1st Quarter 2017 Investor Letter
Clients of the Firm,
The first quarter of 2017 has largely played out according to our expectations with assets behaving in a manner consistent with the unfolding political landscape. While in the past week market sentiment has shifted somewhat, the underlying economic conditions remain sound and supportive of investment. This letter will focus on the shifting political landscape, stock and bond prices and the value of the dollar and what to do with a correction in prices.
Market Implications for the Failed American Health Care Act
On Friday afternoon as the market closed, we witnessed the Republican caucus pulling the bill known as the American Health Care Act. This bill was intended to repeal and replace the Affordable Care Act, known as Obamacare. While this legislation was very unpopular and did not garner broad-based support, it did enjoy support from President Trump and Speaker Ryan and marked a political setback for both men.
Market pundits perceive this inability to pass key legislation, despite the support of the President and Speaker, as having the potential to de-rail other Republican legislative priorities such as tax reform and infrastructure. This perception will likely cause some level of correction of the “Trump” trade which has focused on companies that would benefit from such legislation.
We would therefore expect a pullback in stocks, a decrease in the dollar and a decrease in bond yields to lower market expectations of sweeping rapid reform, particularly on taxes. This correction, like the many others we have seen and see almost every year, should be used as an opportunity to be constructive on investments that meet our criteria for valuation.
Equities and Bonds
Lower prices for equities increase our expected rate of return on incremental capital deployed, as this allows us to buy the same companies at cheaper prices. Ultimately, reasonable and or cheap valuations for good companies result in excellent prospects for future investment success.
Bond prices continue to confuse many. Our considered opinion is that due to the very large short interest in bonds, particularly those of longer maturities, we are seeing an “artificial bid” that is a result of institutional investors covering short positions at key technical levels. In order to cover a short position, investors need to buy the investment they are short in order to close out their trades at a profit. In extreme cases, this is referred to as a short squeeze as investors rush to exit their short positions before they lose a paper profit. Again, long-term we believe that economic fundamentals both from a risk and inflation perspective merit a correction in long -term bond prices to much lower levels. Given the Fed’s recent rate increase to 75 basis points, the short part of the curve and money market funds offer some yield and a compelling hedge against this bond price correction. We believe that the current flattening of the yield curve is a temporary condition that will reverse as economic conditions become clearer and that it is a result of the aforementioned trading conditions and not an indication of recessionary conditions.
The Dollar has enjoyed strength since the election, but we believe that may be coming to an end. While not expecting a complete reversal of dollar gains due to Fed tightening policy, a plateau of the dollar rise may actually remove a negative headwind from multi-national firms. Many of our top holdings have faced some pressure from the strong dollar as it reduces their price competitiveness overseas. A flattening or subtle reversal of the strength of the dollar may be accretive to multi-national corporate earnings and therefore, ultimately their stock prices.
Most economic indicators have been quite strong so far in 2017, this bodes well for the real economy. While a great deal of stock returns have been pulled forward since the election, the economy remains on solid footing with likely GDP growth of around 2%. Indeed, pro-growth policies would likely increase that number, while inaction or geo-political shocks could be risks to our forecast for GDP. Corporate profits are rising, consumer sentiment is at very high levels, oil prices are contained below $50/ barrel, unemployment is low and stock prices remain at the high end of a range of normative valuation. This set of data is supportive of continued strength in the equity markets and continued Fed tightening. It does not support a recessionary thesis.
Short-term market corrections of 5-10% happen regularly and are often the result of profit taking, binary episodes like Friday’s no-vote or sometimes for no discernible reason. A prudent investor uses these corrections as opportunities to make rational investment buying decisions rather than fearing them or fleeing an investment thesis. Measured additions to investments in times of declining prices allow investors to lower their average cost of ownership and thereby reduce the hurdle price at which a profit is realized on an investment.
As the first quarter of 2017 comes to a close, we look forward to continuing our dialogue with our many valued clients and to continue to navigate markets with a valuation-based rational compass. We appreciate the opportunity to serve you and thank you for your confidence in our management of your funds.
Peter C. Wernau
Wernau Asset Management
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This letter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Wernau Asset Management, Inc. ("Wernau Asset Management) is a registered investment adviser with its principal place of business in the Commonwealth of Massachusetts. Wernau Asset Management and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which Wernau Asset Management maintains clients. Wernau Asset Management may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. This letter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Wernau Asset Management with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Wernau Asset Management, please contact Wernau Asset Management or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Wernau Asset Management, including fees and services, send for our disclosure statement as set forth on Form ADV from Wernau Asset Management using the contact information herein. Please read the disclosure statement carefully before you invest or send money.