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The Cornerstone Investment Commentary: 4th Quarter 2017

Happy New Year!  There are two possible framings for 2017: 1) Expectations again proved to be the air that markets breathe in the short-run; and 2) Taken together, the last few years show the prudence of intelligent diversification.  There is truth in both; though we believe the second to be the more significant.

Last year began with expectations that less regulation, infrastructure spending and tax reform would drive the economy to new heights.  A closer look shows profits mostly rose from consumer spending growth.  They spent more because wage gains exceeded inflation again last year and they believe this may continue.  Stock market leaders from 2016 were the laggards of 2017 and vice versa.  Consider the following:




U.S. Large-Cap Stocks (S&P 500)




U.S. Small-Cap Stocks (Russell 2000)




Foreign Stocks (Developed + Emerging)




One year’s ‘winners’ rarely lead the way the following year.  Also in 2016, value stocks – domestic and international – outgained growth stocks by 12% after growth stocks outperformed by 15% last year.  Our 2017 rebalancing and allocation changes did just what, in hindsight, one would have hoped:  add to foreign and growth stocks and lower value stocks.  Things do not always work this well, though in 2017 they did; however, it does not again destine U.S. Small-Cap stocks to top the charts for 2018

For 2018, two main themes stand out: 1) Fundamentals continue to look more favorable for foreign stocks than for those in the U.S. – and results have borne this out since the new tax law was signed; and 2) As the U.S. economic expansion enters its 10th year(!), interest rates will rise further (restricting corporate profits) with unemployment poised to fall below 4% and putting more upward pressure on wages.  This always foreshadows rising inflation, which recorded its highest ‘core’ level in 2017 since the Great Recession.  And rising inflation has never been good news for stocks or longer-term bonds.

This is why we believe your portfolio, with last Spring and Fall’s changes, is well-positioned for 2018.  There are reasons for optimism and caution: foreign economies are growing solidly; they will be helped if the U.S. dollar falls further; rising U.S. corporate profits should boost stocks until a tight labor market, inflation and higher interest rates eventually end this ‘party’.  And what of the recent tax cut?  We’ve never found tax policy to make compelling an otherwise uncompelling investment, and 2018 should be no exception.  Whether it can further stimulate the economy without overheating it remains to be seen.

Our bond market focus on short-term holdings (>80% of your position) is paying off.  With inflationary pressures building, we believe a change is appropriate:  selling Government Bond holdings (VFIUX, SMTFX, SNGVX) to buy inflation-protected Treasuries (TIPS) via low-cost Vanguard and Schwab funds.

We will be watching how markets react to the consequences – intended and unintended – of recent events.  With wishes for a healthy and happy new year, thank you for the continuing opportunity to work with you.