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

Hello Friends!

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

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

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

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

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

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

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

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