Investment Update

Stocks added impressively to their gains of the first half, marking the eighth consecutive quarter of positive returns for most broad based indices. Much of what transpired in the markets fit the “more of the same” narrative that has held course for the year. Bond returns were positive as interest rates ended the quarter little changed.

Key Storylines for the Third Quarter:

Stocks remain focused on improving economic fundamentals and corporate earnings.

The daily news flow out of Washington, rising tensions with North Korea, and two natural disasters have not created the distraction that these events might have caused in previous cycles. The first back-to-back quarters of double digit earnings growth in over five years have provided cover for investors to focus on the issues that directly impact their investments. At the same time, the economic backdrop, aptly referred to as the “Goldilocks” economy, remains characterized by slow growth, low interest rates and benign inflation. This seemingly mundane combination has proven to be an enduring and rewarding environment for financial assets.

A rotation in stock leadership back to the “reflation trade” that followed the election last November re- emerges in September.

Amidst what has been steady gains from stocks over the past 12 months, there have been notable shifts between leadership groups. After the initial surge from the value/ cyclical camp on hopes of a stronger economy following the general election, growth strategies have instead outperformed by a wide margin this year as economic growth expectations faded.

This pattern showed signs of reversing in September after recent data revealed moderate improvement in domestic and non-U.S. economic activity. A more upbeat outlook was also supported by a recovery in oil prices and the release of an outline for tax reform that would provide further stimulus to the economy. The increased odds of a December rate hike do not seem to be an impediment to higher stock prices for now. The more attractively valued economically sensitive sectors (Financials, Industrials, Energy) rallied, giving value strategies and small-cap stocks a nice boost in September. Left to be seen is whether this shift will be more sustainable now than it was last year.

The notable growth of the largest Tech stocks has created concerns about both valuation and concentration of power.

The largest five companies in the world by way of market cap (Apple, Alphabet, Microsoft, Facebook, and Amazon) are technology or tech-related companies. Only Microsoft was in the top five when the bull market began in 2009. The growth in these companies has accelerated over the past several years, reflecting robust revenue growth, strong cash flow, and earnings growth. No surprise that they have outperformed dramatically as investments. As a result, their weight inside the various market indices has become disproportionately large.

It is natural to view the enthusiasm behind this group of tech and tech-related stocks with some skepticism, given the history of the tech bubble in 2000 and other times when a particular sector (e.g. Financials 2007) became overly favored by investors. That said, it is too simple to draw the same conclusions on how the attachment to this group ends simply because of the similarity of historical circumstances. Today’s tech giants share little in common with the preponderance of “dot-com” stocks that soared indiscriminately despite lacking sound business plans and real earnings.

Aside from high stock valuations, which are always difficult to reconcile when growth is exceptionally strong, there is another recent development that could prove more troublesome. That is a nascent pushback against the Silicon Valley culture by regulatory bodies and technology users around the world. Concerns have centered on monopolistic business practices, corporate arrogance, excessive wealth, and sexist work environments. This movement bears watching as this kind of corporate distraction has the potential to impede a firm’s natural rate of growth. We will revisit this topic in another forum, since it is beyond the scope of this update piece to address fully.

Traditional signs of a market top are not present.

Our macro work continues to show the economy in the early phase of a late cycle, with little to suggest that the risk of recession is increasing. Investor sentiment remains neutral, at best, typically a good contrarian indicator. Fed policy is looking to take on one more rate hike before year-end, but the absence of inflationary pressures may stay their hand until next year.

In the meantime, the Fed recently announced their plans to gradually unwind some of the unconventional tactics they used to jumpstart the economy after the financial crisis. Never having done this before, it will be critical for the Fed to communicate their intentions clearly as they move forward with this process, given previous missteps that have caused anxiety for stock and bond holders.

Outlook:

The ninth year of an economic expansion is reason to be cautious, not bearish.

As we discussed in last quarter’s Investment Update, bull markets are not defined by their duration. The current economic expansion has not followed a traditional path in most respects, and as noted above, the excesses that typically accompany a mature economy are not present today. We also know from experience that whenever the cycle ends, most will not see it coming.

Being cautious does not say a lot about how that translates to managing portfolios, but it does imply a greater awareness to downside risk in security selection and portfolio construction. As always, there are multiple uncertainties that can quickly change the tenor of this market. Trying to predict the timing of

such an occurrence at this point of the economic cycle is tempting, but it is no easier than at any point of the cycle. The consequences, however, of a market disruptive event at this point in the cycle, become more significant.

The best way we put this into perspective is to acknowledge that the risk/return proposition for stocks is less attractive from the starting point of all-time highs. This holds for nearer-term expectations compared to the returns we expect from stocks over a longer period of time.

This thought process does not support a knee-jerk reduction in equity exposure for clients, but it does suggest evaluating the existing level of portfolio risk in the context of lower expected returns for a period of time. The message is less about avoiding an inevitable correction/bear market in stocks and more about being appropriately positioned to manage through it.

For now, the window for interest rates to stay low remains the strongest support for this market to hold together and continue providing “more of the same” returns for investors.