First Quarter 2018
Volatility returns; long live volatility. This is a reality, an inevitable part of investing in public markets. Investors must accept this and understand that this can be used for advantage; it is not just a risk factor.
Through January of this year, the U.S. stock market marched day after day to new highs reaching a peak on the 26th. We warned in a weekly blog that investors should not extrapolate these returns. Then in February all the gains were taken away, plus some. March vacillated between positive days and negative ones but did recover some of the February losses then gave them back again; fun, fun. We have predicted a trading range market (see the next section for more on this). So far that is what we are seeing.
Fixed income investors finally faced the reality that interest rates were going to rise. The fixed income bull market was over, and rates had started an irregular, but protracted march higher. Investors in longer-dated fixed income securities saw losses in their portfolios. Worse is yet to come. However, this change in trend is early yet, so some back and forth is likely.
Interest rates are not only responding to Federal Reserve policy, but also to rising inflation. Inflation is still rather tame, but slowly rising and gaining momentum. This may take some time, but the trend is unmistakable. (See the Forecast for our expectations here.)
International equity markets experienced the same volatility. In fact, all markets around the world displayed an amazing amount of synchronization. This may be because our economies also seem to be in synchronized uptrends and money flows today are more internationalized than ever before. Global growth will probably last for some time yet and is a positive for stocks. This positive is offset by concerns, thusly the predicted trading range.
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Investment firms typically have a defined methodology for selecting investments. Riverplace Capital certainly does along with selling disciplines and investment management principles. Our selection process is involved and is applied through an Investment Committee.
Riverplace Capital does not publish its total process considering it proprietary and instrumental in our competitive positioning and success. However, to give insight as to what we consider important here are some of the qualitative metrics we use to analyze individual stock candidates.
- Invest in good businesses with superior growth and profitability
- Focus on high quality companies, particularly those with competitive advantages
- Concentrate on the long-term
- Be willing to go against the consensus
- Pay close attention to valuation
- Diversify for offensive opportunity, not just risk control
- Have realistic expectations
- Great management is paramount
These are qualitative considerations and can be analyzed through the evaluation of public records, commentary, Wall Street research, etc. We also supplement these sources with conversations with suppliers, customers, competitors, and others expected to have particular insight. One source we normally exclude is the company itself. We have found management a poor source for the candor we need.
In future publications we will outline some of the quantitative hurdles we use to further refine our selection process. However, the best factor in selecting good investments is experience. Qualitative and quantitative measures help maintain discipline and are part of the science of investing, but not the art. Investing does need the intangible that comes from a large body of informed experiences. This we also bring to the selection process; Talk with Us.
The U.S. economy is strong and getting stronger. This is a positive for the earnings of most public companies but has negative implications for bonds. Recent forecasts for GDP growth this year are for approximately 2.9%. This is up from growth closer to 2% for the past few years. There is likely to be some lumpiness in the reported quarterly series. The first quarter has been weak the past few years, then picks up subsequently.
Most economic sectors are participating but there is a great deal of change occurring within most all of them. For example, retail is experiencing major shifts in consumer preferences. Among them is a shift to more online sales. Healthcare companies are grappling with reimbursement pressures and more and more competition. Industrials are dealing with the prospect of trade restrictions and tariffs potentially disrupting supply chains and competitive positioning. These are just a few examples of the intense changes. There will be even more as businesses have to adjust to global competition, technological change, and legal issues to name just a few. If anything, change seems to be accelerating and is relentless.
The challenge for investors is to understand the nature and consequences of such a rapidly shifting environment and to take advantage of these changes without increasing risk. Our approach of Growth at a Reasonable Price (GARP) helps steer us though these challenges.
Riverplace Capital is convinced that after the fabulous gains of the past few years, stock market averages are likely to enter a period of range-bound trading. Therefore, it’s unlikely that averages will make much headway. However, within those averages some dramatic changes are taking place.
Some stocks have reached valuations not supported by financial fundamentals and should underperform for an extended period. A good corollary is the 1970’s when the “nifty-fifty” stocks reached similar valuation levels and went into a protracted bear market. At the same time, other companies entered new uptrends. Oil companies, because of the oil embargo, multiplied their values. A new technology industry emerged with the advent of the semi-conductor. Inflation drove higher gold prices. The averages did almost nothing for 10 years as the old favorites declined and new favorites emerged. We could be starting a similar time; hopefully not nearly as long.
The new emerging winners this time are only now emerging. We are working hard to identify them and include them in portfolios we manage. We have already made some changes and will be making more. The new trends are still nascent, we will find more to do as these develop. However, we have been anticipating this shift and have made some changes already. We believe we are getting well positioned.
Interest rates are going higher. This may be an irregular process, but it will be unrelenting. Bonds are in a protracted bear market. The bull market in bonds lasted for 30 years, let’s hope the bear market does not last as long. However, interest rate trends are long lasting.
Changes in trends like this take time to develop momentum. They start out slowly and only pick up pace over time. Initially, there is plenty of doubt that the change has actually taken place. Later, as the evidence becomes irrefutable, the trend gains acceptability.
Our investment challenges are two-fold. We must not be fooled by the emerging trading range; not to panic at the bottom end believing a breakdown, and to not expect higher and higher valuations when approaching the top. The second is to identify those new opportunities that can produce extended gains.
Trading ranges can provide opportunities for short-term tactics, but also provide opportunities to shift portfolios to the new winners at more favorable prices. None of this will be easy but knowing what the game is helps.
In a nutshell, our fixed income strategy is to stay relatively short and average up in yields as bonds mature. Quality is always paramount. We never reach for yield using esoteric, complicated instruments. We have seen many of these blow up, leaving holders with losses. We only use investments that are straight forward with known rates and maturities; vanilla is our motto. After-all, the fixed income portion of a portfolio should be used to reduce risk, not add to it.
At the beginning of the year, we signaled that we would probably be making some changes to our asset allocation selections. These had a bias toward large-cap holdings and we foresaw a shift toward mid and small-cap ones. However, the market did not shift during the first quarter, so we did not make any changes. Our allocation model performed well; there simply was no need to change it.
However, it appears that the changes we anticipated might finally be happening. If current trends persist a little longer we will make the anticipated changes.
as of 3/31/2018
|Large Cap Stocks (S&P 500)||-1.2%|
|Dow Jones Industrial Average||-2.5%|
|Mid Cap Stocks (S&P 400)||-1.1%|
|Small Cap Stocks (Russell 2000)||-0.4%|
|Barclay Aggregated Credit Index||-2.2%|
” The four most dangerous words in investing are: ‘This time it’s different.’ ”
— Sir John Templeton