RCM Managed Asset Portfolio
By Christopher Chiu, CFA
Current Market Environment
During the past quarter, equity markets experienced more volatility in the 1st quarter of 2018, in contrast to the period of low volatility last year.
On the positive front, potential catalysts to the market still include:
(1) Effects of Tax Policy. The US Congress and the Trump administration were able to pass major tax reform legislation. The law lowers the corporate tax rate to 21%, which is expected to increase capital investment, capital inflows, and economic expansion. Corporate earnings as a result may be better than expected for the coming year.
(2) Global and Domestic Growth. On the global front, growth continues in Western Europe and parts of the emerging world. Domestically, while unemployment rates are at their lowest levels in years, wage growth remains limited perhaps reflecting the amount of slack that still exists, not only in the labor market, but the US economy overall.
On the other hand, a number of potentially negative catalysts appeared to move to the forefront during the last quarter, including:
- Rising Rates. While there has been some divergence in central bank policies, there is a growing consensus among the major central banks that tightening is warranted. Investors may consequently prefer bonds over equities. Specifically, in the U.S. Chairman Powell has outlined the path of rates over the next two years.
- Tariffs. Over the last quarter, the current administration announced tariffs on steel and aluminum sectors, as well as intentions to put in place country specific tariffs versus China. There are new fears these may spark reprisals.
- North Korea. Finally, while the risk of a conflict with North Korea has persisted over the last year, it has only moved further into the forefront with continual missile tests.
Gov’t, High Credit Corporates
The Fed funds rate has risen more than half a percent from this time last year. While inflation is at or near its target, there are some indications that inflation expectations may be above target for the coming year. The Fed has signaled that it will continue to raise incrementally throughout the coming year. Bond prices, especially longer dated issues, consequently have begun to show price declines. We expect this continue as the Fed attempts to normalize rates. As a result, we have significantly reduced our exposure to longer dated corporate holdings in the mutual fund program and increased our allocation to floating rate.
The high yield market no longer continues to proceed in a sideways fashion. While credit conditions are still good, there is a limited upside to high yield. We have, therefore, significantly reduced our holdings of high yield in the mutual fund program.
With defaults currently well below 4% and with a new administration advocating pro-growth policies, it seems that the credit cycle may continue for an extended period. Investments in the high yield market represent riskier investments along the risk spectrum. We expect this sector to be among the most vulnerable to any increased risk and volatility; but, it will also be among the fastest to recover in any recovery of credit markets. We anticipate making a return to this allocation after prices have declined significantly.
Recent developments in Large Caps and the Strategic Knight
Equity markets began the year on an upswing, spurred by the implementation of pro-growth policies. However, in the months of February and March equity markets have been volatile.
In the Strategic Knight portfolios, we remain heavily invested in the tech sector. We think companies such as Amazon have an overwhelming competitive advantage in their respective spaces. We do not see these size advantages, which have been enabled by the Internet, changing in the foreseeable future. The one risk that has become greater is future regulatory risk. While the legislative process is a slow moving one, various thought leaders continue to express concerns about the size and influence of large cap tech on competitive markets. Without new competition, it’s hard to see how this negative press diminishes in the new year.
We also opened positions in Disney and Berkshire Hathaway.
Small and Mid-Caps
Lately small caps have performed quite well as the dollar has rebounded from some weakness earlier in the year and as smalls and mids are expected to benefit from the tax reform. In the Strategic Knight portfolio, we had increased our allotment of small and mid-size caps.
In the mutual fund portfolio, we continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and mid-caps sell almost exclusively to domestic markets. We view that in the long term, as rates begin to rise, there is ample cause for the dollar to strengthen. Drawbacks to investments in smalls and mids include higher levels of debt to capital when compared to historical norms. This implies higher levels of risk that need to be weaned down over time.
We should say something about our past holding in Facebook in the Strategic Knight portfolio given the challenges this company is now facing.
Back in 2013, we initially started buying Facebook for many investors when the stock was well below $100. At the time, we recognized the growing adoption of Facebook, its properties and the effect it would have on its earnings. We were subsequently surprised to see that it exceeded our expectations and continued to strengthen its competitive position as it moved from the desktop to mobile. The growth of Facebook has continued on these past four years.
Now the company has come under criticism for allowing third party developers to collect data on the Facebook platform. It is likely that Congress will enact some form of regulation on social media companies. We actually think regulation will ultimately be good for Facebook in the long run. Just as new rules place restrictions on Facebook from collecting data, the same restrictions would be placed on any potential new entrants to the market—Facebook’s competitive advantage would continue. We expect Facebook’s growth to continue for some time.
That being said, since Facebook fell below certain technical levels in a dramatic way and has persisted below that level for an extended duration, we reduced the position significantly and then eliminated it entirely. As we have said before, in the Strategic Knight we require both a technical and fundamental justification to buy and hold a stock. But only one of these has to be true in order for us to sell it.
By George Tkaczuk, MD, MPH
The market is currently undergoing a technical correction: in this first quarter, the market has experienced a bout of volatility which we have not seen for some time. Thus, it appears abnormal. In reality, volatility and corrections are normal occurrences in bull and bear markets. At the time of this writing, it is fair to say that the market is correcting. The market correction continues with lots of volatility both ways, and for now, it is stuck in a trading range (see chart below). The S&P 500 has been able to keep holding above its 200-day average; until this range is broken, either way, it may be unclear which path the market wants to take.
If we look at a monthly chart below (where each bar represents a month) over a few-year period, we can see that these trading ranges and corrections, as highlighted below, are quite common. Before we make any changes to our ongoing bull market thesis, we would need to see a sustained breakdown below the current trading range. Also, at the same time for a sustained bull market to continue, we would need to see a sustained breakout to the upside out of this trading range.
The above is a technical view of the markets, and I am calling it a technical correction since the underlying fundamentals are still very strong for the U.S. economy and the U.S. stock market. We should also take a look at what are some of the underlying fundamental positives for this market.
Monetary policy: Monetary policy is extremely accommodative. Whether the Fed raises rates 3 or 4 times in 2018 it will still be well below nominal GDP growth. So, for now, Monetary Policy will serve as a tailwind for growth. Furthermore, in the last Fed statement, the Fed upgraded the outlook on jobs growth to “strong”; they added new language noting that “the economic outlook has strengthened in recent months”.
Earnings estimates keep rising for companies: During the first quarter, analysts increased earnings estimates for companies in the S&P 500 for the quarter. The Q1 bottom-up EPS estimate (which is an aggregation of the median EPS estimates for all the companies in the index) has increased by 5.4% (to $36.24 from $34.37) during this period. The first quarter of 2018 marked the largest increase in the bottom-up EPS estimate during a quarter since FactSet began tracking the quarterly bottom-up EPS estimate in Q2 2002. The previous record for the largest increase in the bottom-up EPS estimate was 4.8%, which occurred in Q2 2004.
Solid Economy: The Conference Board Gives us a nice overview by looking at Leading Economic Indicators (LEI). The LEI for the U.S. increased 1.0 percent in January to 108.1, following a 0.6 percent increase in December, and a 0.4 percent increase in November. “The U.S. LEI accelerated further in January and continues to point to robust economic growth in the first half of 2018. While the recent stock market volatility will not be reflected in the U.S. LEI until next month, consumers’ and business’ outlook on the economy had been improving for several months and should not be greatly impacted,” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. Also, from the Director, “The leading indicators reflect an economy with widespread strengths coming from financial conditions, manufacturing, residential construction, and labor markets.”
Trade wars: Fear of trade wars continue as President Trump ordered tariffs, of 25% on $60 billion of imports from China to penalize them for intellectual property theft and other unfair trade practices. China appears to be showing restraint and push to negotiate so far. Chinese response thus far has been targeting $3 billion worth of goods, on things like nuts, fruits, wine, pork, steel pipes and recycled aluminum. Trade wars are a bad thing if they escalate. But I remain optimistic, I believe President Trump is aiming for freer trade and using the tariffs as a negotiating tactic.
Geopolitical risks: For now these events seem to be stabilized.
Tax and regulatory reform: Companies now have more incentive to invest in business and pursue new business ideas. We can get a gauge from this by looking at the National Federation of Independent Business (NFIB) survey.
Optimism Index: The Index of Small Business Optimism increased 0.7 points in February, rising to 107.6, the second highest level in its 45-year history, second only to the 108.0 reading in 1983. February results produced several mentionable accomplishments:
- Taxes received the fewest votes as the #1 business problem since 2006.
- Reports of few qualified workers remained the #1 problem, highest since 2000.
- Reports of improved earnings trends were the highest since 1987.
- Inventory investment was the strongest since 2000, fueling GDP growth.
- Reports of actual capital outlays rose to the highest level since 2004.
- Reports of compensation increases held at the highest level since 2000.
Overall, the small business sector is very encouraged by the economic policies of the administration and the strength of the economy, willing to invest more and hire more if workers can be found to fill their open positions.
In Summary: Monetary policy is accommodative, corporate profits are growing, the economy is growing, trade wars for now appear to be more rhetoric than reality, tax and regulatory reform are driving the business optimism. These things should therefore continue to drive the stock market.
The general information provided in this publication is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice. Before making any decision or taking any action, you should consult a qualified professional advisor who has been provided with all pertinent facts relevant to your particular situation. Investors should carefully consider investment objectives, risks, charges and expenses. Past performance is not indicative of future results. Investments are not FDIC insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.