Market Comment Q3 2017



When the stock market took off after Donald Trump’s election, the popular commentary was that his administration’s likely policies were a goody bag for US businesses. Tax reform, de-regulation and fiscal stimulus were commonly cited as explanation for the market’s move. Stocks of companies that stood to benefit the most from these policies advanced the most, including those financial institutions that stood to benefit from the higher interest rates the ensuing economic boom would engender.


At the time we were somewhat skeptical. There seemed to be plenty of opportunity for the reality to fall short of the vision. And so far, very little progress has been made on any of these policies, except that some environmental and energy regulations have been rolled back or suspended. Even here, challenges have emerged based on the Administrative Procedure Act, which requires that agencies take into account not only the costs of regulation but also the lost benefits of reduced regulation, something the administration has not yet done.

Not surprisingly, confidence in the administration’s ability to enact these policies has declined. Tweetstorms, contradictory statements, ethics investigations and the apparent failure to repeal Obamacare have undermined the administration’s perceived political strength.

If the rally was based on outsized expectation, what are we to make of the market’s resilience in the face of reality?

Trump unsuccessfully tryng to get elephant to move Used with the permission of A.F.Branco, All rights reserved

First, it is a reminder that economic growth and corporate earnings are the long-term drivers of the stock market. The impact of any one Presidential administration is dominated by the myriad decisions taken by billions of individual economic actors. In particular, US economic activity has continued to improve, despite the lack of big policy changes. And conditions in the rest of the world have turned more positive.Second, though the stock market has repeatedly set all-time records in recent months, stocks leading the advance are not the ones that were expected to benefit from the Trump agenda.

Finally, though the Federal Reserve has raised rates four times and now has begun discussing unwinding its large holdings of Treasury and mortgage-backed bonds, long-term interest rates have remained low. The market consensus has become “lower for Longer”, meaning most people over-estimated how quickly market rates would rise.


So far this year, the US economy has grown at a rate under 2%, slightly below the average growth rate for the past four years. As lean as this growth is, at least it has persisted, making the current expansion–which has lasted eight years–the third longest in US history. Only the ten-year tech boom that culminated in 2001 and the Great Society/Vietnam War boom of the sixties were longer.

Meanwhile, China, Japan, and the Eurozone have surprised to the upside. Spurred by policy actions, Chinese GDP has exceeded its targets this year and achieved growth of nearly 7%. Japan has advanced five straight quarters, its best run in a decade. And growth in Eurozone was 1.9% in the first quarter, its fastest rate in two years.


The IMF expects global growth in 2017 to approach 3.5%, up from 3.1% last year, and increase further in 2018 to 3.6%. The risks to the continuing economic recover include protectionism–which would reduce world trade and income, as well as the potential impact from monetary policy normalization.


In the immediate aftermath of Trump’s election victory, three categories of stocks advanced sharply in anticipation of new policies–small cap, infrastructure and bank stocks. Small cap stocks were expected to benefit from tax rate reductions much more than multinational companies, who are already adept at avoiding taxes. Infrastructure stocks stood to benefit from an acceleration of investment in roads, bridges, airports and the like. And bank stocks were expected to benefit from higher loan demand and higher interest rates that the policies would engender.

SandP500 versus the Big 5Since the beginning of this year, though, these stocks have retreated from their heights, giving back some of their outperformance against other stocks. While many expected these policies to have effect as early as this year, it now looks like it will take longer for the Trump administration to gain support, if at all.

Instead, the tepid rate of GDP growth has induced the investor to place ever-larger premia on the stocks of companies with secular growth momentum. Most notably, these include five large-cap stocks which together constitute more than 11% of the S&P500. These stocks include Apple, Microsoft, Google, Amazon and Facebook. The chart above shows the out-performance of the Big 5 vs the S&P500 since 2013, which accelerated this year.

In general, we have not embraced the stocks of the companies with excessive valuations, as wonderful as their products are. This is the result our valuation orientation, which restricts the purchase of stocks at stratospheric multiples of earning. This discipline has served us well–notably in the dot-com bubble–and we are sticking to it.


The market has been concerned about normalizing monetary policy since the summer of 2013 when testimony from then-Chair Ben Bernanke sparked the “taper tantrum.” In Congressional testimony, Bernanke stated that the Fed would likely start slowing the pace of its bond purchases later that year. Interest rates reacted immediately and the yield on the 10-year Treasury note quickly rose by 1%; stocks fell 5%. Since then, the Fed has attempted to be very transparent and gradual about removing monetary accommodation and Bernanke’s successor Janet Yellen even skipped several widely-anticipated rate hikes during 2015 and 2016 in reaction to various signs of weakness in the global economy.

Since December 2015, the Fed has hiked rates four times and most expect another rate hike this year. Meanwhile, Fed governors seem to agree that it will begin to reduce its holdings of bonds and mortgages later this year. And though markets were right to be concerned, so far, there has not been a repeat of the taper tantrum.

Despite the rate increases, long-term interest rates remain close to their historical lows. This is likely the result of two major factors. First, the Fed continues to have large holdings of long-term bonds. It is unlikely to sell them, but it will let them mature without reinvesting the proceeds. All things being equal, it is reasonable to expect some gradual rise in rates as this occurs, but not the sudden increase we saw in 2013.

Secondly, the markets are suggesting that long-term rates may not recover to what once was considered a normal level of 4-5% for the 10-year Treasury yield. Though inflation expectations have remained fairly constant at 2%, expectations for the natural or equilibrium real rate of interest have declined. A decade ago, estimates of this natural real rate were between 2%-3%. Since then, estimates have declined to nearly zero.

The decline in expectations for real interests rates reflects a number of structural factors that have only become clearer over time. First, GDP growth in advanced economies has slowed as a result of trends in productivity and population growth. Second, a surplus of global savings, in particular from emerging markets, has reduced the equilibrium rate. And third, aging populations in advanced economies have increased the supply of savings and reduced consumption demand. None of these factors is likely to turn soon.


The market appears to be content with current levels of economic growth and accepts that the Fed can remove monetary accommodation without incident. As a result, the stock market rally has continued despite concerns that President Trump’s market-friendly policies may be delayed or even derailed. Still, there are risks. Non-economic risks include tensions with North Korea, Russia, China and in the Middle East. In addition, the narrowness of the stock market advance is a cause for concern. The Fed could still undermine the recovery with too rapid removal of monetary accommodation or, on the contrary, removing the accommodation too late. In the long-term, factors such as population growth and productivity will play a major role in GDP growth and ultimately the movement of stock markets.


Putting money into an investment portfolio is a lot easier than taking it out. The techniques that apply to accumulating assets—asset allocation, diversification and dollar-cost averaging—remain critical, but with the added complexity in retirement of the need to generate income from the portfolio.

Saving money may be hard, but it is not complex. Most people simply try to save as much as they can, hoping it will grow to a large, but often non-specific, amount. An investment advisor can be useful to help figure out how much to save and how to invest it, but often the retirement nest egg is managed by an employer’s 401(k) plan. It is often said that there is a retirement crisis in America and one of the reasons is that people tend to assume that if they are contributing 3% to a retirement plan, that will be enough. Sadly, it is not.

So determining saving goals presents issues that some people need help with. The complexity of managing retirement investments, however, is of a different order and, as a result, many more people need help. For one thing, most 401(k) plans are very poor at offering investors any sort of advice on how to turn their accumulated assets into income

When faced with the issue of generating retirement income, the first question is how long must the income last? The average life expectancy of males at age 65 is another 17.7 years. For females, the average is 20.3 years. For the past half-century or so, the life expectancy of 65-year-olds has increased by about one year per decade. Someone in their mid-30’s today may expect to live three years longer than today’s 65-year-olds. Lifestyle and family history are good starting points for determining whether one’s own life expectancy is higher or lower than the average.

How much income is needed also requires thoughtful analysis. For many, the most relevant question is not so much “When can I retire?” but “What lifestyle do I desire (or can I afford) in retirement?” Expenses during retirement are not linear but tend to be “U-shaped.” For the first years after retirement, when health and energy are good, many retirees do not see a big reduction in their spending. Travel, second homes, and oft-deferred luxuries or gifts are often high priorities. In later years, however, spending tends to decline. Travel may become less interesting or more onerous, much of the bucket list has been accomplished and so on. Finally, in the latter third of one’s retirement, spending may pick up again, especially on healthcare.

But what if you live longer than you expect? This so-called “longevity risk” should be hedged in some manner. The financial industry is ready with a withering array of annuities to offer, but these are often so loaded with expenses, options, bells and whistles that it is nearly impossible for most people to determine whether they are appropriate. Longevity risk can most directly be offset by accumulating more assets or delaying retirement, concepts which are much easier to understand.

Another prominent risk is referred to as “sequence of returns” risk. Though balanced portfolio returns have averaged 6-8% per year over decades, you cannot know what the sequence of returns will be to generate that outcome. If returns are low or negative in the early years after retirement, the consequences could be much greater than if poor performance happened later. Depending on your financial situation, it may make sense to reduce your investment risk in the years surrounding your retirement date.

Other issues abound. Which accounts should I spend from first? Can I afford to pay for my grandchildren’s education? How can I minimize taxes? It is for all these reasons—and more—that good professional advice can be even more valuable in the asset “decumulation” phase than before.

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