The Cornerstone Investment Commentary: 3rd Quarter, 2016
Considering the Brexit-induced fears of early Summer, it was a remarkably good quarter of investment gains across the board. However, as the next interest rate uptick nears, a few portfolio tweaks now seem prudent.
The best news is that, worldwide, the most attractively valued equities – foreign holdings and U.S. value stocks – led the way. (This also included U.S. small growth stocks, which finally moved into the ‘black’.) This is heartening for two reasons. The most obvious is that your portfolio is weighted more toward value stocks than their counterpart, growth stocks. More important, though, is that markets are rewarding equities with stronger fundamentals – particularly a company’s stock price relative to its level of profitability – than those with momentum from prior gains. We see this in particular with U.S. value stocks, whose 2016 gains are nearly double those of growth stocks. It is also consistent with an economic recovery that is well along in years. There is no compelling reason not to expect this to continue; however, it’s always good to recall that the past is never a perfect predictor of the future!
This quarter also saw a marked increase in expectations that the Federal Reserve would ‘soon’ raise interest rates. There is now one less good argument against them doing so due to the rise in (real) wages as employment continues to rise. So it’s not surprising that the quarter’s fixed income returns were nearly flat after being so strong in the year’s first half. We moved to take advantage of this earlier this year, though that opportunity now seems to be waning. Also of note is that real estate securities (REITs), which comprise about 5% of your equity holdings, fell slightly after an incredibly strong run the last several years. Interest rate increases are not good news for either real estate or intermediate-term bonds, which make up about 25% of your fixed income position.
Based on all this, we believe that it’s now wise to make your portfolio less interest rate sensitive. Doing so involves reducing both real estate and intermediate-term (government) bonds by 15-20% each and adding to U.S. large value stocks and short-term (government) bonds, respectively. As always, we would do so being mindful of tax impact, expense ratios and any transaction costs. Please contact us if you have any questions regarding this or would like us to hear from you before implementing these changes. We will certainly let you know if we come to believe that further changes are also warranted.
Finally, a comment about the impending election seems in order. Obviously, elections do matter. However, financial markets are affected by many other factors (including some more powerful) than what occurs at the ballot box. Even then, its impact is felt more over time than in the months immediately before or after. Accordingly, we will not be advocating any ‘predictive’ moves or changes. We invite you to join us in watching with bemusement the inevitable columns or posts attempting to divine the economy’s resulting winners and losers. Who knows, some may even turn out to be right!
As always, we thank you for the continuing opportunity to work with you. We send our very best wishes to you and your family for the holidays which just were, or soon will be, upon us.