Category Archives: Client Letters

Q2 2018 Letter

July 2018

Markets in 2018 have brought contrast to the prior year. 2017 was a trek “up and to the right” for most financial markets. Except for some drama in the energy sector, most asset classes enjoyed relatively smooth and strong performance. Domestic large cap and small cap equities, international equities, emerging market equities, and even precious metals were all up double digits in 2017. This year, we have seen more dispersion among asset classes and the drama has been more widespread. On the positive side, the S&P 500 is up 2.6% year to date, the Russell 2000 index is up 7.7%, and the tech heavy Nasdaq index is up more than 11% for the year. On the negative side, developed international stocks are down -2.7% year to date and emerging market equities are down -6.7% on the year.

Drilling down further, we have seen several other trends and themes worth noting. High priced stocks (as measured by their price to earnings ratio) have outperformed low priced stocks by a wide margin. Stocks that pay no or low dividends have done much better than stocks that pay high dividends. And growth oriented names have substantially outperformed their value oriented counterparts. All this has taken place against a backdrop of increased volatility since late January.

There are several factors at play here. One we hear about frequently is trade policy uncertainty. Long term investors do not like uncertainty in the markets, particularly when it involves the possibility of an all-out trade war. Big multinational firms have built far-reaching supply chains that help drive down costs and increase efficiency. These global supply chains rely on the free flow of goods and services across borders and around the world. Escalating trade skirmishes threaten to disrupt these supply chains, introducing additional costs, delays, and uncertainty. It’s not good for sales growth, it’s not good for profit margins, and it’s not good for business. Trade policy uncertainty has had a greater impact on emerging markets where global supply chains often originate. All things being equal, greater clarity on trade policy would be supportive of equities in general and emerging market equities in particular.

The future path of inflation and interest rates is another source of uncertainty in markets. In the old days, it was fashionable to think that low unemployment led to tight labor markets and rising wages as companies had to compete for increasingly scarce labor. Rising wages increase costs and cut into profit margins, putting pressure on companies to raise their prices and pass along the added cost to their customers. In recent times it hasn’t worked that way. Unemployment has been as low as 3.8% recently vs. its 50-year average of 6.2% while wage growth has been stubbornly low at 2.8% vs. its 50-year average of 4.1%. The last time unemployment was lower was in 1969 during the Vietnam draft. Unemployment rates and wage growth have never been this low at the same time. What’s more, the Labor Department recently reported there were more job openings than job seekers. At some point we would expect to see upward pressure on wages and inflation. If wage growth breaks out to the upside, it would put pressure on the Fed to raise rates more aggressively to keep inflation in check. That could be a headwind for equities here and abroad. The most recent unemployment report showed more workers entering the labor pool and continued sluggish wage growth, easing concerns for now.

One of the themes contributing to 2017’s smooth and strong performance was the idea, “There Is No Alternative” to equities, or “TINA”. Cash and short-term investments were yielding next to nothing coming into 2017. The Fed was just beginning to raise rates after several years of holding rates near zero. The Fed raised rates three times in 2017 and twice more earlier this year. Expectations are for two more hikes in the remainder of this year. Due to Fed tightening, one-year Treasuries are now yielding more than 2.3%. That’s

higher than the 1.9% dividend yield on the S&P 500 with no credit risk and very little interest rate risk. Many investors are seeing an alternative to equities now that short-term rates are rising. We see evidence of this in Lipper’s weekly fund flow report. Over the past several weeks, money has been flowing out of equity funds and flowing into bond funds. This is a big reversal from recent trends. We too have been very active in helping clients maximize the return on short-term investments. It’s nice to see some yield on cash for a change.

Despite present uncertainties, the outlook for economic growth remains strong. The Atlanta Fed’s GDPNow indicator is suggesting GDP growth slightly above 4% for the second quarter. The Conference Board regularly reports on leading and coincident economic indicators. These indicators are signaling continued economic growth with little threat of recession on the immediate horizon, and small businesses are feeling confident about the future. NFIB’s Small Business Optimism Index is at the second highest reading in their 45-year history and a record number of respondents are reporting plans to increase compensation and expand operations.

Bespoke q218 pic

Source: Bespoke Investment Group

No one knows what the future holds. Markets have always moved forward in fits and starts. As Yogi Berra once said, it’s tough to make predictions, especially about the future. We will remain focused on areas where we have some control and in ways that can add value: long-term strategic thinking, careful cash flow planning, being vigilant about taxes and fees, rebalancing away from assets that have grown expensive in favor of assets that have become relatively cheap, and searching for attractive opportunities in the less efficient and less correlated private markets.

As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm.  We are grateful for the opportunity to work with you and your family.

Nicholas Hoffman & Co.

Q1 2018 Letter

April 2018

The year started with stocks continuing their advance at an ever-increasing rate. Large cap US stocks as measured by the S&P 500 were up 7.5% in the first weeks of January, setting an all-time-high on Friday, January 26. Before the end of January, developed international stocks were up 6.5% and emerging market stocks were up 9.9%.  By the following Monday, however, sentiment had abruptly shifted and the pressure was to the downside. Over the next 13 days the S&P 500 declined more than 10%, the technical definition of a “correction”. It was one of the  quickest corrections in years. Concerns over inflation, rising interest rates, and a potential trade war spooked investors and volatility quickly returned to the markets. Throughout the quarter volatile trading days became the norm. Repeatedly the market experienced days of hundred point drops only to see the market reverse itself the following day. By quarter end, the S&P 500 was down -0.8% for the year to date while developed international stocks were down -1.5% and emerging market stocks were up slightly at 1.3% over the same period.

It is important to note that volatility is a normal feature of equity markets. This latest bout of volatility is not unusual from a historical perspective. What is unusual is the protracted period of low volatility that led up to it. Equity markets had risen for nine quarters in a row while market volatility had declined to generational lows. By some measures, 2017 was the least volatile year in the markets since the mid 1960’s. It looks like this unusual period of low volatility may be drawing to a close.

q1 18

Source: Bespoke Investment Group

When markets are rising in a straight line, day after day, week after week, and quarter after quarter with very little volatility, many of the tried and true investment concepts seem unimportant. Concepts like diversification, fundamental security analysis, and being mindful about the intrinsic value of the assets in a portfolio fall out of favor as the rising tide lifts all boats. Investors are attracted to rising prices and momentum becomes the name of the game. Respect for risk gives way to the fear of missing out. New “opportunities” emerge like Bitcoin and other crypto currencies. They experience explosive growth as they capture the imagination of investors. In this kind of environment investing seems easy. All you need to do is buy what’s going up the fastest.

The re-emergence of volatility means markets may be returning to a more “normal” environment where things like diversification, security analysis, and good old fashioned hard work once again provide demonstrable value. We have been searching for value in a number of areas. Last year it made little difference which vehicle we used to hold cash. With the Federal Reserve systematically raising short term interest rates, we are now helping clients focus on maximizing the return on the cash they hold. We have seen yields of 1.75% on FDIC insured savings accounts, yields of 1.6% on select money market funds, and yields of 1.8% on 3 month Treasuries. This may not sound like much, but compared to last year’s paltry yields, it creates an opportunity for liquid reserves to become more productive in creating income for our clients’ portfolios.

Another area where we have been active is planning around the Tax Cuts and Jobs Act of 2017. We have had conversations with a number of CPAs. Most are still sifting through the complexities of the new law and potential strategies to add value under the new tax regime. One strategy is to bunch deductions together so you can itemize one year and take advantage of the higher standard deduction the next. Another strategy for those who are charitably inclined and must take Required Minimum Distributions from their IRA is to make Qualified Charitable Distributions by directing IRA distributions to charity. The charitable distributions count toward your required minimum distribution but don’t show up in your Adjusted Gross Income. We are continuing to explore thoughtful ways to respond to the new tax environment.

We continue to survey the landscape for attractive investments in both the public and private markets. Regular contact with our existing and prospective investment partners and listening for opportunity is always integral to our process. Many of the trends and themes we have previously highlighted remain in effect. We continue to see incremental value in international and emerging market equities over domestic equities for longer investment horizons.  Interest rates and inflation expectations are being closely monitored given their importance as forces that impact how assets are valued and the incremental returns investors demand for accepting risk. Economic growth continues to be positive both in the United States and abroad. Earnings season will be under way soon and analysts are predicting robust earnings and revenue growth. Broadly speaking, valuations remain stretched despite the recent volatility, but economic and business fundamentals remain strong. Risks include an increase in trade tensions, unexpected inflation, or a surprise slowdown in economic growth.

We are pleased to announce Corey Erdoes has joined the team in the role of reports analyst. Corey will be working on continued enhancement of our analytical and reporting capabilities with our Black Diamond performance reporting software. Corey holds a bachelor’s degree in business administration from the University of Georgia. We are happy to have Corey on the team.

On administrative matters, we have enclosed an explanation of material changes to our annual ADV Brochure filing and a separate letter which highlights several tips for preventing fraud.  Please let us know if you would like a copy of the full ADV Brochure.  Also, please promptly inform us of any significant changes in your financial circumstances that would require revisiting your investment objectives or the management of your assets.

As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm.  We are grateful for the opportunity to work with you and your family.

Nicholas Hoffman & Co.