Quarterly Commentary

2Q 2017

US equities reached new highs during the second quarter.  At eight years and counting, this bull market is the second longest on record. Indeed, over the past twelve months, an aura of inevitability seems to have enveloped the US stock market as dips have been met with renewed buying. The volatility index (VIX), a measure of investor expectations that stocks might move quickly up or down, has been hovering at the lowest levels witnessed over the past twenty years.  Stock markets around the globe have remained firm as well, even as they contend with heightened political uncertainty and disturbing geopolitical events.

There has been movement beneath the calm surface, as changes in demand for individual stocks or industries led to rotation. In fact, returns at the individual security level have been less correlated with index returns than they have been at any point over the past decade.  Disruptors such as Tesla, Uber and Amazon received a great deal of attention, yet second quarter performance was generated from unexpected sources, as is so often the case.

Three months ago, we wrote about synchronous global growth.  The concept of the world’s economies growing at the same time — with positive feedback loops as growth begets growth — remains the most compelling explanation for the market’s continuing advance into summer. Businesses are investing, corporate earnings are growing and investors have been more inclined to provide capital.

Investor optimism may also be supported by expectations for continued gridlock in Washington. Potentially troublesome trade policies are being aired, but nothing has happened yet. Today’s dynamic reminds us of the Goldilocks description popularized three or four years ago —not too hot, not too cold. Inflation remains subdued, yet job growth has been healthy. In such a scenario, corporate earnings could continue to beat expectations and valuations could expand further, resulting in equity markets that continue higher.

Within our universe, second quarter leaders included consumer discretionary (home improvement, not retail), healthcare equipment, European financials, solar power (panels for “The Wall?”) and software stocks.  Foreign shares meaningfully outperformed their US counterparts — after seven years of underperformance. Energy has been the worst performing sector of the S&P in 2017, as those who expected oil to break out of the $40 to $60 range threw in the towel. Other lagging categories included value stocks, small caps and high tax payers, all presumed to be beneficiaries of the Trump agenda (tax reform, regulatory relief and fiscal stimulus) that now looks at risk. Retail stocks were slammed by the news of Amazon’s purchase of Whole Foods.

Bond prices crept higher despite the June rate hike. The Fed sets short-term rates – three-month T-bill yields rose from 1% to 1.25%. Longer-term rates are set by the markets – ten-year T-bond yields fell from 2.45% to 2.3%. The muted response to a well-telegraphed Fed tightening campaign is puzzling. Bond investors appear to harbor low expectations for both the economy and inflation, a view that is at odds with the more optimistic attitude of stock investors.

Bull markets climb a wall of worry. There is indeed always something to worry about – the prospect of Fed tightening has been looming on the horizon for some time.  New geopolitical risks have emerged in the Middle East and Korea.

The adage also reminds us that a healthy market requires a sufficient number of worriers and skeptics – many of them presumably on the sidelines holding cash. It implies that a market top is formed only when everyone is “all in.” Perhaps we should be worried that others aren’t worried.

Taper tantrum ahead? Recall that the Federal Reserve’s response to the Financial Crisis included bond purchases that raised the Fed’s holdings to $4.5 trillion.  One-third of government-backed home mortgages in the US and 17% of outstanding Treasury debt are now owned by the Fed. These central bank purchases supported the economy by pushing the yield curve lower, and by inducing investors to own other, generally riskier, assets (including stocks).

 Investors have become accustomed to “easy money,” and the asset purchases contributed to the outstanding returns earned by all sorts of financial assets since the crisis. The Fed plans to continue raising short-term rates, and it recently outlined its intention to begin reducing the bond holdings later this year. What worked so well for markets as the bonds were purchased may prove to be unsettling as the positions are unwound.

The taper tantrum of June 2013 offers some perspective. An indication from the Fed that it might slow the pace of its bond-buying program led to a 1% jump in the ten-year yield, and declines of 10% or more for prices of riskier assets in the space of a few months. The Fed backed off (and continued to buy bonds at the rate of $85 billion per month until October 2014) and markets recovered.

Financial markets and economies are on much better footing today, yet the flattish yield curve suggests that the Fed may choose to move cautiously on tightening, presumably until there is more evidence that inflation is approaching the Fed’s 2% goal. Other scenarios could unfold, each with its own risks: 1) aggressive central bank actions on rates or asset sales could cause a 2017 tantrum, with negative consequences for stocks, or 2) as part of a “delayed reaction,” investors may realize that rates are going higher after all, and are surprised to find their valuation and correlation assumptions for various asset classes shifting in unexpected ways.

Disruption in the grocery aisle. Amazon’s $13.7 billion purchase of Whole Foods Market sent shockwaves through the grocery industry and much of retail as well. Costco fell 10% on the news and Kroger, almost 25%.  Amazon accounts for a stunning 43% of all online transactions today, yet couldn’t get past a 1% market share in the grocery business, despite ten years of trying. Grocery matters to Amazon because it accounts for 30% of all consumer spending in the US.

The Amazon/Whole Foods union should accelerate evolution in the grocery space. A major question is what will happen to branded products – can Amazon create value for its customers and for itself by developing its own brands in food and other grocery items? Change at Whole Foods may come at a deliberate pace, and is likely to reflect Amazon’s historical focus on convenience (shorter delivery times), assortment and price transparency. Other possibilities may eventually come to pass – consider that Whole Foods’ 440 stores give Amazon a refrigerated presence within 10 miles of an estimated 80% of the US population.

At a minimum, Amazon’s acquisition of Whole Foods is a reversal of the recent trend of traditional businesses (think Walmart, GM, Ford, or Unilever) buying tech start-ups. The largest tech companies are flush with cash — another deal where tech buys traditional would really shake things up.

These notes are intended to communicate our view on what has recently mattered, or might come to matter in the investing world. Sometimes the writing exercise helps us crystallize our thoughts on a particular issue, which may influence our portfolio management. Certainly, all investment decisions are made in the context of current conditions, such as where we are in the economic cycle (late), overall stock market valuations (at the higher end of historical ranges), or currency and interest rate risks. But we don’t rely on macro forecasts to guide our efforts. In fact, it would be fair to say that we try to tune out the concerns of the moment in deciding what to own for several years or longer. Our efforts are focused on identifying individual securities that we think can provide adequate returns irrespective of the macro climate.

Many European and Asian shares continue to look less expensive compared to US listings. Taking a more global approach widens our universe of potential investments, enhancing our ability to construct portfolios with resiliency in mind. Our foreign holdings have done well in 2017, a welcome change from the headwinds of 2011-2016. Part of the current year performance stems from the weaker dollar, a trend that may not continue, especially if interest rates rise. While many of our foreign holdings derive half or more of their sales and earnings from the US, we are thoughtful about the level of our commitment to overseas stocks.

We recognize that brands may be losing some of their power, at least in certain industries. But we don’t assume that Amazon or anyone else has all the answers. As part of our process, we try to challenge prevailing views and look for value in new ways and often in currently unpopular places. We seek bargains among both the disruptors and the disrupted. What will happen, for example if big box stores and poorly-situated malls do empty out? Could there be value in repurposing these properties that investors are ignoring? Are there retailers whose stocks are beaten up but whose business models will prove resilient despite increasing e-commerce?

Congratulations if you are still reading this — we appreciate your interest and your trust.