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Strategy and Themes Update

Index1

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As we approach year-end, I wanted to update you on our investment strategy and themes going into 2018.  But first, I thought a review of the market year-to-date would be interesting.

In the graph above, you can see that the large companies’ stock prices (as represented by the S&P 500 Index in the Red bar) soundly out-performed small companies’ stock prices (as represented by the Russell 2000 Index in the Purple bar).  And Growth style companies (as represented by the Russell 1000 Growth Index in the Green bar) trounced Value style companies (as represented by the Russell 1000 Value Index in the Pink bar).  What this tells me is that investors focused on the largest and fastest growing companies in the country when investing their hard earned money, and ignored to a large degree the smaller companies and the companies in more traditional industries like energy and food production.

One item to note is that beginning in November, the value style companies began to out-perform the growth style companies, but we cannot know if this is the beginning of a structural change in the character of the market or just a one-off occurrence.  There is more discussion of this later in this blog post.

Index2

In the graph above, I have plotted the performance of the various economic sectors of the S&P 500 Index so you can see for yourself which ones were driving the index higher.    The Green bar showing the performance of the Technology sector explains why the Growth style companies were this years price performance leaders.  However, overall, every sector except Energy was positive year-to-date.  But look at these same sectors when we view the market excluding those large companies:

Index3

This graph shows a much different picture year-to-date.  Small and mid-sized companies in the Technology sector still performed well, but the overall market performance was pretty pathetic.  Small and mid-sized energy companies really took it on the chin this year followed by utilities and consumer staples.

One of the signs of a mature market is that the largest companies start to significantly outperform smaller companies.  It is based upon human nature where people who typically do not invest in the stock market see it going up and decide to put money in the market, either buying shares of the companies they know that are doing well (e.g., Facebook, Google, Microsoft) or they buy mutual funds that are heavily weighted into those same large cap companies.  Historically, this is a sign that we are due for a correction – however, there is no way to know when that will occur.

Countering this historic pattern, we have the corporate tax cuts that were just signed into law.  These cuts will have a huge impact on corporate earnings, particularly for companies that whose operations are primarily domestic.  For companies that have significant foreign operations, the impact on their income will be less.  They will, however, be able to bring those earnings from foreign operations back into the US will a significantly smaller excise tax beginning in 2018, which many will do.  Its hard to know how they will use that money when it is repatriated – some will pay bigger dividends to their shareholders, some will increase their stock buyback programs, some will increase wages for their employees, some will invest it in expanding their business, and some will do multiple of these things.   Honestly I was struck by the announcements from several large companies that are beneficiaries of the tax cuts that they would pay $1,000 bonuses to their employees while others were raising their base wage to $15 per hour.  I didn’t see that coming.

Index4

Given that the value style companies are weighted heavily in domestic operations, the out-performance we saw starting in November could be investors anticipating the impact of the tax cuts on those companies earnings beginning next year.  In the graph above, you can see that for the overall market excluding the S&P 500, the companies that had been underperforming (energy, staples) show positive performance whereas technology was down.

Index5

For the S&P 500 since November 1st, you see a similar pattern, with energy and staples both outperforming technology.

In October, we rebalanced client portfolios ahead of year-end based upon changes we believed were going to occur.  This rebalance began to transition our clients’ portfolios to reduce exposure to technology and add shares of energy and staples based upon our view that those sectors would benefit from tax cuts more than the technology companies that have significant foreign sales.  We also began to swap within the technology sector, paring back our big winners with higher P/E ratios to focus on lower P/E companies and technology companies that had recent price declines, all as part of our updated Investment Strategy and Themes heading into year-end and 2018.  The additional benefit of this move is that portfolios became more defensive in posture so that they will ride out the next correction (whenever it may occur) with less downside – and when we have lower prices we can be opportunistic and more aggressive again to maximize portfolio performance on a recovery.

Below is a short summary of our updated strategy and themes which has been guiding our investment activity the past ten weeks or so:

      2017 Investment Strategy

Based upon equity valuations being in the 95th percentile, weak corporate earnings, tepid economic growth, and a slew of unknowns with a new president that has no experience in politics, we view the markets cautiously.

We plan to maintain our above average cash & short-term bond positions in portfolios at the max 10% of equity exposure, but invest the balance in the themes noted above.

     Fall 2017 Strategy Update -> Moving into 2018

We have moved to a more defensive posture within our portfolios, adding shares of mega cap (HON, MMM, UTX) as well as defensive (ADP, ECL, CTAS) industrials.  We have also reduced our technology exposure and added some defensive staples (DPS, PEP, MKC) and health care (PFE) to client portfolios – while maintaining our overall equity exposure.  We will also reduce the overall P/E valuation of our holdings and be opportunistic when price corrections occur.

Based upon the Fed continuing to increase interest rates and their plan to reduce their balance sheet by $0.5 Trillion next year, the tightening monetary policy will eventually have a negative impact on stock prices.  These moves will help to maintain client portfolio values if/when we get a correction.

We will also add to portfolios the companies that should benefit from the tax cuts being discussed.  The companies that will benefit the most or those with primarily domestic operations and the mega caps that have large cash balances outside the US.

2017 Investment Themes 

  1. Cloud Computing
  2. Mobile Internet
  3. Improving Consumer Spending
  4. Energy Recovery
  5. Aerospace & Defense
  6. Baby Boomers’ healthcare
  7. Selfie generation
  8. Stay at home entertainment (video games, TV & movies, food delivery)
  9. Industrial Recovery
  10. Bank & Life Insurance Stock Rally
  11. Weak Dollar
  12. Rising Short Term Interest Rates
  13. Flat to Down Long-Term Interest Rates 

Fall 2017 Themes Update -> Moving into 2018

  1. Mega Cap Industrials
  1. Defensive Industrials
  2. Defensive Staples
  3. Defensive Pharmaceuticals
  4. Casinos/Gambling
  5. Reduced Technology Exposure
  6. Lower P/E Technology
  7. Industries that have not participated in the 2017 bull market
  8. Beneficiaries of tax cuts

There are other themes that will develop as we get into 2018.   We are on the sidelines watching the Bitcoin mania and do not plan to participate.  However, the technology that runs the bitcoin network is a different story – it is revolutionary and could have a major impact on businesses in coming years – likely long after bitcoin bubble has burst.  With Bitcoin dropping from $19,000 to $11,000 in four days, that bubble may be bursting right now.

As we close out the year, I want to wish everyone a Merry Christmas, Happy Hanukkah, and Happy New Year!

–Mark