Quarterly Recap – Page 3 – Lake Jericho, LLC

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

October 15, 2016April 23, 2017 AJ Walker

The thing about crafting a useful Recap at each quarter’s end? Rare times do exist when nearly every style tilt deployed by a manager contributes positively to superior investment performance and the following quarterly review practically writes itself. This quarter-end Recap is such a time for Lake Jericho. But before diving into the Q3 Recap, for context let us first revisit a few points made in the closing of the Q2 Recap.

Closing the Q2 Recap I highlighted what we believed to be the most significant near-term challenge facing us as your investment manager; global political instability and the impact upon economic growth forecasts. I lamented our diminished ability to confidently estimate global growth expectations with the challenge of evaluating potential outcomes of uncharacteristically significant qualitative factors, such as political uncertainty, that fundamentally influence those expectations. While we had before us the data supporting a forecast for broad economic expansion in the U.S. and international markets, we also had before us a great deal of political and social uncertainty. We still do. Our projection at that time was that despite statistical evidence supporting a positive growth bias for both domestic and international markets, the political and social uncertainty would leave us flat for a period of time. Were you to read a sampling of other firm’s already published Q3 investment reviews what would you find? You would observe a pattern in those reviews along the line of “solid but uneventful quarter”. If only looking at the “headline” indices (those you hear about on the evening news), words like “solid”, “uneventful”, and “flat” are generally on point. But the headline indices do not tell the total story.

Most of those other investment reviews minimize the volatility that surrounded the end of Q2 and the early days of Q3. You might recall the surprising June 23rd “Brexit” vote in which the U.K. elected to leave the European Union. Markets reacted wildly, resulting in a significant downturn in global equity markets the following two trading days. U.S. stock markets recovered strongly the next two trading days after those. Shortly into Q3 the major U.S. equity indices had sufficiently rallied to sit comfortably at new all-time highs. Foreign developed markets, and particularly the E.U. markets, were much slower to recover but did so over the course of Q3. Mostly. So sure, it was a “solid but uneventful quarter” once we got past the first few weeks of Q3. If marking the post-Brexit recovery as beginning on June 28th, U.S. large-company stocks were up 8.9% through September 30th, with most of that recovery happening by July 8th. Measured from the open of Q3 to close of Q3, U.S. large-company stocks were up 3.8% for the quarter. So after that quick rebound within the first two weeks of Q3, U.S. equity markets as measured by large-company stocks moved within a narrow trading range for the remainder of the Q3. The CBOE’s S&P 500 Volatility Index (the VIX), a broad measure of market instability, reached lows in Q3 seen only a handful of times in the past 25 years. But large-company stocks do not tell the total story.

Chart 1 illustrates the difference between large-company U.S. stocks (the MSCI USA Large-Cap Index represented by the black line), small- and mid-sized company U.S. stocks (the MSCI USA SMID Index represented by the blue line), and international stocks (the MSCI EAFE Index represented by the gray line) for the post-Brexit recovery period. When you chart the recovery of large-company stocks in the U.S. compared to small-, mid-, and international company stocks you see that valuable opportunity existed over the course of Q3 to achieve superior relative performance versus the performance of the headline/large-company indices.

Large, SMID, International Stock Post-Brexit Performance

In fairness and full disclosure, let’s examine the same index data in Chart 1 but move the start date back 18 months to April 1, 2015, prior to the past year’s major economic events. Chart 2 shows market impacts of Grexit to Brexit, the continued trudge out of the depths of the U.S financial crises, heightened concerns regarding global growth rates, commodity and energy price collapse, dollar strengthening, fears of rising domestic interest rates to actual real negative interest rates abroad, and the most bizarre election cycle in memory. Chart 2 highlights two market tendencies that influence Lake Jericho’s equity management results over time. The first tendency is that during periods of heightened market volatility (the more palatable industry term for market declines) there exists a thing called “volatility clustering”. Volatility clustering, again a palatable industry term, means that when things go south, most everything (all types of stocks, bonds, alternative investments, everything) go south together. It’s a particularly vexing challenge to portfolio diversification as a means for risk reduction as the hoped-for risk reduction benefits of diversification tend to disappear just when you need them most. This tendency greatly influences how Lake Jericho views and manages volatility in client portfolios. The second tendency is that during periods of heightened market volatility investors flock to the “save haven” of U.S. securities, particularly U.S. government securities and large-company U.S. stocks. This “flight to safety” compounds and extends the downward pressure on other sectors of the investment universe. These tendencies are all on display in Chart 2. First, during sharp downturns all parts of the market tend to move down together. Second, during periods of heightened uncertainty few, if any, sectors will outperform large-company U.S. stocks. Third, when markets recover it is possible, through Lake Jericho’s strategic and tactical sector diversification methods, to meaningfully recover lost ground.

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

While Lake Jericho fully expects to capture a great percentage of upside in rising markets, and is adept at limiting downside risk during volatile markets, our strategic and tactical sector allocation methodology is most successful at capturing excess return when markets are less directionally clear and advantageous trading opportunities are more abundant. Our forecast for a flat market, combined with our sector allocation decisions, and opportunistic trade execution provided for a solid, if not superior, investment performance during Q3. I will now walk through that decision making process with you and detail how each decision impacted overall investment performance during the quarter.

As demonstrated in Chart 2 above, the past 18 months have been a challenge as a result of this higher international equity allocation. But just as we said in our Q2 Recap, mean-reversion is real and is part of the reason we remain true to our discipline and committed to our total international allocation level within portfolios. This commitment was rewarded during Q3 as international equity investments as measured by the MSCI EAFE Index returned 6.9% while large-company U.S. stocks returned 3.8%. Even our somewhat beleaguered overweight to E.U. equities returned 5.0% during Q3, besting large-company U.S. stocks by 1.2%. Believing that the U.K. would soon signal the formal process for leaving the E.U., and that the post-Brexit recovery for non-currency hedged U.K. stocks would slow, we did reallocate most E.U. portfolio overweights to existing, and less concentrated, Developed Markets positions prior to quarter-end. As we anticipated, on October 2nd British Prime Minister Teresa May did report that the U.K. would invoke Article 50 by the end of Q1 2017, triggering the formal process of exiting the E.U. and a pull-back in U.K. and E.U securities.

Turning to domestic market decisions and more widely recognized indices, the S&P 500 Index also returned 3.8% for Q3, for a YTD return through September 30th of 7.8%. Small- and mid-sized company stocks as measured by the Russell 2500 Index fared far better with a quarterly gain of 6.6%, for a YTD return through September 30 of 10.8%. Chart 2, again, highlights the outperformance of large companies versus small- and mid-sized companies from April, 2015 through the early days of 2016, then the reversal of that performance pattern since mid-February. Chart 1 makes more clear this continued divergence during Q3 during which small- and mid-sized companies narrowed 2015’s performance gap significantly. These “size” decisions are another among the five levels of our portfolio construction process. Investment performance during Q3 was helped by our continued overweighting of small- and mid-sized companies versus a U.S. equity market-neutral portfolio.

Company valuation metrics are yet another distinct level of our long-term decision making process. Company valuation categorization is a combination of quantitative measurements and qualitative art, referring to companies as value-oriented, growth-oriented, or core. In layperson’s terms, it boils down to “how expensive is the stock versus its earnings expectations”. Although Lake Jericho managed portfolios most often represent elements of each category, our long-term bias tilts toward value-oriented investments. Some refer to our style as “growth at a reasonable price”, a fair label as far as labels go. When examining Chart 3 below, you will see that value-oriented investment strategies (the gray line) continue to outperform both growth-oriented strategies (the blue line) and core strategies (the black line) during 2016. After underperforming both growth and core strategies for all of 2015, the trend reversed during Q1 and value strategies have outperformed since. Value strategies have now outperformed both growth and core strategies for the trailing 18-month period. Value-oriented strategies, which we do significantly overweight versus a market-neutral portfolio, have contributed positively to portfolio performance by besting core strategies by 2.0% and growth strategies by nearly 8.5% thus far during 2016.

Core, Growth, Value Strategies

As for bond markets, they were surprisingly calm in Q3, particularly when compared to the tumultuous final week of Q2. As with the equity markets, initially negative reaction to the surprise Brexit vote quickly faded and bond markets returned to the typical task of assessing economic data and policy moves from the world’s major central banks. In the US, economic momentum continued to track broadly in a positive direction and by September the U.S. Federal Reserve’s Open Market Committee was split on whether to increase interest rates. The extension of accommodative policy by the Bank of England in August pressed gilt yields lower, while the European Central Bank’s decision to leave its current range of support measures unaltered left Bund yields unchanged. And then there is Japan. The Bank of Japan already owns about 40% of Japanese government bonds (JGBs). At its current pace of buying, the BOJ would hold about $2 out of every $3 of existing JGBs by 2020. Most doubt that any additional efforts by the BOJ to jump-start economic growth would have an impact, and would most likely have unforeseen and unintended consequences. Japan, along with China, are big question marks in Asian markets and the reason we underweight both equity and bond exposure to the region.

At home, the 10-year U.S. Treasury yield climbed from 1.47% to 1.59% in Q3. The 2-year U.S. Treasury yield climbed from 0.55% to 0.75% in Q3. Spreads between 10’s and 2’s have been steadily decreasing meaning the incentive to invest longer term is increasingly less compelling. Increased yields were enough to slightly suppress bond market total returns during Q3, but certainly not enough to push returns into negative territory. The Barclays U.S. Aggregate Bond Index, a broad measure of bond market total return positioned somewhere in between 2-year and 10-year bonds (a gross over-simplification but an acceptable way to frame the idea) was up 0.8% is Q3, up 5.8% year-to-date, and up 5.2% for the last year through September 30th. Our U.S. bond holdings returned about 0.5% for the Q3, 3.6% year-to-date, and about 3.2% for the year ending September 30th.

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

We have maintained, and continue to maintain, a less yield-sensitive position for clients than that represented by the Aggregate Index. With interest rates at historical lows, we feel that there is much more risk of interest rates rising in the U.S. than of rates continuing to fall. This low-yield reality is a significant element in why traditional methods of portfolio diversification are less effective today, and part of the reason why volatility clustering is on the rise. Our U.S. bond positions remain invested at a 2.8 year duration, versus the Aggregate Index duration of about 5.5 years duration. Lower duration bond investments will not fall in price as dramatically as a longer duration investment when interest rates increase. The best way to think about duration and how it represents risk to bond investment performance is that should interest rates increase equally across the maturity spectrum, a 2.8 year duration investment will be negatively affected by about half of what the 5.5-year duration investment would be. However, if interest rates remain the same, or fall, the shorter duration investment not only has a lower yield, but also will not increase in value as dramatically as the longer duration investment. Our global bond holdings currently have a negative effective duration, meaning that this portion of client portfolios performs positively in periods of rising interest rates. That is the trade off we make to mitigate price risk in the bond allocations of our client portfolios, and one of the few portfolio decisions that detracted from relative performance during Q3. We are sticking with that decision.

Finally, strategic and tactical sector weighting is the fifth level of our portfolio construction process and an important part of how we add value over time. Few portfolios will match all sector allocations, or sector allocation percentages exactly, or the timing of investments perfectly, and these factors certainly impact exact contribution to performance of our sector decisions. However, our process of underweighting U.S. equity market-neutral benchmark allocations in favor of overweighting higher expected growth sectors (currently materials, medical devices and instruments, and biotech/genomics) added about 0.50% in excess return to client portfolio during Q3. Our pharmaceutical sector overweight has not performed as expected, and remains hamstrung by negative headlines about poor leadership, moral hazard related to aggressive pricing strategies, and the resulting political rhetoric in the election cycle. Pharma sector overweighting, where present, reduced portfolio performance by about 0.18% during Q3. Finally, while the consumer space has remained consistent during this year’s volatility, that strength has not translated well into an our forecasted increase in broad discretionary spending. Evidence that it might turn before year-end was fading, and trading opportunities afforded us to exit our consumer discretionary positions at slight gains during Q3. The gains did not move the needle, so to speak, on overall performance so we reallocated the proceeds to other existing sector positions. The net effect to client portfolios during Q3 was about 0.32% of additional return due to our combined sector decisions.

So what does all of this mean for us going into the final lap of 2016? We continue to see upside in our long-term global economic growth estimates, with higher expectations for both foreign developed markets and emerging markets than for domestic markets. For the near term we are projecting greater market volatility. Markets seemingly got accustomed to the recent summer lull, but we fully expect the reprieve to be short-lived. As we trudge towards U.S. election day we expect more of the same range-bound activity, but expect it to be…well…more active. Post-election, should Secretary Clinton take the White House and the GOP retain the House, we expect another round of record highs for U.S. equities, a continued rebound in developed and emerging market assets, and continued strength in global bonds. Should Trump take the White House? Or should Clinton prove successful and the Democrats take both houses of Congress (a long-shot to be sure)? I am not alone in projecting that all bets are off under either scenario. I feel no need to venture into the politics of either scenario, only to repeat one of our most often stated market realities; uncertainty is worse for stock markets than certain, but bad news. A Democrat in the White House, GOP-controlled houses of Congress, and total gridlock in Washington might be bad news, but it is a certainty that Wall Street knows and perversely finds comfort.

Any other leadership combination creates uncertainty and could be bad news for the markets. Bad for how long depends on the nature of the combination. As we have marched towards election day, we have been building larger-than-typical cash positions in all of our portfolios to provide additional measures of down-side protection. As well, in certain portfolios we are tactically deploying small allocations to investment vehicles that are, negatively correlated with the S&P 500 Index, or to other specific at-risk sector exposures. These “inverse” tools are inexpensive and effective methods of securing portfolio insurance that directly benefits from down-side movements.

Post-election, we expect the U.S. Federal Reserve to press forward at their December meeting with increasing interest rates at home. We expect other major central banks will recognize the limits on their own easing policies. Again, we suspect that there will be downward pressure on markets after that December meeting through the end of the year and perhaps into the new year’s earnings reporting season. We plan to remain a bit cash-heavy and relatively more defensive compared to our normal positions through the early days of 2017. How the Q3 earnings reporting season unfolds might further inform how we position portfolios through year-end. If significant events unfold that dramatically alter our views or strategies I will be in quick contact as usual.

We are available at any time, any day of the week, to discuss specific portfolio and performance questions. I will also be in touch with each of you prior to year-end to conduct a thorough review of goals and objectives, make any needed changes as a result, and to walk through a few administrative tasks that we need to tackle going into 2017. Until then, be well, enjoy the rest of your weekend, and thank you!

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

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

July 17, 2016April 23, 2017 AJ Walker

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

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

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

Lake Jericho’s long-term portfolio construction process involves five distinct levels of strategic decision making. The first level in our process is the global allocation decision; how much of a portfolio should be invested in international markets versus invested in the U.S. market. Our long-term outlook for growth rates in international markets exceed that of our long-term outlook for U.S. growth. The higher growth expectation is why we invest significant assets in international markets. While our allocations are less than a global market-neutral allocation, they are higher than the typical U.S. based investment advisor. No doubt that the past year has been challenging as a result. However, bad times, as with good, don’t last forever. As the table below illustrates, one year’s laggard is often among the next year’s leaders. Mean-reversion is real and is why we remain committed to our total international allocation level within portfolios. These global investment decisions then inform asset allocation decisions amongst stocks, bonds, and alternative asset classes within U.S. or international markets (the second level of the strategic decision making process). If we make any changes during the second half of 2016, it would be to reallocate the geographic distribution of the international holdings rather than any reduction of the total international allocation.

Source: NovelInvestor.com

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

Company valuation metrics are another distinct level of our long-term decision making process. Company valuation categorization is a combination of quantitative measurements and qualitative art, referring to companies as value-oriented, growth-oriented, or core. In layperson’s terms, it boils down to “how expensive is the stock versus its earnings expectations”. Although Lake Jericho portfolios most often represent elements of each category, our long-term bias tilts towards value-oriented investments. Some refer to our style as “growth at a reasonable price”, a fair label as far as labels go. When examining the next chart one will see that value-oriented investment strategies (the red line) have underperformed both growth-oriented (the silver line) and core investments (the blue line) during 2015 and early 2016. This pattern reversed late during the first quarter and value strategies outperformed through the second quarter. Value-oriented strategies, which we do overweight versus a global market-neutral portfolio, now slightly lead both growth- and core-oriented strategies for the last year and have contributed positively to portfolio performance.

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

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

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

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

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

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

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

April 10, 2016May 20, 2019 AJ Walker

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

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

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

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

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

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

Energy and Commodity Prices.

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

Q1 2016: Price Patterns of WTI and Materials.

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

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

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

Economic Factors.

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

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

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

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

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

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

Central Bank Actions.

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

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

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

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

Q1 2016: 10-Year Treasury Yield vs. 2-Year Treasury Yield.

Currency Impacts.

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

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

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

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

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

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

Image January 10, 2016April 7, 2016 AJ Walker

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

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

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

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

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

Math.

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

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

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

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

The U.S. Dollar.

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

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

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

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

U.S Dollar Index — Strength of U.S. Dollar to Major Currencies: 2015

Stuff that goes into other stuff.

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

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

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

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

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

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

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

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

Russell 2500 Index: Small- and Mid-Cap Performance

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

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

New kids on the block.

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

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

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

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

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

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

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

Raising interest rates does not always increase interest rates.

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

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

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

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

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

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

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

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

October 20, 2015October 20, 2015 AJ Walker

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

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

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

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

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

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

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

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