Second Quarter 2021 Market Recap, Performance Review and Near-term Outlook

Q2 2021 saw gains in most stock market indexes, with many closing at or near all-time highs. This is not surprising, as markets continue to be driven by meaningful progress on vaccination rates, accommodative monetary policy, record- shattering fiscal stimulus, and strong corporate earnings growth driven by the reheating of global economies.

This link is to a PDF containing our Q2 2021 Market Recap, Performance Review and Near-term Outlook. This Recap incorporates a broad review of global markets, including a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by iShares (by Blackrock). The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio performance in proper context with just a few numbers.

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

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

First Quarter 2021 Market Recap, Performance Review and Near-term Outlook

Somehow, we overlooked posting the First Quarter 2021 Market Recap, Performance Review and Near-term Outlook after having pushed it out to clients. Better late than never.

This link is to a PDF containing our Q1 2021 Market Recap, Performance Review and Near-term Outlook. This Recap incorporates a broad review of global markets, including a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by iShares (by Blackrock). The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio performance in proper context with just a few numbers.

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

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

 

4th Quarter 2020: Market Commentary and Near-term Outlook

Despite a post-election market rotation into beaten down cyclical sectors, meaningful mid- and small-company allocations provided more than enough cover for our bull-headed commitment to growth sector over-weights. Leaning into our positive outlook global growth strategies provided for meaningful out-performance, relative to benchmarks, for the calendar year.

This link is to a PDF containing our Q4 2020 Market Commentary and Near-term Outlook. This Recap incorporates a broad review of global markets, and a series of directly comparable, globally diversified, balanced portfolio benchmarks constructed by iShares (by Blackrock). The commentary and performance information, coupled with the tabled data will, hopefully, help each reader evaluate their own portfolio performance in proper context with just a few numbers.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4th Quarter 2019: Quarterly Recap and Near-term Outlook

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

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

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

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

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

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

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

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

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

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

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

Is the New Normal just the Old Normal?

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

Q2 Review

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

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

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

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

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

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

Small beats big, but the NASDAQ continues to lead.

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

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

Chart 2: CBOE Volatility Index

Volatility representing more historically average risk.

CBOE Volatility Index: VIX

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

Chart 3: Asset Class Returns

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

Novel Investor Asset Class Returns TableSource: novelinvestor.com

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

Chart 4: U.S. Treasury Yields

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

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

Summarizing the various market forces during the quarter:

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

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

International versus U.S. ( Contribution)

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

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

Bonds versus Stocks ( Contribution)

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

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

Small Versus Big ( Contribution)

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

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

Value versus Growth ( Contribution)

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

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

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

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

Sector Overweight/Underweight Decisions ( Contribution)

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

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

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

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

Near Term Outlook

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

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

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

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

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.

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Right-click to open in a new window. We don’t judge.

Novel Investor Asset Class Returns TableSource: Novel Investor.

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

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

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

U.S. versus International

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

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

Stocks versus Bonds

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

Small Versus Big

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

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

Value versus Growth

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

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

Sector Allocation Decisions

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

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Novel Investor Sector Returns TableSource: Novel Investor

Near Term Outlook

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

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

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

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