Quarterly Commentary

3Q 2017

Our summer in Vermont was pleasant enough, though it started wet and ended hot. There was little wind throughout (noticed by the sailors in the office). Markets were much the same – we can’t recall so many days with so little movement. But the result was agreeable.

Ever calmer is probably not a permanent market condition. Recent storms – natural and political – have not elicited much of a response from the stock market.  Guessing at what might trigger a change can make good reading, but we haven’t found predictions – ours or anyone else’s – to be useful in making investing decisions. We explore a wide range of future scenarios as part of the risk management process, yet we focus on what is held in each portfolio, rather than fretting about things we can’t predict or control.

Earnings growth and steady yet unspectacular economic data kept US stocks on their upward path. Technology-related shares maintained their leadership role, gaining 8% in the quarter. Tech has returned 27% year-to-date, far ahead of other sectors.   Energy shares are lower by 8% this year, even after a third-quarter rally kindled by supply disruption. Other sector returns were clustered around the quarter’s 4% overall result. Foreign stocks remain ahead of US shares, benefitting from accelerating economies and stronger currencies.

The US economy has not lived up to expectations in 2017. Wage increases have been modest considering the reported 4.2% unemployment rate. Steady yet unspectacular can also describe current trends in consumer spending and business investment spending.

Growth stocks (internet, biotech) tend to outperform value stocks (banks, big pharma) when the economy’s health is in question. This has been the case since January – growth has outpaced value by more than 12% this year – a large gap by historical standards, and generally a headwind for Rock Point’s investing strategy (happily not so in 2017).

There was some volatility in US interest rates. Fixed income investors registered caution by bidding bond prices higher, sending the yield on the 10-year treasury from near 2.4% in July to less than 2.1% by early September. Attention then shifted back to the Fed’s intention to curtail its bond buying and the move was reversed – the 10-year yielded 2.33% at quarter end. Financial shares mirrored these moves – large US banks gained 10% over the final three weeks of September.

To remain optimistic, investors may need to believe that accelerating economies abroad can pull the US along (perhaps a payback for past US leadership), or that corporate and individual tax reform will inspire additional investment. We are hopeful that economic growth can provide a positive surprise, and remain in the skeptical camp on taxes, as much as we would all like to keep more of what we make.

The kind of research we do doesn’t translate to readable quarterly commentary. On the other hand, reporting on what the investing “herd” might be thinking or doing makes for a better story, and also offers insight into how investor behavior is shaped by psychological factors. Last quarter we opined that a healthy market requires a sufficient number of worriers – we think of them as eventual buyers. A market top is formed when there are relatively few potential buyers – when everyone is “all in.”

The latest University of Michigan consumer survey reveals 65% of respondents expect share prices to be higher twelve months from now. The 65% reading for August is noteworthy because it’s the highest level on record. The previous high was 63%, registered in June 2015. That, in turn, was just above the 62% response of July 2007, a few months before the end of the previous bull market.

Perhaps this gauge can go higher still (the University of Michigan data only goes back as far as 2007, limiting its usefulness). Other surveys also indicate elevated investor optimism, but likewise cannot tell us what will happen next.

For another point of view, we turn to economist Robert Shiller, a notable market realist, who in a recent column (NYT – 9/15/17) described investing as an exercise in mass psychology. He finds that past market declines have been presaged by both high stock valuations and abundant commentary about widespread speculative investor behavior, such as borrowing on margin in 1929, the dot-com mania in 2000, and the housing bubble that popped in 2007. Today, he says, “Mass psychology appears to be in a different, calmer place. Investors do not seem to have the concern they had in 1929 or 2000 that other investors might suddenly sell their holdings and get out of the stock market.” He can’t explain why investors are unconcerned, and theorizes that they may be distracted by the endless flow of news. “I don’t really know,” he says, but for now, “the stock market does not closely resemble the market in the dangerous years of 1929 or 2000.”

We are continually aiming to reduce risk. This entails pruning or eliminating share holdings as stocks reach targeted valuations. It may mean minimizing exposure to what everybody else owns – popular was not the place to be in previous market declines. While unloved and under-owned qualifying stock opportunities are scarce in this market, there are a few out there. Our mission is to find them.

It is the time of year when mutual funds and other investors are taking losses on the year’s losers to offset realized gains. This tax loss selling can be indiscriminate in some cases, and it can lead to an opportunity to own shares that are less risky because they have just been discarded by impatient investors and because the entry price has become attractive compared to our assessment of long-term value.

Our version of risk reduction can have undesired side effects. First is increased activity. While we are always trying to keep turnover low, we know of no better way to reduce risk than to trim or sell. Second – for taxable portfolios – is realized gains. It is always our hope to keep gains at a minimum, and that such gains be only taxed at the lower rate available for shares held more than one year.

Realized gains do offer an important benefit – the proceeds are available for investment in more attractive opportunities. That’s true in all markets – calm or otherwise.

We close by acknowledging the misfortunes of those whose lives have been disrupted by the recent storms and violence. Recovery will be long and arduous – they need our prayers and support.