Q3 2017 Market Update

October 10, 2017

Q3 Market Update

Third quarter continued the years steady march upwards with low volatility and consistent gains. The Wilshire 5000 Stock Index added 4.44% while the Barclays Aggregate Bond Index added a steady 0.74%. This moves stock returns over 12% for the year and the aggregate bond market over 3%. *(Source Folio Institutional Custodial Reporting)

Accounts have moved forward nicely, in line and exceeding long term planning objectives. We remain pleasantly surprised about performance and market returns year to date. When the year began we held an expectation of volatility returning to markets during the second half of 2017, with the highest probability of a temporary disruption to happen in October / November as the Federal Reserve began the process of unwinding the central bank balance sheet. The other major item that seems worth mentioning is tax reform. These 2 items seem to hold a bit more risk and perhaps will even provide some added opportunity as the market navigates these new initiatives over the coming months.

Federal Reserve Unwinding Balance Sheet

The Fed has become massive. Its balance sheet is nearly 25% of GDP. Never before has it been this large. And yet, the economy has grown relatively slowly. So the impact and manner in which the Federal Reserve unwinds will be key. Analyst are split across the board on the possible impacts. Some are nervous about impact on stocks, while others are concerned about bond prices falling.

Everyone seems to agree the current process of unwinding Quantitative Easing (QE) is going to take time. The Fed has said that whenever it starts (most likely October), it’s going to trim the balance sheet by $10 billion a month for the first three months, $20 billion per month for the next three, and on and on until it hits a pace of $50 billion per month. So, if it starts cutting in October it would take until about 2021 for the balance sheet to reach the Feds target level.

Back in the 1980s and 1990s, with a much smaller Fed balance sheet, the economy grew far more rapidly. During this time the banks passed excess reserves through, in form of loans to businesses and mortgages, at a more rapid pace. So how do you liquidate the Fed without disrupting the system? Very slowly is the likely answer. The Fed is cautious by nature; if they were more aggressive about trimming the balance sheet and suddenly the stock market had one of its inevitable corrections, they would be blamed. This general attitude leads to much slower moves than may otherwise be warranted. As this process unwinds, it adds an element of uncertainty to the general markets. Anytime uncertainty goes up, the chance of temporary declines increase. The highest chance for a decline is when the initiative first starts. After we become familiar with the unwinding, it naturally removes some uncertainty.

Tax Reform

The market run up since the election has been built on a combination of solid earnings and predicted future earning increases. Corporate tax reform has contributed to the prediction of future earnings increasing at a faster rate. We have seen many analyst value companies and the stock market based on lower future corporate tax rates. Confirmation of lower rates would likely send markets a bit higher, while any sign the process will not be complete may very well cause a temporary decline.

We make no predictions on the actions of government, but we research fully to have a deeper understanding of what effects it may have on the market and various sectors / companies. If tax reform adds to volatility, we remain well positioned to act on opportunity. If it passes and we see positive results, then we are positioned to remain in line with plan objectives. In one sense we hope for opportunity from declines as a way to put us further ahead, but a slow and steady move upward on backs of reform would not cause complaint.

Peak Under the Hood

All of this leads us to one general conclusion. Remain neutral in our risk design.

Last quarter we discussed the fact that we’ve grown more cautious in recent months and started to take some profits and build a little extra cash for more moderate and conservative accounts. Stocks and accounts remain near all-time highs. In aggregate, institutions seem to loathe stocks, but keep buying them because interest rates remain stubbornly low. Meanwhile valuations are bit extended (not insane or bubble, but pricey). As such, we remain neutral (meaning, if you are to be at 60% equity in the long run, we try to be right on target). Below is a good reminder from last quarters update about our current thoughts on stock and bond valuation.

Equity Valuation Thoughts:

Risk is correlated with the price of an asset. Give me a stock for free and I have very little risk. Said a different way, the chance for permanent loss increases as the asset gets more expensive. This goes against human nature, we see historically the chance for loss was likely lower in March of 2009 with a PE multiple on three year average earnings of about 9 for the S&P 500 compared with the PE in June of 2017. Today the same metric is over 19. Meaning we are paying 2.10 times more for each dollar of earnings as compared to 2009. While 2009 was clearly a deal, the price as a whole today is clearly not as attractive.

Paying higher multiples for businesses and receiving lower income yields or cash flow yields for companies naturally result in reduced convictions for stocks. Of course, with rates so low, we have learned to accept lower income, cash flows as part of the current reality we live. However, combination of solid corporate management, company innovation and Fed policies have all helped push stocks higher the past 4 years and could continue to push many equities higher over the near term. This is a good example of why we do not market time but prefer proper long-term balance relative to risk.

Bond Valuation:

Despite knowing that bonds are fully valued and perhaps overvalued, we don’t avoid them entirely, although we do remain underweight even for moderate clients. The reason we maintain exposure is duration and ultimately safety of income streams. Bonds, because they pay current and more certain interest rates have a shorter duration than stocks. Should good stuff happen and rates continue a slow increase, we will receive a consistent income stream to help meet client objectives. Should bad stuff happen, bond prices would likely fall less than stock prices and provide a buffer of safety for risk reduction, short-term income, and a place to tap for buying more stocks at lower prices. In the uncertainty of the future, bonds still have a role to play for many investors.

Evergreen Conclusion

We have little ability to predict or control the timing of asset growth or future economic risks. Things well beyond our control will move asset pricing over time. Long term investing is not about controlling but rather an understanding of the process, historical truths and meeting long-term objectives.

2017 continues to be a solid year for markets and clients of all risk levels. Returns continue to meet or exceed long term planning objectives and strengthen portfolios. Use this season to continue paying down debt, build savings, maintain your budget and stick with your long-term plan.

Evergreen Wealth remains committed to providing holistic investment solutions and financial planning. We remain honored to continue stewarding your assets and retirement journey.

Client returns and risk may experience deviation from model performance based on timing of deposits & withdrawals, among other factors. Overall, clients subscribed to Evergreen’s model portfolios experience similar results mentioned in the article.

Index results do not reflect management fees and expenses and you cannot typically invest in an index.

Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.