Q3 2016 Client Letter

October,  2016

The third quarter of 2016 was generally good for risk assets. The market spent much of the summer in the doldrums with the S&P 500 Index going two months without a move of 1% in either direction. Then, towards the end of September risk assets began to advance. In an uncharacteristic reversal, the 50 stocks that performed best during the first half of the year finished Q3 down -0.7%, while the first half’s bottom 50 stocks finished the quarter up 11.8%. Additionally, stocks of companies with a higher percentage of international revenues did better than companies with a greater percentage of domestic revenues. Smaller companies also out-performed large-cap companies.

Investors keep wondering whether stock prices can continue to grind higher. The S&P 500 is currently trading at 16.6 times next year’s projected earnings which is 16% above the average forward P/E for the past decade. Corporate earnings have not recently contributed to advancing stock prices as earnings growth remains elusive. Earlier this year analysts were projecting Q3 earnings growth of 7.3% and Q4 earnings growth of 15.5%. According to research by FactSet, it now appears earnings for the S&P 500 will contract by -2.1% in Q3. This would mark the sixth consecutive quarter of falling earnings, the longest period of earnings decline since the Great Financial Crisis.

The prospects for international stocks are somewhat better. The MSCI EAFE index of developed international stocks is currently trading at 15.9 times next year’s projected earnings, slightly below the long-term average. Emerging market equities are priced even more favorably but they come with a unique set of additional risks, including potentially volatile currencies.

In addition, bond yields throughout the world remain near historic lows and, in certain jurisdictions, are negative (Japan, Germany & Switzerland). Economic expansion in Europe, Japan, and the U.S. remains restrained, increasing the likelihood of continued monetary stimulus, or delayed policy tightening. As a result, ultralow interest rates continue to positively influence equity returns. All these factors lend support to what some have called the TINA thesis: There Is No Alternative To Equities.

In our practice we recognize that the private markets can serve as a complementary alternative, but challenges even accompany non-public assets. Back in the early days of this expansion cycle, we saw a steady stream of compelling opportunities flow through our office. We saw private real estate deals at attractive cap rates with enticing economics. We saw private debt offerings with respectable yields and compelling risk characteristics. We saw private equity opportunities during periods of below-normal purchase price multiples for private companies, a condition linked with superior growth prospects. Much of our time was spent picking the best from a basket of good opportunities. Being selective meant swinging at only the fat pitches.

Today’s investing environment is more challenging. We devote significant time and energy to finding attractive deals, but compelling opportunities appear less often nowadays. Abundant capital has driven prices higher across the investment spectrum, often making deal-level economics less convincing. There are still pockets of opportunity, but being selective now means finding acceptable opportunities from a basket of deals that are priced closer to fair value rather than being discounted.

There has been considerable attention focused on the U.S. Presidential election and how its outcome might impact markets. A recent study by Goldman Sachs found that the S&P 500 has typically risen in the months after a presidential election, regardless of which party wins.  Research by Vanguard found that volatility tends to decrease in the months following a presidential election. Vanguard also found that the average annualized return of the stock market was virtually identical irrespective of which party is in the White House. The system of legislative and judicial checks and balances along with periods of compromise and stalemate have generally been supportive of markets.

Source: Bloomberg & Goldman Sachs

There is always a lot of noise and uncertainty in financial markets. These times are no different.  Long-term success requires patience, diligence, and an adherence to time-tested principles like keeping costs low, managing the impact of taxes, and taking a long-term strategic approach. We continue to scour the investment universe for productive investment opportunities while staying true to these time-tested principles. This will be a busy end of year as we assess the impact on our clients of any new tax proposals of the elected Administration as well as the announced Treasury regulations that dramatically impact discounts for transfers of interests in Family Limited Partnerships.

Please join us in welcoming Nirvanna Silva as our newest full-time employee. Nirvanna grew up in Mexico City and recently graduated from Brevard College. For the past summer she served as one of our interns. We are delighted to have her as a full-time member of our team. As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm.

Nicholas Hoffman & Co.