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Q3 2016 Commentary

Equities put together a decent quarter, more than doubling the gains from the first half of the year. 

 Virtually all of those gains came just in the first two weeks of July.  Since then, things have been remarkably quiet.  For the rest of the quarter, the S&P 500 traded in a 3% range.  That is a historically tight trading range (stocks have been more volatile in 99.5% of comparable time frames).

 All of that quiet has left many scrambling to find some place to make money.  We, on the other hand, spent most of the quarter on the sideline.  We entered the quarter with the lowest stock market exposure since 2007, and broadly maintained that stance though mid-September.   

The most significant concern for us this year has been stock valuations.  With a brief exception early in the year, the S&P 500 has been trading above 20 times record earnings.  This is a price multiple that has never been sustainable in the history of the American stock market.  I have written about valuation concerns at length in past commentaries, but it is worth repeating: any time equity multiples have climbed this high, stocks have eventually seen lower prices.  Additionally, after reaching such loft valuations, stocks have always underperformed Treasuries over the next decade (or longer). 

This is not the type of investment environment to be optimistic about.

Despite these long term concerns, we have been adding to our equity exposure in our traditional Time Overlay accounts over the past few weeks. 

In the last quarterly commentary, I stated that we will be waiting for the markets to come to their senses or present opportunities.  With valuations remaining excessively high, markets certainly have not come to their senses, but amidst the quiet, they have been providing some clear isolated opportunities. 

By mid-September, we saw broad (if shallow) weakness among quality stocks.  Several of those names looked particularly attractive, giving us a chance to move equity exposure in standard accounts closer to 50%. 

The three stocks that account for most of increased exposure are Casey’s General Stores, The Hershey Company, and JM Smucker.  Aside from being out-of-favor discounted quality stocks, there is something that all three names have in common:  low beta.

Beta is essentially a measure of market risk.  The three companies mentioned above have betas of 0.22, 0.27, and 0.48, respectively.  Any stock with a beta below 1.0 generally moves less than market does.  In other words, if we do face any sort of intermediate term weakness, probabilities suggest that these stocks, on average, will only lose about one-third of what the broader market does. 

These are precisely the types of names we are most comfortable owning in a high-valuation environment.  We also continue to hold onto quality stocks with low-valuations and high dividends.

Though valuations and rising interest rates are major long term concerns, the current market has plenty going for it.

Many of the positive points outlined last quarter remain in place today.  The domestic economy continues to grow at a slow but steady pace. There is little sign of a recession on the horizon.  Despite sitting near record highs, investors remain very skeptical about this market, as evidenced by sentiment surveys and massive outflows from equity funds. This type of broad pessimism is generally positive for stocks.

Fundamentally, earnings improved in the second quarter and likely grew again in the third quarter – putting a bottom in the earnings recession (for now).  This is of some relief, considering our emphasis on valuations. Most of our analysis, however, is actually built on an optimistic return to 2014s peak earnings; so, while a rebound in earnings would be good for market confidence, we have a long way to go before it impacts our outlook.

Considering the amount of conflicting data we are currently dealing with, it is futile to predict the next market move.  Accounts are largely positioned to take advantage, whichever way equities move.  Should markets move higher on strong economic news and growing earnings, we will not hesitate to lock in profits, and could find ourselves holding even more cash than we did at mid-year.  Should stock falter on Fed-fears, the election, European dissolution or valuations, we remain prepared to take advantage of further discounting, as accounts across all strategies continue to hold significant cash positions.

As we head into the final quarter of the year, we can anticipate the financial media will do their best to sow uncertainty and fear about the future.  The majority of it will be noise.  At the end of the day, our investment decisions are modeled on data, not talking heads.

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