Fall 2017 Investment Commentary

“Never short a dull market.” This trading idiom has proven true over the past 18 months as the S&P 500 has gained 14% this year with very little volatility. This gain comes on the heels of a 12% total return during 2016. Investor confidence seems unfazed by the litany of upsetting news headlines including distressing natural disasters, senseless violence, and the threat of a nuclear attack from North Korea. Looking past the headlines the market remains focused on the data. Earnings are growing, unemployment is falling, and asset prices are climbing, creating wealth and spending power in the US and abroad. This data supports our outlook that there is a solid foundation underlying the market and that equities could continue to appreciate.

2017 has been a positive year for Bainco portfolios. Our focus on large cap companies with strong balance sheets and underlying earnings growth has led to outperformance. Technology stocks have led the way with the sector climbing +27% and Bainco technology stocks rising +30% led by Facebook (+48%) through the first three quarters of the year (not bad considering the stock was already up +340% from our 2012 initial purchase!). Healthcare, another longtime favorite sector, has also surged this year, +20% and Bainco healthcare stocks have outperformed +22% led by Abbvie (+45%), a leading biopharma company focused on immunology, oncology, and neuroscience.

Our continued underweight allocation to the energy and telecom sectors has also benefited portfolios as they are the two sectors with negative returns on the year, -6.6% and -4.7%, respectively. Although crude oil prices have recently rebounded, due in part to the supply disruption from hurricanes, we do not see oil prices rallying toward previous highs. Oil prices face pressure from the dramatic increase in total supply, adoption of alternative energy and improvements in energy efficiency. We are not calling an end to oil consumption but it is not the simple ‘one-way’ trade we saw for most of the 20th century.

Continuing to hold Put protection has helped us stay invested while equity indices keep reaching new all-time highs. While holding Put options in strong equity markets can create a drag on performance, we continue to think that Put protection is warranted since the market is not inexpensive and markets do tend to experience cyclical pullbacks.

As we enter the fourth quarter, we continue to like our positioning.

Tax Reform

Tax reform has the potential to provide a catalyst to drive equity prices higher. There are two components, in particular, that could be beneficial to US equities. First, the repatriation of an estimated $2-3 trillion of cash held by US corporations overseas. Under current US law, repatriating the money would result in a tax bill of as much as 50%. The proposal is to reduce that tax to as low as 10% and potentially levy it on the cash held overseas regardless of whether or not it is returned, with the hope that it would motivate repatriation and investment in the US. Second, general corporate tax rates could fall to 20% from levels well north of 30% offset partially by a removal of deductions. Companies such as Bank of America, with a 29% tax rate in 2016, could benefit while others wouldn’t benefit as significantly. We know not to trade on rumors in Washington but these are significant changes and are likely to drive stock movements, allowing for opportunistic portfolio rebalancing and support positive outlook for U.S. equity markets.

Technology Innovation

As highlighted in our winter letter, we continue to favor long-term trends in technology innovation such as Artificial Intelligence (AI). Artificial Intelligence as defined by the Merriam-Webster Dictionary, is the capability of a machine to imitate intelligent human behavior. Recent advances in computing power, automation, and robotics have dramatically accelerated the creation and adoption of these technologies. Siri and Alexa, the voice-activated “virtual assistants” from Apple and Amazon, have permeated daily life representing two of the most obvious examples of AI but they are just scratching the surface of what can and is being done in this area.

Big Data and the Internet of Things (IoT) represent two pervasive, intertwined, and investable themes. When billions of items are all “smart” and connected they will be performing tasks and also collecting massive amounts of data. In logistics, it is helpful to know where a product sits in the supply chain at any given time, but the value-add comes from identifying bottlenecks that can be addressed, improving the speed to market. Honeywell and Google have created smart thermostats which not only can be adjusted remotely but also learn about your home and habits, saving you money on your heating and cooling bills by strategically turning on and off. We see data management and analysis as an essential focus for companies to stay relevant and competitive in all industries.

Healthcare is a key beneficiary of the advancement in AI and big data analytics. The decoding of the human genome and advancement in analytical tools have begun to unlock opportunities to identify, treat, and cure devastating diseases. Using image detection software, doctors are able to detect subtle or microscopic changes in CT scans and mammograms identifying cancer and disease at the earliest possible point. New cancer treatments are changing the prognosis of terminally ill patients by essentially reprogramming their immune system to attack cancer cells. Technology is enabling incredibly rapid advances in all areas and we are likely only in the early innings of what can be accomplished.

What we are monitoring

With all of the positives, there are also near-term risks. The replacement of low-cost workers by robots and computers has put a limit on wage growth. Simultaneously, a relentless focus on cost-cutting has enabled producers and service providers to limit price increases, resulting in low inflation. These are two indicators which the Federal Reserve watches closely and typically are indicative of a strong economy allowing the Fed to raise interest rates. Chairperson Yellen has cited this as a concern and a potential reason to slow the pace of rate increases. Conversely, the Fed has stated they will begin their “Balance Sheet Normalization Program” in October, while at the same time they will continue to “normalize” (raise) rates. This surprised the market since a more accommodative positioning had been expected during the start of the wind-down of the balance sheet.

The Fed plans to allow $10B of treasury, agency, and mortgage debt to roll off their balance sheet starting in October. That amount will increase by $10B every 3 months up to a maximum of $50B/month until the Fed has reached a more comfortable level of total assets on their balance sheet. We will, of course, carefully monitor market reaction to this unwinding of Quantitative Easing.

Our conclusion and advice continue to be the same as stated in our last quarterly letter: Stay the course, remain invested, and continue to be diversified with an anchor windward in the form of put protection.

On a separate note, we want to send our thoughts and prayers to all of those people recovering from the recent string of hurricanes, earthquakes, and wildfires, as well as the senseless violence in Las Vegas. These events are a brutal reminder of just how delicate the balance of one’s life can be. They also prompt us to appreciate the people and things we value most in our lives.