The Year 2018

 In Newsletter

The Year 2018

January 2019

Number 82

Can you say wild ride;a stock market that turned out to be far more volatile than many investors are comfortable with. Or perhaps more accurately, far more volatile in the wrong direction than investors like. Suddenly great current conditions were overwhelmed by concerns as to what may be coming. Higher interest rates, a budding trade war, and potential political instability here destroyed optimism and confidence.

The U.S. stock market suffered two corrections this year. The first started in February, then recovered to new highs over the summer and began again with a second correction in October. Put into perspective, the stock market has been in a wide trading range in 2018. Both the upside and downside were defined. That range was 2600 to 2800 on the S&P 500, plus or minus a little, or 24,000 to 26,000 on the Dow. Unfortunately, at the end of December the stock market broke down. It is now clearly in correction territory; something we hoped to avoid. Perhaps it is good to get all the negativity out.

Corrections need to play out. The good news is that they do so quite quickly. Never fun, the best course is to do little, upgrade where possible and set up for eventual recovery. We are doing just that (see our Investment Strategysection).

Stocks haven’t been the only assets that have suffered this year. Bonds and commodities have also incurred losses. Real estate in certain local markets is also beginning to decline. If it isn’t declining, it certainly looks toppy in most other markets. With all that, it is easy to see why some investors seem discouraged. Remember, however, emotions most often work against good investing practice.

Many international markets suffered even more volatility and deeper declines than the U.S. market. Some of these responded to clear signs of slowing growth. There has long been a saying that when the U.S. sneezes, other economies catch a cold. Whether those declines continue or reverse to a large extent depends upon what happens here. See the Forecast section to read what we believe is most likely.

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Index funds over the past number of years have become all the rage. The calculation has been that because so many active managers could not outperform index benchmarks, then why not simply invest in the indices. As long as markets were in uptrends, this strategy worked pretty well. However, in trading range markets they simply track sideways at best.

During big drawdowns index funds must sell the underlying stocks to meet redemption requirements. Since most indices are market weighted, the biggest companies have the heaviest weighting; these stocks may drag down the entire index. This is especially true when high value stocks lose their cache or events go against them as has happened recently to some well know tech and social media companies.

While the former winners may be in downtrends, others may be emerging as new growth opportunities. The indices still dominated by past winners will not reflect the growth occurring elsewhere. We are currently in such a transition.

ETFs (exchange traded funds) are baskets of stocks. The basket may be an index, an industry or sector or some other collection of companies. Most of these are also market weighted and have many of the same flaws as index funds. The basket or collection is usually not based upon fundamental analysis so often one gets the good with the not so good; not a valid reason to own all of them.

Recently a new approach to selecting the securities in any collection has emerged. This is called factor investing and may be found in some of the so called “smart beta” ETFs. In these, capitalization is replaced by some other metric for selecting and weighting holdings such as cash flow or return on equity. The metrics chosen are static and do not change with conditions. Also, the approach tends to be mechanistic and cannot consider many qualitative factors.

Although not perfect, fundamental analysis still offers the best opportunity to earn good returns, especially when the investing environment is in transition as it is today; that is what Riverplace Capital does. Talk with Us.

Forecast

Economy

In response to lower tax rates, economic growth in the U.S. accelerated this year. Along with greater growth, profits jumped to new record levels. Part of the rationale for lowering corporate tax rates was the expectation that businesses would reinvest some of their profit gains in their own business to accelerate their own growth rates. This has not happened to nearly the extent that was projected. Instead companies increased stock buy-backs and some raised dividends.

Because capital investment did not increase as projected, economic growth will again moderate. Profits growth will too. So, the profit jump this year is more of a one-off. That does not mean that they will recede anytime soon. It’s just that profit increases will be more selective and particular to each individual company’s prospects and management ability. However, Riverplace Capital does not see a recession anytime soon.

Equities

The U.S. stock market should recover to its established range. However, we expect it to be locked in a broad trading range for some time yet. There may be violations at both the top and the bottom, but then the trading range should once again be reinstated. Within the broad averages, much has been and will continue to be happening. There will be group rotations, firms falling in and out of favor. New stars will emerge, and past ones may fall; that already has been happening.

Some international markets should begin to deviate from the primary trend. Long-term economic growth is the fastest in the Far East. Some other emerging markets also have good prospects. Many of these have been sold-off heavily and offer good value.

Europe is tricky. As a sector, Europe looks sluggish at best and mired in dysfunction and the challenges of keeping a disparate group of countries tied to a single currency and common policies. There are significant cracks in the European model. However, some companies, nominally located in Europe, have excellent prospects. It may be that their revenue growth comes from outside of the Euro-zone. Perhaps their business is in high demand regardless of the state of the general economy.

Being selective will be tantamount to finding successful investments. Even then, patience may be required as markets go through periodic bouts of fear.However, these are exactly the times when tomorrow’s big winners are made. Tomorrow’s really good returns are often established during the scary and confusing present.

For investors simply wanting to preserve their past success, there are also good strategies for that too. Current income and deep value are keys. See the next section for an outline.

Fixed Income

The recent stock market sell-off has encouraged treasury bond purchases. These are seen as a safe-haven from volatility elsewhere, therefore, treasury bonds have rallied. Many corporate bonds, however, have not. Fear for future business prospects and credit quality have kept some investors away from these.

Longer term, though, interest rates are going higher. This will happen regardless of what the Federal Reserve does. This is simply the supply of new issuance quickly increasing. Higher deficits and the need to roll-over past borrowing will be part of this new supply. Supply that overwhelms demand means lower prices and lower prices on bonds mean higher interest rates.

Investment Strategy

Equities

Without question, investors will need to steel themselves to periodic bouts of volatility.Riverplace Capital has been carefully evaluating all its portfolio holdings. We have made a few upgrades, taking opportunities the stock market decline has given us. Dividends and current income are becoming more important in our analysis. We believe these are underappreciated and help provide returns in a trading range market.

Rebalancing portfolios has also become important. In this volatile environment, winners and losers swap places rapidly. By rebalancing more often, portfolios get the benefit of reducing positions in the in-favor sectors and stocks of the moment and adding to the out of favor ones. Then, as sentiment reverses and losers become winners, rebalancing can again capitalize on taking some profits to buy cheaper holdings. Market forces dictate when it is opportune to rebalance, but clients will see periodic moves.

We have moved some client portfolios to our income strategy from growth ones to better meet their needs during this volatile period. We want to ensure that their cash flow needs would be met regardless of stock market activity. This is a case-by-case situation.

We strongly doubt that passive strategies will produce much in the way of returns. Those became very popular but are fraught with flaws in the current environment. Firstly, simply tracking a trading range market leads nowhere. Secondly, too many indices have the same handful of stocks that are the biggest part of their holdings and become vulnerable to liquidation phases and company disappointments. This is a time for good selection, bargain hunting, and other aspects of active management.

Fixed Income

Riverplace Capital is continuing to buy short to intermediate term bonds that meet our criteria for safety; predominately treasuries and brokered CDs. There is no reason to take credit or duration risk. We are also slowly moving back asset allocations toward reestablishing greater bond portions in balanced portfolios. We are doing this opportunistically by scaling back equities when markets and individual stocks are at favorable sell points. With the most recent decline, we have paused in this process.

Wealth Management

During the recent sell-off, all allocations that have been previously attractive declined precipitously. Therefore, we deferred making any allocation changes until the investing environment stabilized. Present allocations offer good value and should be retained.

Major Indicies

as of 12/31/2018

Large Cap Stocks (S&P 500) -6.2%
Dow Jones Industrial Average -5.6%
Mid Cap Stocks (S&P 400) -12.5%
NASDAQ Composite -3.9%
Small Cap Stocks (Russell 2000) -12.2%
MSCI EAFE -16.14%
Barclay Aggregated Credit Index -2.19%
Inflation 2.3%

Equity indices are twelve-month returns excluding dividends.

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Risk comes from not knowing what you’re doing.”

Warren Buffett

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© 2019 Riverplace Capital Management, Inc.
Information contained herein is prepared by and is the sole property of Riverplace Capital Management, Inc. Written by Peter E. Bower, President.
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