Category: Quarterly Recap

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

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.

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.

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.

Source: novelinvestor.com

Chart 4: U.S. Treasury Yields

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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