3rd Quarter 2020: Market Recap and Near-term Outlook

Despite moving towards more relatively conservative positioning as Q3 progressed, those decisions, along with fruitful sector calls and weightings, provided for continued positive performance relative to benchmarks by quarter’s end. I encourage you to log into your Client Portal and take a look at where we now stand.

This link is to a PDF containing our Q3 2020 Quarterly Recap and Near-term Outlook. This Recap incorporates a broad review of global markets, and a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by iShares (by Blackrock). The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio 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

2nd Quarter 2020: Market Recap and Near-term Outlook

Every couple of years, I get to write and deliver quarterly investment reviews when, seemingly, everything worked in our favor. This is one of those quarters. Markets have rallied a bit more since quarter-end, and we continue to build our lead over benchmarks. I encourage you to log into your Client Portal and take a look at where we stand now.

This link is to a PDF containing our Q2 2020 Quarterly Recap and Near-term Outlook. This Recap incorporates a broad review of global markets, and a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by iShares (by Blackrock). The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio 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

1st Quarter 2020: Market Recap and Near-term Outlook

If any historical sequence of unfolding events exist that could have resulted in more difference between two quarterly investment reviews, I am unaware of what those might be. Our Q4 2019 Market Recap was a celebration of the historic economic expansion and bull market run. This Q1 2020 Market Recap is its eulogy

For nearly two months, the US economy and US markets remained resilient as officials and pundits discussed the emerging corona virus threat in terms of the impact on China, and what effect China’s economic fall-out might have on the global economy. Whether wishful thinking, or naive comfort, those two months of whistling past the expansion’s graveyard allowed the corona virus threat to escalate from a regional concern to a worldwide health crisis.

This link is to a PDF containing our Q1 2020 Quarterly Recap and Near-term Outlook. This Recap incorporates a broad review of global markets, and a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by iShares (by Blackrock). The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio 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 2019: Quarterly Recap and Near-term Outlook

As we close the chapter on Q4 and 2019, we also close the chapter on a decade rightly considered among the most note-worthy in economic and financial market history. For Lake Jericho clients, it was a strong way to close the book. I am thrilled to deliver performance information for Q4, as after a couple of years of give-and-take in financial markets, client reports contain a lot of good news.

Over the last year, I have talked at great length about sticking to the continued global growth thesis, despite periods of interim pain as markets seemingly roiled over every Tweet and headline. Patience was rewarded. Our lead during Q4 was meaningful, sufficiently so to put us well ahead of benchmarks for all of 2019.

This link is to a PDF containing our Q4 2019 Quarterly Recap and Near-term Outlook. This Recap incorporates a broad review of global markets, and a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by iShares (by Blackrock). The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio 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

2nd Quarter 2019: Quarterly Recap and Near-term Outlook

After a rough 2018, and continuing periods of volatility thus far in 2019, I am happy to post yet another Recap with positive results. One would think happy enough to remember to post this weeks ago when delivered to clients, but it seems that late has been my M.O. for a while now. Hopefully, help is on the way.

This link is to a PDF containing our Q2 2019: Quarterly Recap and Near-term Outlook. This Recap incorporates a broad review of global markets, and a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by Morningstar. The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio 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

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