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Market and Investment Mid Year Update

| July 03, 2018
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Mixed Q2 Results Amid Increased Market Volatility

We are a little late posting reports and commentary due to vacation and holiday schedules.  Thank you for your patience. 

Performance has been mixed over the last quarter.  US stocks did well.  Foreign stocks lagged.  Bonds started off down as interest rates rose – then recovered somewhat.  Generally speaking, most portfolios saw the decent performance by US stocks mostly offset by surprisingly poor performance by foreign stocks, resulting in rather flat results for most investors.  (July however, has started off with a nice pop - let's hope it lasts!!)  

U.S. stocks are holding their own, despite the threat of trade wars, rising interest rates, and a host of other apparent threats to our economic well being.  The Dow Jones Total US Stock Market index was up about ½ of 1% in June.  But that fairly mundane performance is not indicative of the volatility that the market was experiencing.  Market moves of ½ to 1.5% in a single day are once again becoming routine. If you listen to the news from day to day, you would think that Armageddon was coming.  Then the next day, everything is back to normal.  And at the end of the month, a modest but positive return.   Despite strong recent performance, our exposure to US stocks is a little LESS than normal in most portfolios due to historic high valuations.  See below for more detailed discussion of why we are somewhat underweight in our US stock allocation at this moment.

Foreign stocks have lagged.  A rising dollar, trade tensions, uncertainty over growth prospects in Europe, potential impacts from Brexit and a new populist (and anti EU) government in Italy have all weighed on foreign stocks so far this year (following a strong 2017).  While poor recent performance overseas has been a primary drag on our portfolios this year, particularly the last quarter, valuations of overseas stocks are very attractive compared to their US peers.  This bodes well for potential long term returns from this asset class.  We maintain a healthy allocation to overseas stocks, including some emerging markets, as we think both growth and dividend potential seem attractive. 

Bonds are the financial media’s favorite whipping boy.  And with some good reason.  When interest rates go up, bond prices go down, and investors see the value of their bond holdings decrease.  So far this year, returns on bonds have been poor, as interest rates spiked higher.  But LONG TERM investors can enjoy the flip side of that situation.  When interest rates go up, bond investors can REINVEST low interest bonds, as they mature into new HIGHER INTEREST instruments.  In the short run, bond investors may lose some money – but in the LONG RUN – they may be better off as they lock in more interest income. 

There is also a defensive justification to owning bonds.  When fear grips markets, investors tend to flood into “safe havens” – and investment grade / government bonds are one of those safe havens.  After all, a 2.85% interest rate on a 10 year Treasury note may not be particularly exciting when stocks are growing at 9% per year – but if stock prices are crashing down around you that 2.85% rate looks pretty good!  Bonds are still an effective, if imperfect, defensive tool.

In fact, despite all the warnings around higher interest rates, we have recently seen bond prices rally a bit (and interest rates pull back).  In particular, inflation adjusted bonds (TIPS) have done well of late.  TIPS have their principle amount adjusted when inflation moves higher – and higher inflation expectations of late have been reflected in the price of TIPS.  We have a substantial allocation to TIPS in our fixed income allocation, so this has been a welcome development.

Still, we would be foolish not to recognize that bonds offer relatively paltry returns – even while risk seems somewhat elevated due to higher interest rates.  This is why we have been implementing “bond alternatives” across some of our client portfolios.  We have been using more brokered bank CD’s, which have been sporting yields as high as 3% for 3 year CD’s.  We have even been using some fixed indexed annuities (NO LOAD of course!!!) which offer some attractive fixed and variable rate options – and no downside if rates move higher.    

So fixed income remains important in portfolios – but just buying a plain bond index fund and forgetting may not be the best approach in this low interest / rising interest rate environment.  Rather, we have a multi-pronged approach to fixed income.  A) keep maturities short – so we can more quickly benefit from higher rates B) address inflation risk with TIPS C) diversify internationally where rates may be more attractive E) rely on experienced fixed income managers with excellent track records and D) consider alternatives such as CD’s and annuities where appropriate.

More Thoughts on Stock Valuations.

US stock valuations are very high by historical standards.  There are some good justifications for this.  The economy has been strong.  Taxes are lower.  Interest rates are still low, offering few other investment opportunities.  All of these positive factors have buoyed stock prices to very high levels.   It is important to realize that high valuations do not mean a stock market crash is inevitable.  In fact, high valuations (expensive stocks) says\ very little about what is going to happen tomorrow, or next week.   However, high valuations are a very strong predictor of LONG TERM future returns (10 years for instance).  Periods with low valuations (cheaper stocks) have historically been followed by higher than average 10 year returns.  Periods with historically high valuations have been followed by lower than average 10 year returns.  Looking at valuations today, it would seem the best investment opportunities for the next 10 years are in cheaper foreign stocks and emerging markets - while US stocks offer the least opportunity for growth.  So poor Q2 results notwithstanding, we think it is wise for investors to review portfolios and make sure you are well diversified geographically.   

Remember - investing in stocks and bonds entails risk of loss, including loss of principle.  Past performance is no guarantee of future results.  

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