3rd Quarter 2017 The Risk Reward Trade-Off
Clients of the Firm,
The third quarter of 2017 ended with stock markets at record notational highs. This fact again prompts us to look at the risk/reward tradeoff that characterizes successful long-term investing. Much of the current environment is supportive of stock prices, although prices are now at the high end of historic ranges with the S&P 500 trailing P/E ratio of 24.22 and forward P/E ratio of 19.19. Bond prices remain well above normative ranges and consequently bond yields remain depressed, at least for the time being. US GDP growth was 3% for the 2nd quarter ahead of the trend 2% level for the past several years. Unemployment is near record lows and manufacturing activity has picked up recently. In addition, the potential for both corporate income tax cuts and repatriation of overseas assets has enhanced bullish sentiment. Notwithstanding the daily political turmoil, these data points have led many to believe that the elusive escape velocity of the US economy may finally be at hand, thereby justifying current stock prices and elevated forward P/E ratios.
Strategy to Deal with Record Highs
Our general investment strategy has been to maintain current equity levels in portfolios, adding to ideas that are cheap enough to merit investment, while not chasing performance or the market. In addition, we continue to try to avoid long-term bond exposure and duration risk as a hedge against rising interest rates. This strategy allows for the continued participation to the upside if the bull market in equities continues, while avoiding the price declines in longer dated bonds that would occur with a steepening or lateral move up in the yield curve. We expect the Fed will continue to increase short-term interest rates, which will enhance the yields of short-term bonds and money markets, allowing those assets to earn more over time without the price risk of longer dated bonds.
The Fed has announced it will run off its balance sheet which currently stands at $4 Trillion. This runoff, which will be gradual and will build over time as market conditions warrant, will serve as a reduction in the accommodative stance of monetary policy. As an extraordinary measure, the Fed has for the past several years, increased the money supply and used those funds to buy US Treasuries to help keep yields and borrowing costs low. This increased the balance sheet size and the selling of these assets now should have the reverse effect, raising rates and borrowing costs. At the same time, the Fed intends to proceed on its current course of slowly removing accommodation by raising the Fed Funds rate. We expect the next rate hike to occur in December of 2017 and as many as four more hikes to follow in 2018.
This type of balance sheet unwind has not been attempted by the Fed before and may have unintended consequences on the prices of assets. This potential outcome demands close monitoring. The most likely impacts will be to corporate and individual borrowing rates and consequently bond and real estate prices. That said, the Fed believes its current plan is the best path forward to normalization of monetary policy from the extreme accommodation it put in place following the 2008-2009 credit crisis.
On September 27, 2017, the Trump Administration put forth a pamphlet entitled, Tax Reform: Unified Framework for Fixing Our Broken Tax Code. This framework outlines the initial proposal for tax reform, which will be hotly debated and possibly turned into legislation in the coming weeks and months.
The framework addresses items like the individual rate structure proposing consolidation of the current 7 brackets into 3 at the 12%, 25% and 35% levels. It recommends repeal of the AMT, elimination of the Estate Tax and GST, and elimination of most itemized deductions except for mortgage interest and charitable contributions as a “pay for”.
The proposal also calls for a limit to the maximum pass-through rate on small businesses at 25%, the reduction of the corporate tax rate to 20%, territorial taxation of global profits, immediate expensing of capital investment for businesses and the partial limiting of interest expense for corporations as a “pay for”.
It is highly unlikely that this proposal as written will be enacted by Congress. Consensus is that if any tax reforms are made they are likely to focus on a reduction in corporate taxes, territorial taxation of global American companies (a.k.a. repatriation) and possibly modifying the tax rate limit on small businesses.
Outlook for Year End 2017
There is significant momentum in equity markets and some tail risk to interest rates due to the Fed unwinding of accommodation. Absent a black swan binary event, we expect a melt-up in equity prices through year-end. This rise may accelerate if major tax reform appears likely and decelerate or abate if tax reform does not materialize. In addition, there may be latent tax gain/ loss selling by institutional investors, as tax reform would have a significant impact on the taxes paid by corporations and LLCs. This dynamic could cause larger moves both up and down on individual stocks short-term as a result. We expect a slow decline in bond prices over the coming months and years which could be amplified by the Fed moving faster than expected or warranted. Thus, we continue to recommend short-term bond exposure for that part of an investor’s allocation.
Investors often encounter the risk of getting caught-up in market psychology, whether that be overly bullish or bearish. Value investing focuses on making investment decisions based on the fundamentals of an investment over a longer time period and its projected future earnings. We then determine a reasonable price to pay for those earnings that would likely yield a positive investment result. A major input to that analysis is interest rates, which help us measure the rate of return of risk-free assets in relation to risk-bearing assets like equities or corporate bonds. Staying true to that discipline helps us avoid overpaying for assets in times of elevated prices.
We continue to look at portfolios with a risk/reward lens, focusing on both parts equally and balancing the risk of overpaying for an asset with the reward of participating in the bull market. Risk management differs by client and we always welcome your feedback and preferences as an input to the appropriate investment mix for your portfolio. We wish you a wonderful fall and holiday season and send best wishes to you and your family.
Peter C. Wernau
Wernau Asset Management
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