QUICK LINKS          Market Commentary 9/30/18
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Riding in the West

We had the great fortune of spending our vacation on a week-long bike tour in the western portion of South Dakota.  Together with my wife, Anne, we rode our tandem bicycle through Badlands National Park, the Black Hills Forest to Mt. Rushmore, and northward to Devil’s Tower in Wyoming.  We covered a lot of ground, and struggled up more than a few long climbs, but our efforts always seemed to be rewarded with another magnificent view of the amazing western landscape.

After subjecting investors to some ups and downs during the first half of the year, the stock market rewarded us with strong performance in the 3rd Quarter.  The S&P 500 generated a total return of 7.7%, the best 3rd quarter performance since 2010.  With year-to-date return for the index at 10.5%, most of the return this year occurred in just one quarter.  But this strong performance was not distributed evenly, as growth stocks once again outperformed value stocks, and large-cap stocks outperformed small-caps.  This divergence is a continuation of market action in the first half of the year when market returns were driven by a small group of high-valuation stocks in the technology sector, a topic that we covered in our previous market commentary.

A number of factors contributed to the market rally.  The domestic economy continued to show signs of improvement as GDP growth accelerated from 3% to over 4%, the strongest growth in a number of years.  The labor market strengthened, pushing the unemployment down and wages up, and, as a result, consumer confidence rose and consumer spending increased.  The virtuous circle of a stronger economy, better labor conditions, and higher consumer spending was apparent when companies announced quarterly results.  Strong demand and the positive impact of tax reform measures contributed higher revenues, higher profit margins, and strong earnings growth.  Encouraged by the strong results many companies increased revenue and earnings guidance.

The market rally was not without its cautionary signs.  Valuations remained high, although somewhat lower than early in the year.  Volatility in the major indices was unusually low as the S&P 500 index did not register a move of more than 1%, up or down on any day, a possible indication of investor complacency.  Typically, a quarter as strong as this would have generated a strong up move and some sort of pullback.  In addition, underlying measures of market strength were weak as the number of stocks hitting new highs declined and stocks hitting new lows increased.

But the economy and stock market face a significant headwind as the Fed gradually tightened policy.  For almost 10 years the Fed has pursued a very accommodative policy to spur economic growth.  They pushed interest rates to almost zero and held them there for an extended period of time.  They also aggressively purchased government and mortgage debt, expanding the Fed balance sheet by more than $1 trillion, a policy known as “quantitative easing”.  Now, as economic growth has begun to accelerate, the Fed is beginning to slowly reverse those policy actions.  The initial step in this process has been a gradual increase in short term interest rates in an effort to “normalize” rates.  Recently, the Fed initiated the second step of this process to reverse quantitative easing, by not reinvesting the proceeds of bonds on their balance sheet as they mature.

Despite the somewhat effortless rise of the markets during this past quarter, investors need to balance their return expectations with the risk of a steep descent that might lie beyond the next curve.  Global economic and political events could unsettle our markets.  As the European Union struggles with Brexit and tense negotiations with Italy, the European central bank may find its policy options limited.  Tense trade negotiations between the US and China or the European Union could raise uncertainty for both multinational corporations and investors.  In addition, the threat of higher inflation, which has been well contained to this point, could add another measure of risk for bond investors, and the withdrawal of liquidity by the Fed could impact the markets negatively.

While these macro factors can impact investor expectations, and by extension the market itself, we recognize that they are clearly beyond our control.  If fact, while we may be able to anticipate investor reactions to any of these potential events, we find it difficult to convert any of it into actionable portfolio decisions.  Instead, we believe that the best foundation for an investment portfolio is to manage risk on an individual stock by stock basis.  We focus our search for stocks that trade at attractive valuations based on their earnings potential and financial strength relative to their peers and the market in general.  We manage risk by building a diversified portfolio among industry sectors with a long-term investment horizon to ride out the inevitable ups and downs of investor emotions.

Sincerely,
Daniel A. Morris

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