2nd Quarter 2017 Investor Letter
Clients of the Firm,
The first half of 2017 has been punctuated by political and international drama. While this has been noisy and created consternation for both right and left, it has failed to derail the equity bull market particularly in technology. Here, earnings have accelerated and we are finally seeing an amplified cannibalization of traditional business, particularly brick and mortar retail. Earnings for the first quarter were solidly in-line or above expectations for the S&P 500 and dollar-strength was contained. Interest rates, while rising substantially above pre-election lows, remain at levels that are well below normative ranges.
The Market in the First Half of 2017
While equity markets have moved higher in recent months, valuations have been building to levels that imply accelerated earnings growth from current levels. We feel this level of expectation and the corresponding price level could be justified through a combination of general improvement in the economy combined with significant corporate tax reform. That said, neither one of these two scenarios has yet materialized. Therefore, our base thesis is to tread cautiously with new capital and to include a healthy cash and short-term bond allocation that will benefit from the Fed’s continued increases in short-term interest rates.
The Fed’s rate increase schedule remains intact, as do expectations that rates will likely increase at least one more time this year. This likely shift in monetary policy, leads us to consider the strategic choice of cash as a viable investment asset class for the first time in many years. This is a welcome development for many of our clients, as it allows us to reduce risk with a portion of their portfolio while still generating a positive return. Cash and short-term bonds may now play a double role in portfolios, as both a hedge against overvaluation in the stock and long-term bond market and a positive returning liquid asset. The latter feature remains available to be used to acquire equities in either a market correction or individual stock value opportunity. We continue to avoid heavy exposure to long-term bonds, as the likely risk exposure to rising interest rates outweighs the minimal yield these bonds offer.
Wall of Worry
Many notable investors continue to build a wall of worry regarding overvaluation of assets, blaming easy Fed policy as the culprit. They blame low interest rates for incentivizing risk behavior outside of normal ranges, as well as the opportunity cost of low rates, which make assets other than fixed-income look more favorable. The Fed embarking upon a course of corrective action, they fear, will cause a corresponding market correction, normalizing both rates and equity valuations simultaneously.
The magnitude and speed of an expected correction are significant unknowns. Average historical valuations for equities are around 15 times trailing earnings with forward earnings multiples of approximately 18 times. Today, valuations are at about 18 times trailing earnings and 20 times forward earnings making them at the higher end of historical normal ranges. This amplifies the downside risk of the stock market, if earnings growth drivers don’t materialize.
Bonds are more significantly overvalued. The historical average interest rates for the 10 Year Treasury are in the 5-6% range, despite the fact that the 10 Year Treasury rates have not been at 5% or above since 2002. Today’s 10 Year Treasury yield of 2.37%, implies a significant decline in the price of long bonds to get to normative levels. This price decline may be partially absorbed by the yield on the bonds depending on the speed of the correction.
Fed Strategy to Climb the Wall
It is our view that the Fed will likely err on the side of caution to prevent such a rapid decline, preferring instead to try to manage the risk of a collapse of the long-end of the yield curve through the size of its balance sheet and controlling short-term rates. The Fed’s assertions that it will continue to raise short-term rates, as indicated by its dot plot, and that it will likely start reducing its 4 Trillion Dollar balance sheet, give us confidence that the Fed will try to manage the rate rise. We also believe that it clearly intends to attempt to at least partially normalize rates.
As investors, we should consider the long-term implications of our asset allocations in order to meet whatever our personal investment objectives might be. For some, this may involve holding larger stable value positions in order to preserve wealth. This preservation strategy is made easier by a rising rate environment, as interest rates will exceed the cost of investment on this part of one’s allocation with limited downside risk.
For others, some cash may be a viable positive return alternative for patient waiting for an investment opportunity to present itself. Still others, will choose to simply stick with their asset allocation strategy re-balancing periodically as prices warrant, in a dance of valuation dictated harvesting. Any of these strategies may be appropriate, depending on your circumstances and can be implemented through consultation with our team. Importantly, valuation and likely volatility should govern whatever strategy is implemented in order to optimize your portfolio for your individual needs.
As we begin the second half of 2017, we do so with our eyes open to the risks and opportunities inherent in these markets. We continue to believe the appropriate mix of asset classes viewed with a value-based lens, will lead to positive long-term results. We look forward to assisting you with your investment needs and hope you are enjoying your summer season.
Peter C. Wernau
Wernau Asset Management
Important Legal Disclosure
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.