Nauset Wealth Managment

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Nauset Insights

Nauset Market & Strategy Update

Key takeaways regarding recent market activity:

  • The market’s old companion volatility is back and likely with us in 2018
  • Rising rates and inflation concerns will continue to be a key concern for all stock markets
  • Despite solid US and global economic fundamentals, potential for market gains are lower than in 2017
  • Our approach is to stay diversified and rebalance as opportunities occur

What Happened: Welcome Back Volatility

A market correction can be unsettling but it’s important to remember it is normal. We haven’t seen one in a while as we have been in an unprecedented period of low volatility. The market sell-off of the past week was swift and appeared just days after a new market high. The S&P 500 stock index hit a new all-time high of 2873 on January 26. Thirteen days later on February 8, the S&P 500 was down -10.2% from that high, mostly from losses in the past five trading sessions. To put this into perspective, the S&P 500 is down -3.5% for 2018 due to the spike up in the first three weeks of the year.

The reason for the sell-off: rising interest rates on the 10-year Treasury bond along with a whiff of wage inflation from the Feb 2 jobs report got the attention of stock investors. Higher rates are generally negative for equities, especially after the prolonged period of historically low rates. The 10-year Treasury yield moved up from 2.4% at the end of 2017 to 2.8% in early February. And when coupled with a forward P/E ratio on S&P 500 stocks at the upper end of its historic range, investors got nervous. Add to this mix, the intention of the Fed to push up short-term rates at least 3 times this year, and the stage was set for a sell-off. The sell-off itself was likely amplified by short-term trading programs and hedging activity, which often dominate daily trading.

The irony of the situation is that S&P 500 earnings have been excellent this quarter and are projected to continue to be strong in the near term. And that is usually positive for stocks. We believe that the positive economic environment will likely limit the decline in equities. However, the bottom line is that rising rates will likely make it difficult for markets to move up in 2018 as the current US economic cycle, now almost nine years old, may finally be in its late stage.

Going Forward: Why Stay Invested?

So, what happens now? The economic backdrop continues to be positive, which will support markets. While growth is almost always a good occurrence, too much growth and earnings momentum can cause inflation to rise, which above a certain level is problematic. Some analysts believe the recent cut in corporate tax rates may push the economy toward an overheating phase. We are not in full agreement with this view, as the impact of tax reform on both consumers and corporations is still unclear. However, if inflation does rise, the Fed would address it by raising rates more quickly, which in turn would push up interest rates in general. And that scenario would likely be negative for stocks.

Under almost all scenarios, we do see rates and inflation rising. The concern for the markets is how much and how quickly. Right now, the bond market is expecting the Fed to tighten 2-3 times this year, up from lower assumptions only six months ago. That means that the bond market’s expectations are much closer to the Fed’s projected tightening path. Which, in turn, suggests that the 10-year yield may now be closer to “fair value” than it has been, and interest rates may settle in the current range and perhaps move slowly to the upside. As such, we will keep a close eye on both inflation and rates.

Even with rate and inflation concerns, the solid economy and earnings picture does provide a way forward that may result in gains for stocks this year. It just won’t be the smooth ride of 2017. Whether the market settles down from here or continues to exhibit high volatility is not knowable. Our view is that it will stay choppy for a while. The recent whipsaw is a reminder that volatility and pullbacks are the price we pay for the excellent returns that stocks can produce over the long run.

The chart below shows that sizeable sell-offs and pullbacks are normal even in years where the market is positive.

 

Finally, let’s put some context around the current market sell-off. The US stock market has had a strong run over the past 15 months without even a -10% market pullback. As a result, the S&P 500 was up over +30% in that period. Corrections of -10% are normal and happen about every 2-3 years, so it is no surprise that one would occur now. Over the past 50 years corrections, defined as a -10% to -20% price drop from the peak level of the market, have averaged about -14% and bottomed in about five months.

While we can’t predict what will eventually happen, this provides some context. At worst, a bear market, defined as a drop of -20%+ in the broad index, could develop from this correction. We put a low probability on that occurring given the US economy is on solid footing and not showing any signs of a recession, which usually accompanies a bear market. In summary, a correction is normal, and for long-term investors who stay the course, it’s often a healthy development that can help markets consolidate and eventually move higher.

Current Investment Strategy: Keeping Our Balance

As we have noted at volatile times in the past, we at Nauset are long-term investors, not traders, so our mantra is to stay balanced, diversified and disciplined. Our advantage is that we are long-term investors and we can handle short-term volatility as we manage positions for the long-term. 

We build clients’ portfolios for the long run and to fit clients’ financial plans. As part of that approach, we weather market corrections like the current sell-off, and as conditions evolve, we adjust to new market realities. While a market correction may be unsettling, we have a bias to action around the following three areas:

  1. Rebalancing – we continuously monitor our clients’ portfolios and will take steps to rebalance to specific client asset allocation target ranges and risk profiles. 
  2. Tax-loss harvesting – With the recent sell-off, recently purchased positions may be in a loss position. We may sell these positions from taxable accounts to create a capital loss and buy back the same security 31 days later, or buy a similar security, to replace it in the allocation. This will provide clients with a tax offset for a portion of earned income or gains we take in the future.
  3. Opportunistic buying – Volatility and sell-offs often create price distortions and thus opportunities in individual securities, subsectors or sectors. We are monitoring the market for the opportunity to add to areas that we find attractive, such as cyclical and growth stocks in tech, financials and consumer discretionary sectors.

Saving Your Identity…Or At Least Your Sanity

As a result of the Equifax breach several clients have called us for advice on how to protect their identity. Below is our view on the situation and some recommendations for how you can lower the risk that your identity is misused. We have also attached a short article that provides further recommendations.

  1. Assume your critical, personal information has already been obtained by someone through a data breach. It’s an unfortunate result of our interconnected world. Equifax is only one of many major data breaches over the past several years. Anthem, the state of Connecticut, several major retailers, even a company that provided recreational state licensing services to several western states are a few examples of other incidents.
  2. Taking precautions should reduce (but not eliminate) the risk of misuse of your information.
  3. Check your credit card statements and bank statements each month.
  4. Consider a credit monitoring service. Credit monitoring services vary but, generally speaking they will alert you to changes in your credit, suspicious use of your credit cards and other accounts. They may also coordinate the freezing of your credit. Here are a few credit monitoring services to consider. Nauset neither endorses any of these services nor do we receive compensation from any of them. You should do your own due diligence before working with any of them.
  5. Freeze your credit report. Freezing your credit restricts access to your credit report, however, also requires you to unlock your credit if you want to obtain a new loan, credit card, etc. For this to be effective you have to freeze your credit report at all three major credit bureaus. As noted above, a credit monitoring service may do this for you, which might make paying for the service worth it. If you want the added protection of freezing your credit on your own, here are the addresses for each of the three credit bureaus: Equifax, Experian and TransUnion. You can call or initiate the service online for each.
  6. Here is a brief article, written by Nick Clements and published in Forbes, about other steps you can take to prevent misuse of your information. 

Redefining Wealth

I have come to believe that most people view wealth as having more money than they currently have. However, I assume that at some asset level that definition changes. Amazingly, at least according to a Spectrum Group study, the number may be more than $25,000,000. How can this be? I remember in Paul Sullivan’s book, The Thin Green Line, his observation that the wealthiest person he ever knew was his grandfather, who was as a mailman. How is this possible? He lived comfortably, and apparently happily, within his means.

As I reflect on it, our clients who feel the wealthiest are not necessarily the ones with the most money. For them, wealth is about spending and enjoying the life their assets and income offer.

There are two actions we find that help clients become wealthier and neither involve having more money. First, look at money as the mirror of wealth, not the definition itself. Let your assets and your income tell you how to become wealthy by living within your means. Second, apply your life’s timeline to your definition of wealth. Do you want to act wealthy today by out-spending your means only to be poor in the future?  That’s short-term wealthy. Don’t you want to be long-term wealthy by living comfortably for your lifetime?

It’s not always so easy to figure out what lifestyle you can afford over the long term. It’s even harder to make decisions about what to keep or cut out of your lifestyle in order to be long-term wealthy. Having helped clients go through this process, I can tell you it’s worth it.

http://spectrem.com/Content/wealthy-define-wealthy.aspx

 

Waiting for Godot?

The chorus of investment pundits calling for an end to the current US stock rally has grown larger and louder and yet, the market continues higher. Let’s examine why a correction will happen, why predicting it is hard (and potentially hazardous to your portfolio) and how we think about it.

Corrections have a strong track record of showing up (unlike Godot), as part of a normal market. A correction is commonly defined as a -10% decline. The average intra-year decline is historically -14%. Even in positive years, it is unusual not to experience a mid-to-high single digit decline. (See chart).

We have been waiting for a correction (like Godot), but not for very long. The last S&P 500 correction began in the summer 2015 and hit its low for the year in October. The drop happened to be a decline of about -12%. From November 2015 until February 2016 the market again took a double-digit dive. Since then the market has climbed +33% with fresh highs being set on July 12, experiencing one measly -6% drop along the way.

Based on history we expect a correction to occur before the end of the year. However, timing and duration are elusive and we are not trying to predict it. A correction may be triggered by almost any event – Fed Reserve action, oil prices, a poor jobs report, or a geopolitical incident. Rather than trying to guess the timing, the key is to understand the drivers of any correction in order to assess new investment opportunities.

Post-election Views or Much Ado About…

Well, we can’t say nothing. We aren’t going to rehash the election surprise. What we will do is share our views on the post-election market behavior, outline a possible scenario and actions we are considering and what we will be watching for over the coming months and years.

What happened? Virtually no one in the financial world predicted a rally immediately following a Trump victory, which also very few people predicted. For the record, the S&P 500 opened the day after the election, November 8, at 2130 and closed at 2182 on November 16. This equates to a +2.4% rally that leaves us just below the all-time market highs hit this past August. Now the underlying story is a bit different. During this same 8-day period financial stocks, particularly banks, rallied over +10% and some individual stocks by close to +20%, but many tech companies like Amazon fell by -3% or more. Healthcare and bio tech have also experienced a nice bump up. Bond prices have been knocked down driving yields on the 10-year Treasury bond from 1.88% to 2.35%; right at the 1-year high.

It’s important to note that other than bank stocks making a very decisive move up, none of these numbers are, in and of themselves, eye-catching from an absolute perspective. We have seen most of them in the past 12 months.

What do we see driving this behavior?  Right now we surmise the biggest driver is speculation on the third derivative of policy expectations. It is clearly not investing based on observed facts. Many market participants have made big rotations based on policies President-elect Trump hasn’t made clear, haven’t been implemented and whose effects are just hypotheses, i.e., speculation on the third derivative. Here is a summary of the big themes:

  1. Bank regulations get relaxed or go away so banks are more profitable
  2. Obamacare gets changed or eliminated and capping drug prices is not on the agenda, helping health care and biotech companies
  3. Fiscal stimulus, primarily through infrastructure spending goes up, international trade gets choked off, taxes are lower, all driving inflation and interest rates which helps banks and generally hurts bonds.

Now we don’t argue that these sound directionally right. However, the market movement was quick and in some areas sharp. Quick and sharp are not words often associated with governmental change and therefore we believe the market has over-reacted.

What do we hypothesize will happen over the next 12 months?  Here is a working, third derivative hypothesis, roughly in order of our conviction. It is not precise as we are using the third derivative —  think compass orientation not laser targeting.

  1. We get fiscal stimulus and lower taxes
  2. Rates and inflation rise, but not dramatically
  3. Bank regulations get tweaked not thrown out
  4. The economy improves a bit.
  5. Obamacare gets changed. What’s the effect? See the third derivative, i.e., who knows?

So what are we doing?  We have not been making major investment decisions. As investors, not speculators, we don’t react to quick market moves driven by assumptions from third derivative hypotheses. We are spending a lot of time looking at how we implement our existing overweight positions to technology, healthcare and biotech. We are also looking at financials as a possible overweight. We have been selectively adding to real asset positions due to higher expected inflation and what we believe has been undo pressure on REITs and our infrastructure positions. We have been selectively selling out of some fixed income positions.

What will we be watching? We will be watching measures of economic activity that might indicate a coming recession because we haven’t had one in over 7 years. We will be looking for dislocations in the market to add/rebalance to core positions. We will be listening and looking for real policy statements and activity that give us a better idea as to how those policies will eventually be implemented. We are particularly intrigued to see what happens to US Treasury rates as they will be a good indicator of how the world judges the relative safety of our markets versus all others.

In dealing with the next few years, it will be best to embrace Confucius’ blessing (curse?): “May you live in interesting times,” and to maintain a diversified and carefully monitored portfolio.