific portfolio needs and performance questions. I will also be in touch with many of you in the coming weeks to conduct our regular and thorough review of goals and objectives, make any needed changes as a result, and to walk through a few administrative tasks that we need to tackle. Until then, be well, enjoy the rest of your weekend, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC