We hope this letter finds you well and you are enjoying a pleasant summer with family and friends. During the second quarter, US and International markets continued moving higher on positive economic news while shrugging off negative headlines. The market posted its fourth straight quarterly record and added to the robust returns achieved since the market bottom in 2009. The S&P 500 now stands 265% above the market low on March 9, 2009 and 55% above the October 9, 2007 highs. Despite geopolitical risks, rising interest rates, and a log jam in Washington, markets continue to move higher driven by improving fundamentals. International markets have finally joined the party this year, posting strong returns for the second quarter in a row further helped by improving economic data. As we enter the second half of the year we continue to be cautiously optimistic as the economic backdrop remains attractive with continued strong corporate earnings and limited inflation.
After a run of such magnitude, naturally the question of valuation comes into play. Excluding the energy and materials sectors (~9% of the S&P 500), markets are trading at their 20 year average price to earnings valuation. As supplies of crude oil and the use of alternative energy sources have increased, prices have remained uncharacteristically low during this stage of a bull market. As a result, energy and materials stocks are trading at very high levels and driving up the overall market multiple. In other words, the market laggards are pushing the market’s valuation to above-average levels rather than momentum stocks.
What’s driving the market?
In the context of interest rates, equity markets remain attractive with the dividend yield of the S&P 500 (2.1%) nearly mirroring the 10-year US treasury rate (2.3%). Typically, equity bull markets end with an asset class rotation into bonds as investors question fully valued stocks and shift into bonds with attractive interest rates. With current low interest rates, that motivation is clearly missing. Historically, from low levels of interest rates, equities have outperformed bonds and most other asset classes.
Every stock market rally is slightly different and understanding the driving forces is important in determining why the rally may continue and why it might end. Amazon is clearly one of the recent winners and provides a great example of how a company can have enormous revenue growth and profitability by disrupting a traditional industry instead of capitalizing on economic expansion. Creating efficiency and unseating traditional players in a market can be disruptive for the economy as a whole but can also generate significant shareholder wealth and lead the stock market higher (as Walmart did during the 1990’s). We see this trend continuing at Amazon and in other companies in such industries as advertising and media, pushing the stock market higher, but pressuring the weaker competitors. This presents a great opportunity for active management, as there are clear winners and losers in this market. We would love to see more broad based economic growth which could be helped by an infrastructure spending bill or watered down tax reform legislation to include an allowance for repatriation of foreign assets out of Washington. This would add further stimulus to the stock market and our optimism about how far this bull can run.
Could we be heading back to more normalized rates?
The Federal Reserve continued its path with another interest rate hike this quarter to 1.25%, and they have also begun discussions regarding reducing their balance sheet by not purchasing new bonds as their bond holdings mature. The Fed may attempt to unwind the great experiment that was quantitative easing starting as early as the fourth quarter of this year and is likely to become the economic story of the second half of 2017. Timing is critical as Chairwoman Yellen sees her term come to an end in January. Many feared that increasing interest rates over the past year would have stalled the economy. Perhaps the Fed has done exactly what they needed and achieved what they wished for possibly creating a utopian environment of low inflation, low interest rates, and decent economic growth. A key unknown is how central banks around the world will respond to the Fed’s actions as changes in global interest rate spreads could negatively impact their flexibility.
With the rise in short term rates the current yield spread between a 2-year and 10-year US treasury is less than 1%, down from almost 3% at the end of 2013. Driven by such a flat yield curve one cannot justify bond holdings with maturities beyond a few years. Mindful of this, we are managing fixed income portfolios carefully and are looking for other ways to generate strong risk adjusted returns. For now, we think it remains prudent to maintain a short duration portfolio and opportunistically invest in longer dated bonds when yields improve.
Are International Markets Joining the Market Rally?
International economic data has continued to improve and their markets have had a good start to 2017 after many years of underperformance. The US dollar spiked at the end of 2016 but has reversed course in the early part of this year amplifying international returns. The year began with the potential of disruption from a populist political movement in Europe but those fears have faded with the failed election of populist candidates in France and England. As a result, the Euro rallied, reversing a positive cost advantage which had been developing for European companies. Emerging markets have also performed well with India and China showing positive market returns as improving economic data – which is great for them and all of their global trading partners. With this in mind, we are looking to build on the investment we made both directly in India and more broadly in international markets last year.
With the current backdrop, the potential for volatility remains. We are cautiously optimistic about markets and are excited about the future of those companies we have diligently selected for client portfolios. We continue to look for attractive opportunities to achieve strong risk adjusted returns in our portfolios while ensuring assets are adequately protected where possible. We continue to buy puts as part of our goal to create risk adjusted portfolios that generate growth. For now our advice is to stay the course, remain invested and continue to be diversified.
We hope that you have a wonderful summer and we look forward to speaking with you in the near future.
Bainco Company Update
We would like to update our clients, their advisors and friends of Bainco of some recent news and changes at our firm.
You may have seen our recent announcement that Bainco was named to the Financial Times 300 Top Registered Investment Advisors. The list recognizes the top independent RIA firms across the US and we are pleased to be included among these outstanding firms.
To best serve our clients expanding needs and growth of our assets under management we have made a significant promotion and a new hire. We are pleased to announce that Justin DuMouchelle has been promoted to Head of Investments. Justin has been at Bainco for 12 years and in recent years has served as a Fundamental Analyst, Head of Research and currently as a Managing Director, Portfolio and Private Equity Strategist. He is a Chartered Financial Analyst (CFA), holds the Certified Financial Planner (CFP) Designation, and is a member of the CFA Society of Boston. Justin will continue his leadership work on Bainco client’s liquid portfolios, private investments and other alternative investments as appropriate for our clients. Outside of Bainco, Justin is very active with the Museum Council at the Museum of Fine Arts, having recently served as Co-Chair of their annual gala.
Also, we welcome our newest team member, Geoff Kuli. Geoff grew up as an expatriate in Brussels; attended Middlebury College and after a time as a Mathematics teacher has spent his last 20 years in various roles, most recently as a Senior Security Analyst and Vice President Portfolio Manager. Geoff is a Chartered Financial Analyst (CFA) and he was chosen from among 11 final candidates by Bainco; we anticipate he will make an impact in our collaborative office culture. His role will be Portfolio Strategist and we look forward to introducing him to many of our clients and advisors.