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

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

The thing about crafting a useful Recap at each quarter’s end? Rare times do exist when nearly every style tilt deployed by a manager contributes positively to superior investment performance and the following quarterly review practically writes itself. This quarter-end Recap is such a time for Lake Jericho. But before diving into the Q3 Recap, for context let us first revisit a few points made in the closing of the Q2 Recap.

Closing the Q2 Recap I highlighted what we believed to be the most significant near-term challenge facing us as your investment manager; global political instability and the impact upon economic growth forecasts. I lamented our diminished ability to confidently estimate global growth expectations with the challenge of evaluating potential outcomes of uncharacteristically significant qualitative factors, such as political uncertainty, that fundamentally influence those expectations. While we had before us the data supporting a forecast for broad economic expansion in the U.S. and international markets, we also had before us a great deal of political and social uncertainty. We still do. Our projection at that time was that despite statistical evidence supporting a positive growth bias for both domestic and international markets, the political and social uncertainty would leave us flat for a period of time. Were you to read a sampling of other firm’s already published Q3 investment reviews what would you find? You would observe a pattern in those reviews along the line of “solid but uneventful quarter”. If only looking at the “headline” indices (those you hear about on the evening news), words like “solid”, “uneventful”, and “flat” are generally on point. But the headline indices do not tell the total story.

Most of those other investment reviews minimize the volatility that surrounded the end of Q2 and the early days of Q3. You might recall the surprising June 23rd “Brexit” vote in which the U.K. elected to leave the European Union. Markets reacted wildly, resulting in a significant downturn in global equity markets the following two trading days. U.S. stock markets recovered strongly the next two trading days after those. Shortly into Q3 the major U.S. equity indices had sufficiently rallied to sit comfortably at new all-time highs. Foreign developed markets, and particularly the E.U. markets, were much slower to recover but did so over the course of Q3. Mostly. So sure, it was a “solid but uneventful quarter” once we got past the first few weeks of Q3. If marking the post-Brexit recovery as beginning on June 28th, U.S. large-company stocks were up 8.9% through September 30th, with most of that recovery happening by July 8th. Measured from the open of Q3 to close of Q3, U.S. large-company stocks were up 3.8% for the quarter. So after that quick rebound within the first two weeks of Q3, U.S. equity markets as measured by large-company stocks moved within a narrow trading range for the remainder of the Q3. The CBOE’s S&P 500 Volatility Index (the VIX), a broad measure of market instability, reached lows in Q3 seen only a handful of times in the past 25 years. But large-company stocks do not tell the total story.

Chart 1 illustrates the difference between large-company U.S. stocks (the MSCI USA Large-Cap Index represented by the black line), small- and mid-sized company U.S. stocks (the MSCI USA SMID Index represented by the blue line), and international stocks (the MSCI EAFE Index represented by the gray line) for the post-Brexit recovery period. When you chart the recovery of large-company stocks in the U.S. compared to small-, mid-, and international company stocks you see that valuable opportunity existed over the course of Q3 to achieve superior relative performance versus the performance of the headline/large-company indices.

In fairness and full disclosure, let’s examine the same index data in Chart 1 but move the start date back 18 months to April 1, 2015, prior to the past year’s major economic events. Chart 2 shows market impacts of Grexit to Brexit, the continued trudge out of the depths of the U.S financial crises, heightened concerns regarding global growth rates, commodity and energy price collapse, dollar strengthening, fears of rising domestic interest rates to actual real negative interest rates abroad, and the most bizarre election cycle in memory. Chart 2 highlights two market tendencies that influence Lake Jericho’s equity management results over time. The first tendency is that during periods of heightened market volatility (the more palatable industry term for market declines) there exists a thing called “volatility clustering”. Volatility clustering, again a palatable industry term, means that when things go south, most everything (all types of stocks, bonds, alternative investments, everything) go south together. It’s a particularly vexing challenge to portfolio diversification as a means for risk reduction as the hoped-for risk reduction benefits of diversification tend to disappear just when you need them most. This tendency greatly influences how Lake Jericho views and manages volatility in client portfolios. The second tendency is that during periods of heightened market volatility investors flock to the “save haven” of U.S. securities, particularly U.S. government securities and large-company U.S. stocks. This “flight to safety” compounds and extends the downward pressure on other sectors of the investment universe. These tendencies are all on display in Chart 2. First, during sharp downturns all parts of the market tend to move down together. Second, during periods of heightened uncertainty few, if any, sectors will outperform large-company U.S. stocks. Third, when markets recover it is possible, through Lake Jericho’s strategic and tactical sector diversification methods, to meaningfully recover lost ground.

While Lake Jericho fully expects to capture a great percentage of upside in rising markets, and is adept at limiting downside risk during volatile markets, our strategic and tactical sector allocation methodology is most successful at capturing excess return when markets are less directionally clear and advantageous trading opportunities are more abundant. Our forecast for a flat market, combined with our sector allocation decisions, and opportunistic trade execution provided for a solid, if not superior, investment performance during Q3. I will now walk through that decision making process with you and detail how each decision impacted overall investment performance during the quarter.

Lake Jericho’s long-term portfolio construction process involves five distinct levels of strategic decision making. The first level in our process is the global allocation decision; how much of a portfolio should be invested in international markets versus invested in the U.S. market. Our long-term outlook for growth rates in international markets continues to exceed that of our long-term outlook for U.S. growth. The higher growth expectation is why we invest significant assets in international markets. Our allocations are less than a global market-neutral allocation, of course, as all Lake Jericho clients are U.S. based. However, our allocations are higher than the typical U.S. based investment advisor. These global investment decisions then inform asset allocation decisions amongst stocks, bonds, and alternative asset classes within U.S. or international markets (the second level of the strategic decision making process).

As demonstrated in Chart 2 above, the past 18 months have been a challenge as a result of this higher international equity allocation. But just as we said in our Q2 Recap, mean-reversion is real and is part of the reason we remain true to our discipline and committed to our total international allocation level within portfolios. This commitment was rewarded during Q3 as international equity investments as measured by the MSCI EAFE Index returned 6.9% while large-company U.S. stocks returned 3.8%. Even our somewhat beleaguered overweight to E.U. equities returned 5.0% during Q3, besting large-company U.S. stocks by 1.2%. Believing that the U.K. would soon signal the formal process for leaving the E.U., and that the post-Brexit recovery for non-currency hedged U.K. stocks would slow, we did reallocate most E.U. portfolio overweights to existing, and less concentrated, Developed Markets positions prior to quarter-end. As we anticipated, on October 2nd British Prime Minister Teresa May did report that the U.K. would invoke Article 50 by the end of Q1 2017, triggering the formal process of exiting the E.U. and a pull-back in U.K. and E.U securities.

Turning to domestic market decisions and more widely recognized indices, the S&P 500 Index also returned 3.8% for Q3, for a YTD return through September 30th of 7.8%. Small- and mid-sized company stocks as measured by the Russell 2500 Index fared far better with a quarterly gain of 6.6%, for a YTD return through September 30 of 10.8%. Chart 2, again, highlights the outperformance of large companies versus small- and mid-sized companies from April, 2015 through the early days of 2016, then the reversal of that performance pattern since mid-February. Chart 1 makes more clear this continued divergence during Q3 during which small- and mid-sized companies narrowed 2015’s performance gap significantly. These “size” decisions are another among the five levels of our portfolio construction process. Investment performance during Q3 was helped by our continued overweighting of small- and mid-sized companies versus a U.S. equity market-neutral portfolio.

Company valuation metrics are yet another distinct level of our long-term decision making process. Company valuation categorization is a combination of quantitative measurements and qualitative art, referring to companies as value-oriented, growth-oriented, or core. In layperson’s terms, it boils down to “how expensive is the stock versus its earnings expectations”. Although Lake Jericho managed portfolios most often represent elements of each category, our long-term bias tilts toward value-oriented investments. Some refer to our style as “growth at a reasonable price”, a fair label as far as labels go. When examining Chart 3 below, you will see that value-oriented investment strategies (the gray line) continue to outperform both growth-oriented strategies (the blue line) and core strategies (the black line) during 2016. After underperforming both growth and core strategies for all of 2015, the trend reversed during Q1 and value strategies have outperformed since. Value strategies have now outperformed both growth and core strategies for the trailing 18-month period. Value-oriented strategies, which we do significantly overweight versus a market-neutral portfolio, have contributed positively to portfolio performance by besting core strategies by 2.0% and growth strategies by nearly 8.5% thus far during 2016.

As for bond markets, they were surprisingly calm in Q3, particularly when compared to the tumultuous final week of Q2. As with the equity markets, initially negative reaction to the surprise Brexit vote quickly faded and bond markets returned to the typical task of assessing economic data and policy moves from the world’s major central banks. In the US, economic momentum continued to track broadly in a positive direction and by September the U.S. Federal Reserve’s Open Market Committee was split on whether to increase interest rates. The extension of accommodative policy by the Bank of England in August pressed gilt yields lower, while the European Central Bank’s decision to leave its current range of support measures unaltered left Bund yields unchanged. And then there is Japan. The Bank of Japan already owns about 40% of Japanese government bonds (JGBs). At its current pace of buying, the BOJ would hold about $2 out of every $3 of existing JGBs by 2020. Most doubt that any additional efforts by the BOJ to jump-start economic growth would have an impact, and would most likely have unforeseen and unintended consequences. Japan, along with China, are big question marks in Asian markets and the reason we underweight both equity and bond exposure to the region.

At home, the 10-year U.S. Treasury yield climbed from 1.47% to 1.59% in Q3. The 2-year U.S. Treasury yield climbed from 0.55% to 0.75% in Q3. Spreads between 10’s and 2’s have been steadily decreasing meaning the incentive to invest longer term is increasingly less compelling. Increased yields were enough to slightly suppress bond market total returns during Q3, but certainly not enough to push returns into negative territory. The Barclays U.S. Aggregate Bond Index, a broad measure of bond market total return positioned somewhere in between 2-year and 10-year bonds (a gross over-simplification but an acceptable way to frame the idea) was up 0.8% is Q3, up 5.8% year-to-date, and up 5.2% for the last year through September 30th. Our U.S. bond holdings returned about 0.5% for the Q3, 3.6% year-to-date, and about 3.2% for the year ending September 30th.

We have maintained, and continue to maintain, a less yield-sensitive position for clients than that represented by the Aggregate Index. With interest rates at historical lows, we feel that there is much more risk of interest rates rising in the U.S. than of rates continuing to fall. This low-yield reality is a significant element in why traditional methods of portfolio diversification are less effective today, and part of the reason why volatility clustering is on the rise. Our U.S. bond positions remain invested at a 2.8 year duration, versus the Aggregate Index duration of about 5.5 years duration. Lower duration bond investments will not fall in price as dramatically as a longer duration investment when interest rates increase. The best way to think about duration and how it represents risk to bond investment performance is that should interest rates increase equally across the maturity spectrum, a 2.8 year duration investment will be negatively affected by about half of what the 5.5-year duration investment would be. However, if interest rates remain the same, or fall, the shorter duration investment not only has a lower yield, but also will not increase in value as dramatically as the longer duration investment. Our global bond holdings currently have a negative effective duration, meaning that this portion of client portfolios performs positively in periods of rising interest rates. That is the trade off we make to mitigate price risk in the bond allocations of our client portfolios, and one of the few portfolio decisions that detracted from relative performance during Q3. We are sticking with that decision.

Finally, strategic and tactical sector weighting is the fifth level of our portfolio construction process and an important part of how we add value over time. 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, and biotech/genomics) added about 0.50% in excess return to client portfolio during Q3. Our pharmaceutical sector overweight has not performed as expected, and remains hamstrung by negative headlines about poor leadership, moral hazard related to aggressive pricing strategies, and the resulting political rhetoric in the election cycle. Pharma sector overweighting, where present, reduced portfolio performance by about 0.18% during Q3. Finally, while the consumer space has remained consistent during this year’s volatility, that strength has not translated well into an our forecasted increase in broad discretionary spending. Evidence that it might turn before year-end was fading, and trading opportunities afforded us to exit our consumer discretionary positions at slight gains during Q3. The gains did not move the needle, so to speak, on overall performance so we reallocated the proceeds to other existing sector positions. The net effect to client portfolios during Q3 was about 0.32% of additional return due to our combined sector decisions.

So what does all of this mean for us going into the final lap of 2016? 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. For the near term we are projecting greater market volatility. Markets seemingly got accustomed to the recent summer lull, but we fully expect the reprieve to be short-lived. As we trudge towards U.S. election day we expect more of the same range-bound activity, but expect it to be…well…more active. Post-election, should Secretary Clinton take the White House and the GOP retain the House, we expect another round of record highs for U.S. equities, a continued rebound in developed and emerging market assets, and continued strength in global bonds. Should Trump take the White House? Or should Clinton prove successful and the Democrats take both houses of Congress (a long-shot to be sure)? I am not alone in projecting that all bets are off under either scenario. I feel no need to venture into the politics of either scenario, only to repeat one of our most often stated market realities; uncertainty is worse for stock markets than certain, but bad news. A Democrat in the White House, GOP-controlled houses of Congress, and total gridlock in Washington might be bad news, but it is a certainty that Wall Street knows and perversely finds comfort.

Any other leadership combination creates uncertainty and could be bad news for the markets. Bad for how long depends on the nature of the combination. As we have marched towards election day, we have been building larger-than-typical cash positions in all of our portfolios to provide additional measures of down-side protection. As well, in certain portfolios we are tactically deploying small allocations to investment vehicles that are, negatively correlated with the S&P 500 Index, or to other specific at-risk sector exposures. These “inverse” tools are inexpensive and effective methods of securing portfolio insurance that directly benefits from down-side movements.

Post-election, we expect the U.S. Federal Reserve to press forward at their December meeting with increasing interest rates at home. We expect other major central banks will recognize the limits on their own easing policies. Again, we suspect that there will be downward pressure on markets after that December meeting through the end of the year and perhaps into the new year’s earnings reporting season. We plan to remain a bit cash-heavy and relatively more defensive compared to our normal positions through the early days of 2017. How the Q3 earnings reporting season unfolds might further inform how we position portfolios through year-end. If significant events unfold that dramatically alter our views or strategies I will be in quick contact as usual.

We are available at any time, any day of the week, to discuss specific portfolio and performance questions. I will also be in touch with each of you prior to year-end to conduct a 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 going into 2017. Until then, be well, enjoy the rest of your weekend, and thank you!

A.J. Walker, CFA CFP® CIMA®
Founder and Senior Consultant
Lake Jericho, LLC