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

Lather. Rinse. Repeat. Continued.

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

Q4 Review

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

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

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

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

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

Novel Investor Asset Class Returns TableSource: Novel Investor.

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

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

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

U.S. versus International

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

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

Stocks versus Bonds

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

Small Versus Big

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

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

Value versus Growth

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

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

Sector Allocation Decisions

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

Click on the chart to embiggen and activate features.
If you are not a back arrow person, right-click to open in a new window.

Novel Investor Sector Returns TableSource: Novel Investor

Near Term Outlook

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

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

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

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

 

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

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

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

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

CBOE Volatility Index (VIX) through Q3 2017

CBOE Volatility Index (VIX) through Q3 2017

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

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

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

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

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

Rising Interest Rates/Flattening Yield Curve

Rising Interest Rates/Flattening Yield Curve

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4th Quarter 2016: Quarterly Recap and Near-Term Outlook

The thing about crafting a useful Recap at each quarter’s end? When quarter-end is also year-end we have much more ground to cover. And if the combination of quarter-end plus year-end was not sufficiently broad, we also have the U.S. Presidential election to talk about. So I will get to work. My apologies in advance for the coming wall of text.

2016 Annual Review

You likely recall that as the year 2015 closed, financial optimists were in short supply with heightened anxiety over China’s economy and stock market, falling global demand for oil and commodities, fears of a potential U.S. recession, and negative interest rates in major world economies. On the first trading day of 2016 the U.S. equity markets began a steep decline creating the worst start of any year on record. The first 10 trading days of the year resulted in the biggest decline, about 8.25%, of the Dow Jones Industrial Average (DJIA) throughout the 120-year history of that index. The S&P 500 index, a far more broad measure of the market, fell about 8% in the first 10 trading days. Results in early January appeared to confirm the most pessimistic of views as markets around the world, seemingly in sympathy, fell sharply. Not one of the nine investment strategists participating in the Barron’s 2016 Roundtable expected an above-average year for stocks. In fact, six expected U.S. stock market returns to be flat or negative, while the remaining three predicted low single digit returns at best. Prospects for global markets appeared no better, according to this group. Two panelists were sufficiently bearish to recommend outright betting against emerging markets. Then things got worse.

Oil prices fell sharply. Worries about an economic debacle in China dominated the news cycle. Stock markets in France, Japan, and the UK registered losses of more than 20% from their previous peaks. Plunging share prices for leading banks around the globe had many worried that another financial crisis was brewing. By the time U.S. stock prices hit their bottom on February 11, shares of the five largest U.S. banks where down 23%.

U.S. markets began improving in mid-February and continued that pace through midyear, just in time for investors to then face uncertainty from June’s Brexit vote. While stock prices had generally recovered, as late as June 28th the S&P 500 Index was still showing a year-to-date loss. Throughout the year, observers fretted a lagging pace of U.S. economic recovery. The New York Times reported that “weighed down by anemic business spending, overstocked factories and warehouses, and a surprisingly weak housing sector, the American economy barely improved…”. A number of well-regarded professional investors argued that the next economic downturn was fast approaching while one prominent activist predicted a “day of reckoning” for the US stock market encouraging investors to “sell everything”, to “get out of the stock market.” As late as August a prominent Hedge Fund managed announced a doubling of his downside bet against the S&P 500 Index. It would appear that well-regarded predictions are worth exactly what one pays for them.

Despite the dire predictions, equity markets around the globe staged a nice comeback throughout Q3. Aside from a few industry sectors that got continuously caught up as fodder for bi-partisan vote-pandering during the U.S. election cycle, it was a very good quarter for investors. Each new bit of economic data implied an improving U.S. economy and employment market. Stabilizing oil prices and corporate earnings helped turn the market around prior to the later-days of Q3.

Q4 Review

After highlighting the good news that Q3 brought for Lake Jericho clients, when closing the Q3 Recap we highlighted our strategy to manage increased volatility (to the down side) leading up to the actual election. The increased volatility call was an easy call, no doubt, as most investors tend to sit on the sidelines in advance of big economic or political events. When investors are sitting on the sidelines, not bidding up prices on new investments, stock prices will fall. That is exactly what happened in the weeks after the end of Q3 leading up to election day, a period in which the S&P 500 Index gave back about 2% of its year-to-date gain. Then came the new elephant in the room.

Putting aside personal biases, we believed for some time that Donald Trump would win the Presidential election. While correct about the election outcome, along with many others we were surprised about the short-term market impact. Well, we were for a few hours. But then we was not. Either way, we decided well in advance of the election to more neutrally construct risk exposures in client portfolios. That is just a fancy way of saying that we hedged our bets. We positioned portfolios to mitigate some measure of the downside risk associated with either candidate’s victory even though it meant that we would forego some of the upside potential represented by each candidate.

On election night, as early results began to indicate a likely Trump victory, global markets and the U.S. futures markets (think pre-opening indication of where markets are going that day) went into a tailspin. Near midnight in the U.S. the futures market for the S&P 500 Index and DJIA had both fallen by more than 4%. Not unlike 2016’s surprise Brexit vote results, stocks tumbled on the unexpected outcome (unexpected based upon polling data at least). To repeat one of our most often stated market realities; uncertainty is worse for stock markets than certain, but bad news. While futures markets remained in chaos through much of that night, by morning, after Trump was declared the winner, investors shifted focus from unexpected election outcomes and policy uncertainty to a unified, seemingly instantaneous expectation that his plans for higher government spending, lower taxes and fewer regulations will create more economic growth, higher inflation and, potentially, rising corporate profits. This, to us, is where a disconnect occurred between markets and realistic expectations of what a Trump administration might bring. Our internal view is that markets have put the cart well before the horse.

Within a very short window of time, post-election markets priced to perfection flawless policy execution. Implying no value judgement on policy positions themselves, the immediate repricing of market as if the Trump administration would be able to immediately and fully institute those policies is a disconnect from the administrative reality of how the U.S. government functions. Donald Trump is many things, a remarkable showman for one, but a monarch ruling in a vacuum he is not. While he has much common ground with the GOP leadership in both houses of Congress, there are many challenges ahead to crafting mutually agreeable paths to achieve many shared goals. In many respects, such as the budget deficit impacts of increased fiscal spending, Trump’s vision of some policy matters are further removed from political reality than those faced by Barack Obama and GOP leadership.

Be that as it may, the result of the November election provided a kick that drove markets to new highs before settling slightly below those highs at year-end. The S&P 500 Index finished the year up 9.5% on a price-return basis (11.96% total return basis), an impressive 20% swing from the market lows in February. For Q4, the S&P 500 Index finished up 3.25%, essentially matching the Q3 2016 return of 3.31%, but about half of the Q4 2015 return of 6.45%. So is it true that the markets love Donald Trump? Maybe. Maybe not. Some sectors have been big winners since the election, while others have not fared well at all. Although there have been a few eye-popping headline numbers, the market rally has not been as widespread as those headlines imply. This is why we prefer to think of the post-election market as getting more of a Trump-bump than a Trump-rally. At Lake Jericho we spend a great deal of time helping investors look beyond the headline numbers to better understand what is happening in the market and in their portfolios. To understand why the post-election rally is not a clear-cut as the headlines make it appear, it is important to look at some specific sectors and styles.

Sector & Style Reviews

  • The Dirty Economy: Oil drillers, gas pipelines, coal, construction and industrial equipment, infrastructure, defense, and materials are all post-election winners . The Trump administration could take the lid off coal and fracking regulations, begin an extensive repair of the nation’s roads and bridges, and rebuild defense. Each of these are generally considered pro-growth, pro-inflation measures and the markets priced these possibilities fully into the post-election rally. Again, some of these are particular areas in which Trump will likely be fighting the establishment GOP when budget and deficit realities work their way into the discussions. Unless Paul Ryan and his budget committee experience a reversal in their long-communicated austerity position, many of these projects are likely to be the subject of long, protracted budget battles should they materialize at all. Our approach to this space throughout 2016 has been through portfolio overweights to the Materials sector. During 2016 the Materials sector bested the S&P 500 Index total return by nearly 10%, providing a significant tailwind for client portfolio performance.
  • Value Bias: We regularly discuss Lake Jericho’s “value” bias investment style, versus a “growth” oriented investment style. We use the term “bias” purposefully, as we are not a pure value investor, rather we tend to more heavily weight value-oriented investments more than the style itself represents in the U.S. equity market. During the past several years, particularly during 2015, stock market increases were driven in part by investor enthusiasm for fast-growing companies (“growth” oriented companies) with marginal, even no, profits. Many value-oriented strategies (which seek to buy and hold profitable businesses when they are trading at discounts to intrinsic value) did not fully participate in the market’s returns. This was part of the reason that some Lake Jericho portfolios underperformed the broader markets during 2015. However, as we regularly reinforce, when these types of environments persisted in the past they consistently ended with big rewards for value-oriented investors maintaining their discipline through the cycle. 2016 in total, and particularly post-election 2016, was a validation of this discipline. Each of the sectors discussed above (banking, financial services, infrastructure, industrials, and defense) have been considered “value” investments for a number of years.

Shifting benchmarks a bit (merely because Morningstar, Inc. does a better job of quantifying value/core/growth style performance differences), Morningstar reports that while a 100% U.S. large-company, core portfolio returned 13.75% for 2016, its value-oriented counterpart returned 18.91% while its growth oriented counterpart returned a meager 1.79%. These performance differences between value/growth styles become even more pronounced as one moves down in company size through mid-cap and into small-company stocks. These combinations of style bias provided a significant tailwind for client returns.

  • Small Company Bias: Small-company stocks tend to be more economically sensitive. Economic data has been strong the last two quarters. With the election over, Wall Street finally seems to finally be paying attention to our improving economy, and the potential impact of Trump positions on smaller U.S. firms. Investors are betting that a Trump administration will focus on policy changes positive for the U.S. economy but less so for the global economy. Since small-company stocks generate a larger portion of their revenue in the U.S., small-company earnings will be less affected by potential negative ramifications in foreign markets. Also, if Trump and a Republican-controlled Congress lower domestic corporate income taxes as many predict, small companies will benefit most. Further, large companies with a major international footprint could be adversely affected when Trump seeks to renegotiate global trade agreements. They could even find themselves subject to additional penalties if new laws are enacted adversely impacting companies that operate abroad and import products back into the U.S. market. Rising interest rates have already caused the U.S. dollar to strengthen, another headwind for large companies with global operations. Small companies operating exclusively in the U.S. avoid this problem.

In the weeks following the election, the Russell 2000 Index (a commonly used index for U.S. small-company stocks) gained 16.14% from the pre-election close to a new high-water mark. Although the Russell 2000 Index would give back about 2.25% before year-end, the spread in performance between small-company stocks and large-company stocks post-election was the widest it has been in about 14 years. Our approach to small-company investing bested the S&P 500 Index by nearly 15.00% during 2016. This excess performance combined with the fact that we overweight small- and mid-sized company stocks provided significant tailwinds for client portfolios during the year.

  • The Rolling Tech-Wreck: On the opposite end of the spectrum, the Technology sector (the biggest sector of our economy by market capitalization) was a complete wreck post-election. In fact, 2016 has been filled with mini-cycles within the various sub-sectors of Tech. Post-election, anything tech related was considered to have a giant target on its back for the industry’s nearly absolute support of the Clinton candidacy. Significant concerns loom in the background over whether Trump will expand the government’s surveillance powers and attempt to weaken security and encryption. Trump vowed to “penetrate the Internet” to prevent ISIS from using it to recruit fighters. He chastised Apple for refusing to create a back door that would let the FBI unlock an iPhone used by the attackers in San Bernardino, Calif. Each bit of rhetoric has sent chills through Silicon Valley and prompted a flood of responses from engineers and big company leadership. Reservations exist about staffing as during the campaign Trump attacked the H-1B visas program for high-skilled immigrants, only to walk back the statement in private conversation. During the campaign, many feared that Trump would serve to stifle competition via FCC appointments only to have him make later comments that were pro-competition. His campaign’s only policy adviser, Stephen Miller, seemed uninterested in tech and made little outreach to the industry. Lobbyists and officials from tech giants beaten down in the post-election market said they would need to watch closely for clues to Trump’s tech policies. But in fairness to the Trump administration, the difficulty expressed by many companies to know how Trump would act is largely because they had not had any contact with the Trump campaign. And some Silicon Valley investors and entrepreneurs acknowledged that he could be more friendly to business than Clinton, opening up some opportunities for start-ups in emerging areas, such as financial technology and the gig economy. Overall, the Trump campaign has said very little in absolute terms about issues affecting the tech industry and instead focused largely on manufacturing. In the end, client portfolios that were overweight to technology sub-sectors (such as cloud infrastructure and semi-conductors) did well during 2016 as the sector slightly outperformed the overall S&P 500 Index. But post-election and heading into the new year the sector dramatically underperformed the broader market. This is a space that appears to be stretched in valuation and is a space we consider to be a bit of a challenge for 2017.
  • Healthcare: The healthcare sector presents, currently, a confounding challenge. Fundamentally speaking, valuations are attractive across the sector. There are many great companies, doing great work, and achieving wonderful results. There are also some knuckleheads that can’t keep themselves out of the news for tone-deaf business strategies. While for 2016 the “healthcare” sector was the worse performing S&P 500 market sector, our portfolio overweights to the medical devices and technology sub-sector provided marvelous results for client portfolios. Unfortunately, portfolios with additional allocations to pharmaceuticals, and/or biotechnology, struggled to keep pace. During the presidential campaign, Clinton was often critical of the pharmaceutical industry when it was likely more appropriate to focus on specific companies and their pricing policies. It appeared that the market is incapable of differentiating between pharmaceutical companies and biotechnology companies so both sub-sectors would get taken to the woodshed. Her defeat suggested that the regulatory environment for drugmakers and research companies could be more lenient than many expected before the election. Not surprisingly, post-election the drugmakers did very well, although at the time it was more about what Trump had not said than what he had. Biotech and pharmaceutical stocks swung up sharply the day after the election and continued to climb for about a week. But then one prominent drug-company CEO noted in a speech that drug prices were a populist issue, implying that investors were getting ahead of themselves thinking Trump will leave companies alone. Days later, Time magazine published an interview with Trump in which he said he was “going to bring down drug prices”, a position he reiterated in a post-election news conference and in interviews. Sharp declines resulted.

In fact, Trump is not really seen as good news for anything in the healthcare space. His plan to unravel the Affordable Care Act has hit some healthcare stocks very hard. With the ACA unlikely to survive in its present form under a Trump administration, the future health insurance of some 20 million Americans is uncertain. If Congress and the incoming president roll back the ACA’s subsidized individual insurance exchanges and Medicaid expansion, many of those 20 million Americans insured under those provisions could lose coverage. Millions of potential patients for doctors would no longer be able to afford healthcare, and markets appear to think that could mean lost business for hospitals, medical service companies, medical technology, and even firms focused on R&D. Whatever the GOP “repeal and replace” plan might look like, it must be a comprehensive measure to soothe market fears about this crucial segment of the economy. This is the confounding part of the sector; attractive valuations with otherwise attractive prospects but subject to the greatest political risks in recent memory.

  • Interest Rates, Currencies, and International Markets: It should be no surprise to any Lake Jericho client that our typical portfolio will have significant allocations to international investments, both stocks and bonds. This past year in international investments is a bit difficult to get one’s head around without some discussion of currency values and interest rates. They are all connected in complex ways, but I can break down the complex relationship in one dangerously over-simplified, run-on sentence — When country A has a higher rate of inflation than country B, then country A will also have higher interest rates than country B, and those higher interest rates will incentivize investors to sell investments held in country B, use the proceeds to buy country A’s currency that they then use to buy investments in country A. That is the dynamic in post-election U.S., a bit of “which came first, the chicken or the egg” dynamic. But they are all countervailing forces at work against one another as they seek some long term equilibrium. Using this pattern (assuming that we are in a virtuous inflationary cycle rather than a destructive inflationary cycle) we can discuss how these moving parts are affecting client portfolios.

A number of Trump’s pro-growth items will demand much higher government spending (fiscal policy) to achieve. Expansionary fiscal policy is necessarily inflationary (growth=inflation). That is the whole point. Meanwhile, restrictive trade policies that make imported goods more expensive for American consumers, or a crackdown on immigration (possible labor shortage) would most likely also lead to higher inflation. Two things happen in an growth/inflationary period; (1) stock prices rise because stock investors assume corporations will earn more, and (2) bond prices fall because bond investors demand higher yields to protect them from inflation. Suddenly, the U.S. stock market and the U.S. bond market look much more attractive to the world’s investors. To capture the higher returns/yields available in the U.S., international investors start buying the U.S. dollar so they can make new investments in U.S. securities. Suddenly, again, you have a much stronger U.S. dollar, higher U.S. investment values, and lessened demand for international securities.

In local currency terms, equity performance in many international markets was stellar during Q4. Eurozone equities were stronger over the quarter, with the MSCI EMU index returning 8.1%. In the UK, even in the face of a looming hard BREXIT, the FTSE All-Share index rose 3.9% over the period. The Japanese equity market rose each month in the quarter to produce a strong total return of +15.0%. However, when one accounts for the affects of the strong U.S. dollar on currency adjusted returns, these areas of excess performance are much more muted and in some settings the currency affect resulted in negative returns. For example, the unhedged MSCI EAFE (Euro, Australasia, Far East) Index gained just 1.5% with dividends, or 10.5% less than its U.S. counterpart, the S&P 500 Index. Aware of this heightened risk, Lake Jericho executes our international allocations using multiple strategies. In some situations currency exposure is unhedged, while in others the exposures might be partially or even fully hedged. Regardless, on average our higher-than-typical international allocation was a drag on client portfolio performance during 2016. Our mix of strategies did result in net gains for clients for the year, but the return did lag the broad U.S. market.

  • Interest Rates and Bonds: Without diving into the specifics, one can view bond markets as a mirror for growth expectations. Despite the volatility in both the domestic and the global bond markets, expectations for global economic growth tentatively grew more optimistic during Q4. It appears that others are beginning to increase their global growth outlooks and are now more in-line with the expectations that we have had internally for about 18 months. We were correct in our Q4 Outlook that the U.S. economy was on sure enough footing that the Federal Reserve’s FOMC would take the next step in rate normalization. Of course, we actually believe that they should have taken that step at least four times by now. So it isn’t that we think we are smarter than other folks, rather we tend to embrace the data in our decision-making earlier than other folks.

For much of the year, we have talked about how our lower-duration bond portfolios lagged the returns of the broad bond market as long-term interest rates continued to fall. Our preference to use domestic bond allocation as a ready source of liquidity and as dampener of stock volatility means that we are not chasing returns from longer duration bonds. Anticipating the affects of rising interest rates was as much of a reason as well. As previously stated, during Q4 bond yields moved higher and the yield curves steepened much as we had anticipated for much of the year. As the tides turned, post-election, and rates rose quickly, our bond portfolios held up much better than the broad bond market. In the end we were able to provide lower volatility and higher returns for clients than traditional long-duration bond funds for 2016.

Like domestic bond markets, global bond market movements were overwhelmingly driven by political factors. At the forefront of the political dynamics stood the victory of Donald Trump, but upcoming elections in Europe also rose in prominence as potentially destabilizing influences. The uncertainty surrounding the UK’s negotiations to withdraw from the European Union also impacted bond portfolios significantly. Some level of global bond exposure is standard for Lake Jericho managed portfolios. Not surprisingly, it is also an allocation that we use differently than most managers. As such, while most global bond allocations disappointed during Q4, our allocations bested broad market bond indices by nearly 11%, and even beat the S&P 500 Index by more than a full percentage point.

So what does all of this mean for us going into this new year? The Trump-bump has left stocks historically expensive relative to their intrinsic valuations. The Shiller Price-to-Earnings Ratio is a commonly used, though not without flaws and limits, measure of how expensive stocks are relative to their intrinsic values. It shows the ratio of S&P 500 Index company stock prices to their earnings, after adjusting for a set of macroeconomic factors. As 2016 closed, the Shiller Ratio was 28.8. The only times the Shiller Ratio has been higher were right before the 1929 crash, the dot-com bubble of the late 1990s, and the run-up to the 2008 financial crisis. I am NOT implying that a stock market crash is imminent. I am NOT implying an abiding faith in the Shiller Ratio. It is NOT even part of the set of metrics that we use internally. All I am saying is that stocks have generally gotten very pricey lately and most popular, independent, simple measurements do tend to agree. It creates an uncomfortable time to make new investments for a value-biased firm like Lake Jericho.

This is also a bit of a double-edged sword for us and our clients. While existing investments enjoyed a nice run-up in value, it has become increasingly difficult to get cash positions and new deposits invested. We suspected that there will be a period of downward pressure on markets after the December FOMA meeting through the end of the year and perhaps into the new year’s earnings reporting season. This did happen and created a few opportunities for us to get the majority of cash and new deposits invested. As for the remaining cash, new deposits, and the remaining inverse positions we hold, we remain constantly on watch and are being very careful about allocation and timing decisions of new investments.

Generally speaking, we are continuing with our long-term global economic growth estimates for both domestic and international markets. Our targets, generally, remain the same as those we have held for the past year with higher expectations for both foreign developed and emerging markets than for the U.S. market. As such, we will maintain our healthy allocations to international investments, less so despite the period of underperformance but more so because the period of underperformance leaves international investments as one of the few places where valuations remain attractive. For the near term we are expecting reduced market volatility. We are not alone. A wait-and-see attitude persists in the markets right now, a breather as it were, to see exactly how fast, or slow, or how much of the Trump agenda might materialize. We suspect that any hiccups along the way will have immediate impacts upon securities prices.

Most importantly, we are still formulating our sector strategies for 2017. We typically have these matters settled and executed by this point in the new year. However, the Trump presidency (more specifically the Twitter presidency) has added additional complexities that we are still sorting out how to properly evaluate and manage. In a time when a single Tweet can send an entire industry group into a tailspin, we are revisiting some aspects governing how “long-term” our sector outlooks and strategies should rightly be. As is typical, a more simple framework of embracing sensible asset allocation and broad diversification is likely the best strategy in what could be a more volatile environment. In the final analysis it is possible that for some time we will simply be more “core” focused than in the past in the hope that the Twitter-in-Chief settles more calmly into his new role. As 2016 closed, the U.S. market reached new highs, and stocks in a majority of developed and emerging market countries delivered positive returns for the year. The 2016 turnaround story highlights the enduring importance of diversifying across asset groups and regional markets, as well as staying disciplined despite uncertainty. Although not all asset classes had positive returns, most broadly diversified portfolios logged attractive returns in 2016, a reality most could not imagine early during the year. Maybe 2017 will be just like that.

We are available at any time, any day of the week, to discuss specific portfolio and performance questions that you might have. I will also be in touch with each of you in the coming weeks to discuss any changes in strategy that should be considered, or to walk through any administrative tasks that might be needed. Until then, be well, enjoy the rest of your week, and thank you!

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

3rd Quarter 2016: Quarterly Recap and Near-term Outlook

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.

Large, SMID, International Stock Post-Brexit Performance

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.

Large, SMID, International Performance Since 4/1/2015

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.

Core, Growth, Value Strategies

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.

US CMT Treasury Yields, 10's and 2's.

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

2nd Quarter 2016: Quarterly Recap and Near-term Outlook

The thing about crafting a useful investment review at each quarter’s end? I’ve been writing such reviews for more than 20 years and at times I struggle for days (if not a week or so) trying to decide what it is that I most need to communicate. This quarter-end has been one of those times. Often an appropriate review does require one to artfully connect many of the complexities and nuances of the markets. Most times, however, the appropriate review focuses on a short and direct message. Fortunately, even though I have to go through the struggle, I eventually remember that I overcomplicate things just when the message need be most simple. My short and direct message for this quarter? All things considered, we all did pretty well.

When we step back and consider all the crises, both manufactured and real, of the past couple of years (from Grexit to Brexit, from the long trudge out of the depths of the U.S financial crises to current deceleration of growth in major world economies, from fears of rising nominal interest rates domestically to actual real negative interest rates abroad, and let’s not even start on the most bizarre election cycles across developed markets in memory) we are benefitting from U.S. markets that seem to defy gravity’s full effect no matter the headlines. The U.S. economy appears in good shape overall following the slowdown in the first quarter (and the 11% decline in markets) that resulted largely from reduced corporate earnings during 2015. First quarter GDP growth was revised upward in May and continues to exceed inflation measures. Consumer spending (the main engine of the U.S. economy) continues to expand. Manufacturing reports indicate expansion, although still suggest soft growth in the sector. Real estate (including construction and construction spending) continues its upward trajectory. Job opportunities continue to grow (although a bit weaker mid-quarter) with the unemployment rate in the U.S. falling to 4.7%. Despite a few setbacks and a bit of volatility U.S. stocks were nicely positive for the second quarter, a welcome continuation of the rally from the mid-February lows.

Yes, on June 23rd voters in the U.K. elected to leave the European Union, to the surprise of basically everyone. Global markets reacted wildly with big drops in stocks the following two trading days. U.S. stock markets recovered strongly the next two trading days after that, making up much of the decline. Most major U.S. broad market indices now sit, post quarter-end, comfortably at new all-time highs. Foreign developed markets, and particularly the E.U. markets, have not yet fully recovered but have moved solidly higher. The chart below illustrates the difference between large- and mid-sized U.S. stocks (the MSCI USA Index of large- and mid-sized companies represented by the blue line) versus international stocks (the MSCI EAFE Index represented by the black line). The MSCI EAFE Index represents the performance of large- and mid-sized securities across 21 developed markets, including countries in Europe, Australasia and the Far East, but excludes the U.S. and Canada. The chart makes clear the impact of continued challenges in overseas markets from the Grexit fears of mid-2015, through the global growth fears related to China surrounding the 2016 new year, and to the latest impact of the Brexit vote. Versus the resiliency of the U.S. market, the past year in international markets was disappointing at a negative 12.7%, with a year-to-date return at June 30 for the EAFE Index of -6.3%. A continued rally since the end of the second quarter has cut the year-to-date loss to -3.9%, although effects from weaker foreign currencies continue to drag on a full price recovery.

International Equity versus U.S. Equity

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 exceed that of our long-term outlook for U.S. growth. The higher growth expectation is why we invest significant assets in international markets. While our allocations are less than a global market-neutral allocation, they are higher than the typical U.S. based investment advisor. No doubt that the past year has been challenging as a result. However, bad times, as with good, don’t last forever. As the table below illustrates, one year’s laggard is often among the next year’s leaders. Mean-reversion is real and is why we remain committed to our total international allocation level within portfolios. 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). If we make any changes during the second half of 2016, it would be to reallocate the geographic distribution of the international holdings rather than any reduction of the total international allocation.

Novel Investor Asset Class Returns TableSource: NovelInvestor.com

The S&P 500 Index returned 2.5% for the 2nd quarter, resulting in a year-to-date return through June 30 of 3.8%. Small- and mid-sized company stocks (represented by the Russell 2500 Index) fared even better with quarterly gains of 3.6% (for a year-to-date through June 30 return of 4.0%). Certainly, being invested in U.S. equities (particularly in large U.S. companies) has been most advantageous during the past year. The chart below compares the S&P 500 Index and the Russell 2500 for the past year. I draw your attention to two things; the outperformance of large companies versus smaller companies through the early months of 2016, and then to the reversal of that performance difference between during the last four months. You will see (by the slope of the two green lines) that during the second quarter small- and mid-sized companies narrowed that performance gap. These “size” decisions are another among the five levels of our portfolio construction process. Investment performance during the quarter was helped by our typical overweighting of small- and mid-sized companies versus a U.S. equity market-neutral portfolio.

Large Company Stocks versus Mid- and Small-Company Stocks

Company valuation metrics are 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 portfolios most often represent elements of each category, our long-term bias tilts towards value-oriented investments. Some refer to our style as “growth at a reasonable price”, a fair label as far as labels go. When examining the next chart one will see that value-oriented investment strategies (the red line) have underperformed both growth-oriented (the silver line) and core investments (the blue line) during 2015 and early 2016. This pattern reversed late during the first quarter and value strategies outperformed through the second quarter. Value-oriented strategies, which we do overweight versus a global market-neutral portfolio, now slightly lead both growth- and core-oriented strategies for the last year and have contributed positively to portfolio performance.

Value-Oriented Strategy

Bonds prices increased as interest rates fell for another quarter (interest rates and bond prices move in opposite directions). Over the last three months the Barclays Aggregate Bond Index (a broad measure of bond-market performance) was up 2.3%, 5.1% year-to-date, and is up 5.40% for the last year through June 30. We have maintained a more conservative position for clients than that represented by the Aggregate Index. Our bond positions remain invested at about a 2.7 year duration versus the Aggregate Index duration of about 5.5 years duration. The best way to think about duration and how it represents risk to bond investment performance is that should interest rates rise, a 2.7 year duration investment will be negatively affected by less than half of what the 5.5-year duration investment would be affected. The lower duration investments will not fall in price as dramatically as a longer duration investment when interest rates increase. 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. However, when interest rates fall the price of a short duration investment will not rise as dramatically as a longer duration investment. That is the trade off, and that is why our holdings returned about 1.5% for the 2nd quarter, 3.2% for the year-to-date, and about 3.8% for the year ending June 30.

By sending interest rates lower, the bond market could be anticipating economic weakness or simply conceding that the U.S. Federal Reserve will be challenged to increase rates in the face of rising global uncertainty, regardless of the state of the U.S. economy. Either way, ever lower bond yields bolster a continuing argument that increasing stock prices are now the result of a lack of viable return alternatives to stocks, known as TINA (“There Is No Alternative”). The TINA argument acknowledges that the S&P 500 Index dividend yield has hovered around 2% for about 10 years while the yields on U.S. Treasury notes have steadily declined. The chart below illustrates the movement in U.S. Treasury bonds over time versus the rather steady nature (green line) of average stock dividend yields. Many large U.S. company stocks now provide dividend yields in excess of the yield on their own 10-year corporate bonds, and certainly above 10-year Treasury bond yields. Granted, the principal risk is higher for stocks, but the trade-off is perceived as manageable for long-term investors. For these reasons, it is easy to understand why some argue that stock prices are being pushed higher simply by those seeking a steady income stream jumping into stocks from bonds. Bonds, with prices that move inversely to interest rates, have been moving ever higher as well and now look incredibly expensive by comparison to stocks. At Lake Jericho, our view is a bit more tempered. We believe both the lofty stock and bond prices in the U.S. are more of a function of the “flight to quality” that investors undertake during times of heightened uncertainty and less to do with stretching for yield. Patience, ever our watchword, reminds us that normalcy always returns. As such, we feel that we are best positioned by maintaining modest bond exposures in our client portfolios and that those modest exposures themselves are quite conservatively invested. If (or when) interest rates do turn higher, we are well positioned.

Treasury Yields versus Dividend Yield

Finally, tactical sector weighting is a fundamental element (the fifth level of decision making) of what we do and 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 “bets”. However, our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting higher expected growth sectors (materials, medical devices and instruments, and pharmaceuticals) added about 0.40% in excess return to the typical client portfolio during the second quarter. Two sectors plays that have not performed as expected are our overweights to the consumer discretionary sector and our overweights in certain large and less risk-adverse portfolios to the genomics/biotechnology sector. While the consumer space has remained strong during this year’s volatility, that strength has not translated well into an increase in broad discretionary spending. While there are some signs of life beginning to emerge, discretionary spending has expanded much slower than we anticipated heading into 2016. The genomics/biotechnology sector has been hamstrung to a great extent by political rhetoric in the primary cycle. In fairness, there has been some concern about the pipelines for approval of new therapies but that shadow is beginning to fade and there now seems to be more merger and acquisition discussion in the space. We remain confident of a turn-around in the coming year. These two sectors served to reduce performance by about 0.20% during the second quarter.

So what does all of this mean for us going into the second half of 2016? More than 100 years ago American Financier and Banker J.P. Morgan said “No problem can be solved until it is reduced to some simple form. The changing of a vague difficulty into a specific, concrete form is a very essential element in thinking.” I think J.P. Morgan himself would agree that the essential element we need examine is global political stability and economic growth. I fear J.P. Morgan himself would agree that we have a deeper difficulty at the moment in our ability to examine global growth appropriately as we are faced with a unique challenge presently; increased ease and efficiency at doing the quantitative analysis required of us, but increased complexity and difficulty in the qualitative elements that influence our results. We have before us the statistical evidence supporting a forecast for broad expansion in the U.S. and international markets. We also have before us a great deal of political and social uncertainty, that which is impossible to quantify, that can undo all of the hard evidence and leave us flat for an extended period of time. Lake Jericho’s process is designed to capitalize most upon this latter prospect. While we fully expect to capture a great percentage of upside in rising markets, we are most adept at limiting downside risks during volatile times and through our tactical sector strategies capture value where ever it presents itself when opportunities are scarce. We are going to stay the course at least through the end of the third quarter. At that time we will re-evaluate the quantitative evidence before us and temper our outlook with the atmosphere (qualitative) that develops in advance of the U.S. elections. And of course, we will be continuously watching movements in the U.K., the E.U., and developments in Asia and the impacts upon client portfolios.

We are available at any time, any day of the week, to discuss specific portfolio and performance questions. Until then, be well and enjoy the rest of your weekend!

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

1st Quarter 2016: Quarterly Recap and Near-term Outlook

The thing about crafting a useful investment review at each quarter’s end? It is often the case that one will need to construct a coherent discussion of what were actually two (or more) very different markets. The 1st quarter of 2016 is a tale of two halves.

2015’s volatility continued into the 1st quarter of 2016 amid much fretting about a possible U.S. recession, a lack of global growth, and the collapse of oil and commodity prices. U.S. markets were as close to an actual bear market not seen since the depths of the 2008 financial crisis. The bears had a lot of ammunition to make their case. Weak economic data at home fueled speculation that the U.S. economic expansion was coming to an end. Chinese stocks were crashing and many feared Beijing’s debt-fueled economy would follow suit. The prices of oil and commodities were in free fall. Bank stocks were tanking from fears of potential defaults within their energy loan portfolios. The U.S. dollar continued to climb as global demand for U.S. denominated assets reached a new peak, delivering a hit to earnings of U.S. multinationals. Global markets turned turbulent and wildly volatile. The Bank of Japan pushed borrowing costs into negative territory for the first time. Adding to market fears, most on Wall Street feared the Federal Reserve would soon make a second hike of short-term interest rates, and was likely to make too many hikes in 2016.

The S&P 500 (a measure of the largest 500 U.S. companies) opened 2016 by falling 1.5% on the first trading day of the year. At the end of the first week of the year the S&P 500 was down 6.0%. And though the market bounced about the following weeks, the S&P 500 would find its bottom on February 11th with a 10% total decline for the quarter. Other sectors of the market would fare far worse. The Russell 2500 Index (a measure of small- and mid-cap U.S. company stock performance) was down 14.0% at the February 11th bottom. International equity markets, generally expected to provide some measure of diversification and shelter from U.S. market volatility, were also down sharply. As measured by the FTSE Ex-US Index (a comprehensive measure of non-U.S. publicly traded companies), international stocks were down about 11.0% at the February 11th bottom. At the peak of pessimism on February 11th the Dow Jones industrial average closed nearly 15.0% below its May, 2015 record high.

After hitting the panic button in the first half of the quarter, investors regained some composure mid-February. One by one, the fears and obstacles that had put the U.S. stock market on the brink of its first bear market in 7 years began to dissipate. In a sharp reversal of outlook, markets shrugged off global concerns and rallied aggressively through quarter-end. The S&P 500 finished +1.35% for the 1st quarter. The small- and mid-cap company Russell 2500 Index finished +0.3% for the 1st quarter. International equities as measured by the FTSE Ex-US Index finished the quarter lower by about 0.6%. Emerging market equities outpaced developed markets by about 2.3% finishing in positive territory for the 1st quarter.

Relative Performance: S&P 500 Index vs. Russell 2500 Index (Small- and Mid-Cap)
Relative Performance: S&P 500 Index vs. Russell 2500 Index (Small- and Mid-Cap).

Early during the first quarter any type of reversal seemed unlikely. So what happened? Arguably, the market simply was oversold and due a big bounce. While true, a bounce has to be kicked-off by some thing, or some group of things. This bounce got its kick largely from a recovery in energy and commodities prices, from a few bits of improved macroeconomic data, a steady hand by central banks both in the U.S. and abroad, and a weakening U.S. dollar.

  • Energy and Commodity Prices.

Without question, the most influential market variable in the past 15 months has been oil and commodity prices. While cheaper energy and lower commodity prices are good for the typical consumer in the long run, there exists a delay in the short run translation of those consumer benefits into meaningful economic impact. In the interim, the cyclical (business cycle change) and secular (permanent change) impact upon energy related companies (upstream or downstream), mining companies, heavy equipment manufacturers, transportation (railroads, shipping, trucking) companies, has been devastating to earnings. When earnings drop, stock prices drop. It was no surprise that continued weakness in oil and commodities during the 1st quarter translated directly to weakness in the stock market. And equally without surprise, was the turn higher in stock prices coincident with the turn in energy and commodity prices.

Q1 2016: Price Patterns of WTI and Materials.
Q1 2016: Price Patterns of WTI and Materials.

It is no coincidence that on the same day stocks bottomed that U.S.-produced oil (WTI) hit a 13-year low of $26.21 a barrel. When oil, which was down nearly 30% in 2016 and 80% from its high, stabilized, that lifted pressure off of energy and energy-related firms struggling to meet their operating income needs and to make debt related payments on time. Rising oil prices also relieved pressure in credit markets tied to the oil/energy complex. In reality, this was the turning point that sparked the market’s recovery.

Q1 2016: Price Relationship of WTI and S&P 500.
Q1 2016: Price Relationship of WTI and S&P 500.

Crossing the $40 p/barrel mark near quarter-end was a meaningful accomplishment as this level provides much relief to energy and energy-related companies. And while a $45 p/barrel mark is widely considered an industry average breakeven price, to cling to the $40 mark in the near-term is an important support level. We shall see if anticipated OPEC production cuts later during 2016 actually occur. IF they come to an agreement, and IF they abide by that agreement, then a meaningful move higher in the price p/barrel could occur in the summer and fall of this year. A price in the neighborhood of $50 p/barrel would likely soothe the markets. A price anywhere close to $70 p/barrel and we will then likely start talking about oil as getting “expensive” again.

  • Economic Factors.

The start of 2016 was plagued by concerns that the U.S. (if not the globe) was heading into recession. The reported upward trend in initial jobless claims caused immediate concern. Historically, initial jobless claims have tended to trough several months before unemployment starts to rise. This triggered fears that the steady fall in the unemployment rate that has supported the 7-year recovery could be coming to an end. Revisiting last quarter’s discussion of the math behind stock prices, we know that even small changes in long-run growth expectations will have a large impact on current stock prices.

However, initial jobless claims are naturally more volatile than the longer-term unemployment rate and often give false warning signs. Since mid-February, the trend in initial jobless claims improved, calming market fears about the U.S. labor market. Considering some positive news from the Household Labor Force Survey, and strong job openings data, stock prices began their lift-off in the second half of the 1st quarter.

Another source of concern at the start of the year was the continued weakness in U.S. manufacturing. While not a robust measure of hard data, The Institute for Supply Management (ISM) Manufacturing Survey is a widely followed report and can be useful for quick signals on economic activity. The ISM reported survey data in both January and February signaling a contraction in manufacturing underway since the latter part of 2015. More recently, the index data has bounced back into positive territory (indicating an expansion of manufacturing), and the Regional Manufacturing Surveys have also shown some signs of improvement.

While manufacturing accounts for 14.0% of U.S. GDP, the non-manufacturing component of the Survey (the services sector of our economy) is a more influential element at about 77.0% of GDP depending upon the measurement. While the non-manufacturing index data remains positive (continues to indicate expansion) service sector rate of growth has been slowing for 5 moths, and it will be important to watch this data-point closely in the months ahead.

Releases from major economies around the globe mirrored similarly weak fundamentals as the U.S. and fueled similar concerns throughout foreign markets. Central banks in those markets (the E.U., Japan, and China most notably) were forced to intervene in much more direct fashion.

Nonetheless, the U.S. economy is on more solid ground than thought as we opened 2016. While we will likely have another quarter or two of softness, including some revisions downward of these and similar numbers, our view is that we are simply experiencing a slowing of the rate of growth in the near term rather than a reversal towards recession.

  • Central Bank Actions.

Looking back through my daily notes for the 1st quarter, it appears that the seeds for the dramatic rebound were planted on January 27th. That is the day the Federal Reserve’s FOMC surprised markets by not hiking interest rates again immediately on the heels of the December hike. The markets were bouncing about in a range-bound fashion waiting for any signal that could provide direction for the next trading leg. Although the FOMC’s restraint did not immediately break us from the range-bound trade, the minutes from that FOMC meeting did send notice that the members were paying close attention to concerns at home, and to the mounting risks abroad. The Fed’s soothing words helped when they indicated that the pace of future interest rate increases would be affected by international events. Those seeds planted on January 27th sprung forth in the evening of February 11th in a confluence of events that signaled the change in direction.

Between the January 27th meeting and the market bottom on February 11th, there were signals that the market was in bottoming mode. Energy prices had slowed their free fall, and the number of stocks hitting fresh 52-week lows was no longer expanding. That latter statistic is a meaningful measure for most technicians. On February 11th, America’s unofficial central banker, JPMorgan/Chase CEO Jamie Dimon, cast a vote of confidence for his beaten down bank’s shares, and the stock market as a whole, when he put up more than $25 million of his own wealth to buy an additional 500,000 shares of JPMorgan stock. While not the “cause” of the turnabout, a lot of credit is given to Jamie Dimon with turning investor sentiment.

In the weeks that followed, the stock market got another boost from additional stimulus measures from the European Central Bank, steps by China to steady its economy and wild currency swings, solid economic data in the U.S. allaying recession fears, and a sharp rally in distressed assets powered by bearish investors reversing their negative bets. Fed Chair Janet Yellen added to the bullish tone and turnaround late in the quarter when in mid-March the FOMC dialed back its plans for interest rate hikes planned for 2016 from four to two.

In the bond markets, once the fear of rapidly rising interest rates abated, both government and corporate bond price indices moved to the upside. The 10-year Treasury yield fell from 2.27% at the end of December to 1.77% by the end of March (bond prices and bond yields move in opposite directions). The Barclay’s Aggregate Bond Index (a broad measure of intermediate terms fixed income investments) returned 3.03% for the quarter. We were not willing to take the risk that the FOMC would pause in its move towards higher rates. We have taken a more conservative position with our bond allocations for clients, choosing to remain invested at about a 2-year duration. A shorter duration investment (2-year) will not fall in price as dramatically as a longer duration (10-year) investment when interest rates increase. However, when interest rates fall the price of a short duration investment will not rise as dramatically as a longer duration investment. This is why our holdings returned about 1.6% for the 1st quarter.

Q1 2016: 10-Year Treasury Yield vs. 2-Year Treasury Yield.
Q1 2016: 10-Year Treasury Yield vs. 2-Year Treasury Yield.
  • Currency Impacts.

As we discussed in last quarter’s review, a strong dollar is good for U.S. consumers (we can buy more stuff from other countries), but not so good for U.S. businesses (they can not sell as much of their stuff to other countries). So while the consumer-based parts of our economy are helped, U.S. businesses that generate significant earnings abroad are hurt. Additionally, the translation effect on those foreign earnings mean that those U.S. companies lose when exchanging those earnings back into U.S. dollars (those foreign currencies can’t buy as many dollars). As with last quarter, the U.S. dollar is too expensive. But it did get a little cheaper during the last half of the 1st quarter.

With a cheaper U.S. dollar, when a U.S. business generates earnings in foreign markets, and those earnings are converted back into U.S. dollars for financial reporting and tax purposes, they simply get more U.S. dollars in the exchange. When the value of the U.S. dollar is lower relative to foreign currencies, those foreign earnings, simply by exchanging them back into U.S. dollars, are suddenly worth more. U.S. companies keep more of what they earn overseas, their earnings increase and stock prices increase. It is a virtuous cycle, but one that is easily upset and can take many years to equilibrate.

Q1 2016: U.S. Dollar Index.
Q1 2016: U.S. Dollar Index.

As always, we are keeping our eyes on all of the moving pieces across the globe and across markets. While much of 2015 and the first few weeks of 2016 did not favor some of our portfolio biases, most of our biases contributed solidly to client returns in the post-February 11th recovery.

  • Our overweighting of small-cap (+2.63%), mid-cap earnings (+3.65%), and mid-cap value (+1.73%) company indexes contributed nicely to excess return versus the S&P 500 during the 1st quarter.
  • Our overweighting of the materials sector (+4.64%), and the consumer discretionary sector (+1.61) contributed positively to excess returns versus the S&P 500 during the 1st quarter.
  • Healthcare represents one of the largest sectors of the U.S. economy. It is pervasive throughout every size and style category and encompasses an unimaginable breadth of related businesses. There are parts of the healthcare sector that we like very much, and some parts that we don’t like. During the 1st quarter the healthcare sector underperformed all other sectors with a loss of -5.90%. In our portfolios we create an effective underweighting of the general healthcare sector by creating overweights to specific sub-sectors within the healthcare sector. For example, we overweight medical devices and medical technology companies. Devices and technology returned +0.04% during the 1st quarter, below the 1.3% return for the S&P 500 but far better than the -5.90% for the general healthcare sector.While many of our biases contributed nicely to excess returns during the past quarter, there were a few biases that did create a drag on quarterly returns.
  • Continuing the healthcare sector discussion, in our large, growth oriented portfolios we also overweight biotechnology/genomics companies (-24.2%), and pharmaceuticals (-14.1%). While we maintain our conviction that these are fruitful areas for long-term growth, they are also more volatile than most sectors of the market and react more harshly to growth-related fears. As such, these sectors were among the most beaten down during the 1st quarter. And while one would expect that they also be among the quickest to recover, political pressures associated with the Presidential election cycle have influenced the sector in ways that are unrelated to fundamentals. We believe time and patience are the watchwords in these spaces.
  • All of our portfolios have large allocations to international markets, both international equities and international bonds. During the 1st quarter our method of executing comprehensive international exposure returned approximately -1.4%. We feel pretty good about this number actually when compared to many of the major markets across the globe. For example, the MSCI EMU (a representation of the 10 Developed European Monetary Union countries) returned -6.6% for the first quarter.We remain committed to our strategies for the long haul and see no reason to undertake any significant changes. We have, however, adjusted some of our sector performance expectations and in response will be making small changes in some allocations as opportunities present themselves during the 2nd quarter. Should significant events unfold you can be certain that we will provide updates as needed and advance notice of any significant deviations in portfolio strategy should market forces warrant them. We are available at any time, any day of the week, to discuss specific portfolio and performance questions. Until then, be well and enjoy the rest of your weekend!

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

4th Quarter 2015: Quarterly Recap and Near-Term Outlook

The thing about crafting a useful investment review at each quarter’s end? As each quarter-end approaches I spend a lot of time thinking about the messages most important to reinforce with clients. Then without fail, within days after each quarter-end any manner of hell will break loose that deserves equal coverage. The 4th quarter of 2015 and the 1st week of 2016 are no exception.

The single, most striking theme during 2015 was that although the U.S. economy continued its pattern of economic recovery, not much in the investment arena worked really well. Although the S&P 500 Index (basically the largest 500 U.S. companies) managed to eek out a modest positive return (1.36%) thanks to stellar returns of a few companies, most asset classes ended the year in negative territory with highly positive correlations. This lock-step movement of asset classes provided few safe havens for investors during 2015. It was a year that reminded us that when we talk about a strategy, or a tactic, that works to our benefit “over time” that it does not mean that it will work to our benefit every year.

S&P 2015 Total Return
S&P 500 Index: 2015

A year like 2015 is why we remain committed to a long-term course of action for client portfolios. Every quarter we remind clients that Lake Jericho is an investment firm and not a trading firm, and as such we remain invested in our decisions rather than playing the game of speculation and short-term trading.

As for the past week, I am reasonably certain that by now everyone is aware of the dumpster-fire that was the first week of 2016. The multitude of various sector and style indices aside, the first trading week of 2016 goes into the history books as the worst opening of a new year’s stock market. In the coming years it will no doubt be the subject of much review and ivory-tower analysis. The factors driving the past week are many and complex, but are simply a continuation of the challenges endured throughout most of 2015. Therefore, I choose to roll it all up into the following discussion. I am going to break down just a few of the most important elements that have had the greatest impact on Lake Jericho client portfolios. I will also briefly talk about how these factors impact our strategy for 2016.

  • Math.

Last quarter I used a few hundred words to describe how we look at the value of a thing (what an investment is worth to us) versus the market price of that thing (what that investment is worth to someone else). If an investment is of more value to us than the price the market is offering to purchase that investment, then we hold that investment until the market price and our value converge. Many circumstances can cause our value of holding any investment to change over time. But why does the market price of investments change all the time? Simply stated; math. It is a cheeky response, but true.

The market price of an investment is nothing more than a momentary consensus of willing buyers and willing sellers estimation of the future value of a company’s expected cash flows. We take some rate of growth, grow that exponentially over some period of time, multiply that by expected cash flows. Easy breezy. Even if you hate math you know that when you exponentially grow some number that the result grows really quickly. You also know that if you make little changes in numbers grown exponentially (grow 2 by 3 and you get 8, but grow 3 by 3 you get 27, grow 4 by 3 you get 64) your result increases dramatically. Small changes, over time, have big results.

Very simply, this is what is happening with stock prices and why they have been moving so much. Small changes in a company’s earnings, or small changes in growth rates, over time, result in large (exponential) changes in stock price. Some more math (known as discounting) happens in the middle of that, but you get the idea. This idea is fundamental to understanding what is happening in the stock market these days.

Last quarter I suggested that uncertainty is worse for stock markets than certain, but bad news. Uncertainty is driving this market volatility. In the investment arena, there exists a razor-thin line between something being too expensive, and that thing being too cheap. Markets are in perpetual motion trying to maintain equilibrium on the edge of that razor attempting to discern what, based upon corporate earnings and growth rates, is too expensive and what is too cheap.

  • The U.S. Dollar.

The U.S. Dollar (in relation to other currencies) is an example of something that has become too expensive. One example of the effect is pretty easy to see at work. The second example is more complex. Unless you are an accountant or analyst it is one you likely never think about.

First, a strong dollar is good for U.S. consumers (we can buy more stuff from other countries), but not so good for U.S. businesses (they can not sell as much of their stuff to other countries). So while the consumer-based parts of the U.S. economy are doing well, U.S. businesses that do a large percentage of their business abroad are not doing so well. U.S. companies are earning less internationally.

Second, when a U.S. business generates earnings in foreign markets, those earnings have to be converted back into U.S. dollars for financial reporting and tax purposes. When the value of the U.S. dollar is high relative to foreign currencies, those foreign earnings, simply by exchanging them back into U.S. dollars, are suddenly not worth nearly as much. U.S. companies, already struggling to maintain sales/income in international markets (because their goods and services are now more expensive) are hit with a double-whammy. The earnings that they fought to achieve are simply worth less because of exchange rates.

Both of these examples illuminate the math discussion above; how big changes in corporate earnings (in this example due to the strength of the U.S. dollar) occur in unanticipated ways and how those changes in earnings impact stock prices.

U.S Dollar Index
Strength of U.S. Dollar to Major Currencies: 2015
  • Stuff that goes into other stuff.

Americans have bemoaned the high cost of gasoline and our lack of energy independence for the last 15 years. The country almost elected a different President because some thought it cost too much to fill up their truck. We have been punching holes in the ground and pumping in fluids to extract so much oil that the U.S. is now an exporter of the stuff. And for the last 25 years the world’s largest mining companies were digging big holes, with big machines, to get tiny, important, rare, expensive stuff out of the ground to help fuel our demand for smaller, faster, cheaper stuff.

Gas is now cheap. Every house has something like 10 bagrillion-inch flat screens TV’s. We all get new phones, tablets, or laptops with every refresh cycle. We love this part of the global slowdown! But if this is so good, then why does it look so bad? It looks bad because there is cheap, and then there is too cheap.

Oil, commodities, and other factors of production have now become too cheap. As a leading indicator of global growth rates, falling prices in the factors of production is interpreted as purely a reflection of demand and therefore a harbinger of slowing global growth. One tangible example of a direct effect is pretty easy to see at work in our daily lives. But when we extend this effect into the markets? The result is more complex, and unless you are an accountant or analyst you do not think about it much.

Materials Index 2015
Industrial Materials Index: 10-Year Price Level

First, cheap oil and low commodity prices are GREAT for the average U.S. consumer. The money we save due to cheaper energy and lower priced good means that we can save more or buy more. Saving more or buying more must be a good thing, right? In the long run, perhaps. But it takes a long time (and usually a lot of economic pain) to get to a new normal based upon changes in consumption and savings habits. Again, it is about markets in constant motion trying to maintain equilibrium on the edge of the razor.

While cheaper energy and commodities might be good for the average American consumer, the cyclical (business cycle change) or secular (a permanent change) friction upon energy companies (upstream or downstream), mining companies, heavy equipment manufacturers, transportation (railroads, shipping, trucking) companies, has been devastating to earnings. Having made significant investments in capacity for the past couple of decades using assumptions of much higher prices, these companies now have excess capacity and overhead that they can not support. Many companies are being forced to slash production, lay off workers, shutter wells, close mines, and even seek bankruptcy.

In these industries, you are not simply seeing a reduction in the rate of growth. Rather, you are seeing negative growth rates. Negative growth is just an economist’s way of saying “shrinking”. Again with the math, but when you have exponential negative growth, earnings quickly disappear. In short order, debt overwhelms these companies and the assets are forced into liquidation.

Many companies in these industries are small- and mid-sized companies. The energy, commodities, and materials sectors are a big part of the reason that the small-cap and mid-cap sector indexes (represented below by the Russell 2500 Index) have significantly underperformed big-company stocks during 2015.

Russell 2500 Index: Small- and Mid-Cap Performance
Russell 2500 Index: Small- and Mid-Cap Performance

Lake Jericho overweights both small- and mid-sized companies in our portfolios. This adds the potential for more price volatility in our portfolios. However, the potential for additional return afforded by this overweighting more than compensates long-term investors for the additional risk. Only during a few, short-term, investment horizons, have small- and mid-sized company investments under-performed large-company only portfolios. 2015 happened to be one of those years. We maintained these overweights throughout 2015 and will continue to do so during 2016.

We did move to purposefully underweight the energy sector in our asset selection throughout the year. However, it is nearly impossible to completely shield a portfolio from the influences as energy permeates every part of our economy.  Towards year-end 2015 and into 2016 we have chosen to add additional weight to the materials sector of the U.S. economy as we believe this category should benefit from lower factor costs and recover quickly following recent underperformance. We believe the material sector is likely to be a leading indicator of a larger global turnaround later during 2016.

  • New kids on the block.

Our discussion of U.S. Dollar strength and the cost of stuff both feed into the corporate earnings part of our math discussion. What follows is a discussion about the growth part of the discussion.

Developed economies don’t manufacture stuff. Developed economies own stuff, consume stuff, and get served stuff. Emerging economies manufacture stuff in the hopes of earning enough money to also just own, consume, and get served stuff. Frontier economies get plundered for resources but that is another story for another time.

We need not rehash the transformation of the U.S. from a manufacturing economy into a consumer/service-based economy. For a long time, the saying was “as goes the U.S.A., so goes the world” when referring to the engines of economic growth. And we need not rehash the transformation of the Chinese economy from a largely rural and agrarian society into the world’s fastest growing manufacturing economy. That growth transformed China into the world’s second largest economy by 2003. Indeed, that saying can arguably be expanded to “and also as goes China, so goes the world”.

In working with clients, we have spent much of the past three years cautioning others to be mindful of exposure to emerging markets and the Chinese economy. From its founding, Lake Jericho has been thoughtful and purposeful with exposures to emerging markets generally, and China specifically. Emerging market exposure is an important part of a portfolio’s long-term asset allocation. However, we knew that the lofty rates of growth, specifically in China, could not be maintained sustained.

As 2015 progressed we took several steps to either underweight emerging market and China exposures in our portfolios, or have the exposure actively managed by another top-tier firm. We were keenly aware of the tie between European developed markets and China, yet we underestimated the degree to which the Chinese and the U.S. economies are inextricably weaved. Our overweighting of international markets and the inherent exposure to emerging markets, inclusive of China, adversely affected our investment performance for clients during 2015.

China has, rightfully or wrongly, become the idiomatic “Canary in the Coalmine” for global growth. Manufacturing growth? Maybe. But I have a problem with China being the proxy for all global growth. Nonetheless, during the past year manufacturing output data from China has been weakening and investors have interpreted that to mean that economies around the globe must be slowing. Falling energy and commodities prices also were used to foretell of China’s slowing economy.

In my estimation, there is a bit of “cart before the horse” going on. I think that the markets have reacted too strongly to suspect data from the Chinese markets. While it is true that China is slowing, other emerging manufacturing economies are experiencing higher rates of growth (India, Malaysia, Indonesia, Nigeria, Ethiopia, etc.) and are simply producing more stuff now. Only time and more data (which China releases with a great lag) will tell the full story of the secular or cyclical frictions within these evolving economies. Regardless, the result is the current oversold conditions in the markets and the negative impact upon our client portfolios 2015.

  • Raising interest rates does not always increase interest rates.

One final thing to touch upon briefly, as it did guide allocation decisions heavily this year, is the non-action of the U.S. Fed for most of the year regarding the normalization of interest rates. With certainty I predicted that the Fed would begin raising rates in the summer of 2015, leading to underperformance of the bond markets versus stocks. When interest rates increase, the prices of bonds fall. At high rates of interest, the price movement does not represent much of the total return from bonds. But in the current environment of low rates, small increases in yield could have a dramatic impact upon the price return of a bond portfolio. This is the reason for our cautious allocation to bonds for most portfolios. And for those portfolios for which we are holding meaningful allocations, we are doing so at very short maturities.

While I stand by my belief that the Fed could have acted in June, they did not do so until December. The chart below demonstrates the yield of the 2-year Treasury Notes (our average maturity for clients) throughout 2015. You will notice that well in advance of the Fed’s move, rates began to climb. As well, you will see (as the chart extends through the first week of 2016) that changes of the Fed’s target rates might not have a long-lasting effect. Yields had already started to fall once again due to a “flight to safety” by many market participants during the past week’s volatility.

2-Year CMT: January 1, 2015-January 8, 2016
2-Year CMT: January 1, 2015-January 8, 2016

Although the returns provided by bonds during 2015 were nothing to cheer about (and in real terms were actually negative when accounting for inflation), bond allocations did protect investors from some degree of the stock market’s move lower. When compared to many advisors, Lake Jericho does maintain lower allocations to traditional bonds and this did adversely affect portfolio performance during 2015. Our underweighting of traditional bonds will continue into 2016. Our continued analysis maintains that an overweighting to equities in the current interest rate environment is the best approach to meet long-term investment objectives for clients.

Trust that we are keeping our eyes on all of the moving pieces across the globe and across the markets. While 2015 did not favor many of our portfolio biases, we remain committed to our strategy for the long haul. The year has just begun. And while January is a fair statistical indicator of the markets direction for the coming year, we will sit tight for the near term. As significant events unfold you can be certain that we will provide updates as needed and advance notice of any deviations in portfolio strategy should market forces warrant them.

Each of you can expect to receive your account-specific quarterly statements in the coming days. We are available at any time and any day to discuss specific portfolio performance. Until then, be well and enjoy the final few hours of your weekend!

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

3rd Quarter 2015: Quarterly Recap and Near-Term Outlook

The thing about the 3rd quarter of 2015? There was a little something for everyone to dislike. Markets across nearly all sectors were beat down, particularly in September. Even broadly diversified investors, historically able to find some shelter in lower-correlated sectors, were left with nowhere to hide as practically all major asset classes had significant losses for the quarter. Large-company U.S. stocks were down, and small-company U.S. stocks were down double-digits. Developed international markets were also down, off just over 10% on average with some such as Germany down in the neighborhood of 20%. Emerging markets were simply crushed, down nearly 20% for the last three months and continuing a multi-year slide. The U.S. energy sectors continued to slide as well. Longer-term U.S. bonds as measured by the Barclay’s Aggregate Bond Index were a bright spot up 1.23% for the quarter, but were a dicey wager in light of interest rate uncertainty in the U.S.

As investment professionals we could barely absorb unsettling information from one area of the investment marketplace before another cycle of news from a different space would rise to the headlines. It was a lather-rinse-repeat type of quarter in which a sure-footed basis for certain investment valuation was difficult to find. Take particular note of my choice of the word “valuation” rather than the word “pricing”. I’ll get to the “why” of that choice quickly. But until then take your pick of the investment news headlines of the past quarter:

  • a “kick the can down the road” short-term resolution of Euro-area pressures caused by the Greek debt crisis,
  • concerns over slowing global economic growth potentially indicated by the sudden devaluation of the Chinese currency,
  • continued strengthening of the U.S. dollar against other world currencies, potentially making U.S. produced goods and services less attractive in foreign markets,
  • a continuation of the years-long trend of slowing economic growth in emerging markets,
  • the perpetual wait-and-see approach of the U.S. Federal Reserve towards interest rate normalization in the U.S.,
  • short-term earnings pressures on the global energy infrastructure as the world awaits realization of long-term benefits of reduced energy expenditures on other sectors of the economy,
  • tone-deaf hedge-fund managers so dramatically increasing costs for medications that a shift to increased government regulation of pharmaceuticals and biotech becomes increasingly possible,
  • corner-cutting and unethical behavior by the world’s largest automaker single-handedly dragging down a leading industrial economy’s stock market to a 20% correction.

What is it that each of these headline items have in common? Each of these items injects into the investment marketplace a heightened level of economic uncertainty. In many aspects, uncertainty in the investment valuation arena is much worse than certain, but unquestionably bad, news. There exists an unattributed quote “price is only ever an issue in the absence of value”. The 3rd quarter was somewhat a manifestation of this idea. When increased uncertainty is injected into the process of valuing an investment, smart investors typically do the smart thing (nothing). During these periods of heightened uncertainty smart investors (and analysts) revisit their valuation models, carefully examine the inputs to those models in the light of a broad range of potential inputs and possible outcomes, and only then patiently execute any change to long-term strategy. Conversely, not-so-smart investors fall prey to the instinctual need to avoid volatility (and of course only the downside volatility) and sell. Not-so-smart investors ALWAYS sell too late, almost always sell at the worst possible time, do so in a panic, and will do so at any price that they can get. As Warren Buffett says, if you want a deal badly enough you are sure to make a bad deal. Panicked investors are driven by instinctual behaviors to drive markets, irrationally, lower.

Admittedly, a fundamental tenant of economics is that the only value of something is the price someone is willing to pay for that thing. Ok, fine. But that also assumes there exists a willing buyer and a willing seller. But if we aren’t selling, then what do we care about someone else’s price? That other person’s price might be reflected on a report we receive or on our screen when we log into our account, but practically it means little to the long-term intrinsic value in our long-term investment. In the end, cooler heads always prevail and the smart investors have waited for greater clarity to present itself before finalizing any revaluation, and certainly before making any trading decisions.

It is this type of sure-footed basis for investment valuation and trade pricing that puts a floor under every market’s downside volatility. Smart investors are rewarded for their patience. While the global economy outside of the U.S. is showing signs of current softness, most major U.S. economic data is comfortingly positive. The jobs market continues to improve as the unemployment rate continues its slow, but very steady, downward trend (currently at 5.1%). The average U.S. consumer is doing well as indicated by The Conference Board Consumer Confidence Index®,. We are seeing consumer-focused signals of the positive effects of lower energy prices. Rapid deleveraging after the 2008 recession and sustained low interest rates have resulted in the average U.S. household using less income to make debt service payments. These trends have likely contributed to auto sales from most major manufacturers reporting results well above forecasts. The U.S. construction economy, including residential building, again showed signs of strong growth. And remembering that everything is cyclical, an improving U.S. consumer situation, a stronger dollar, and lower commodity prices may very well lead to increased consumption of goods manufactured in China (an area on which an undue amount of attention is spent). We maintain our basis for forecasts of net-positive gains for 2015. And in fact, the first days of the 4th quarter have provided much needed relief as markets have recovered meaningfully from the lows of the 3rd quarter. In many cases, more than half of the territory lost was quickly regained in the past week.

As I have stated, and will continue to restate, Lake Jericho is an investment firm with a long-term focus. We are not a trading firm that seeks short-term or speculative profits for clients. We understand that “risk”, if defined simply as price volatility, is not a bad thing to take in our investment portfolios. Without risk, there can be no reward. So at Lake Jericho we measure, and carefully manage, the amount of and the price of the risk we assume for client portfolios. While we concern ourselves with daily price fluctuations of the market to inform our decision making, clients should take comfort in our capability to differentiate between what is true change in long-term value prospects and what is behaviorally driven short-term pricing changes. Each of you can expect to receive your account-specific quarterly statements in the coming days. We are available at any time and any day to discuss specific portfolio performance.

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