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.
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.