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The Brave Report: Market Commentary for April 2017

View the PDF version of this report hereThe Brave Report-April 2017

The hope trade is finally starting to fade.  Since Trump’s election in November, the markets have jumped considerably. What many have called the “Trump Trade” has largely been based on optimism surrounding the pro-business promises that Trump made while on the campaign trail and since his election.  So far the market has been pricing in an expectation that all or most of his policies will be implemented and his agenda will be realized in its entirety with little opposition.  We are beginning to see that campaign promises are one thing. Actually turning these promises into policy is another.

Outside of his executive orders, the president has failed to make any real progress on any of his major initiatives and the timetable for many others continues to be pushed out. The first major setback was the failure to get his healthcare bill pushed through congress. The repeal and replace rhetoric that we heard so much this fall didn’t even make it to a vote. Following this setback, the Senate had to resort to the “Nuclear Option” to get Neil Gorsuch confirmed to the Supreme Court, setting a dangerous precedent for future debates. These early setbacks have forced the markets to take pause and reassess the potential of other major initiatives being delayed or abandoned. Most notably for the markets the President’s promises for major infrastructure spending, corporate tax reform and deregulation are beginning to be called into question. So, the big question that still remains is; has the market been pricing in too much optimism?

Market Overview

Over the past month, the markets have experienced a bit of a pause, with the S&P 500 pulling back more than 1% and the DOW dropping just shy of 2% as of market close on April 18th. The bulk of this drop was attributed to the sharp pullback following the failure of the healthcare bill in congress.  This failure led to the first one-day loss of over 1% for the S&P500 since mid-October, breaking an historic streak.  The Dow also saw a consistent negative stretch dropping for 8 out of 10 straight sessions starting on March 31st. While these losses are quite mute in historic terms.  It definitely represents a departure from what we have seen since the election.

The biggest and most notable move we have seen over the last month is in the fixed income space.  Since my last report, we have seen the yield on the 10-year bond drop from around 2.5% to a low of 2.17% on April 18th.  This decline was steady and consistent throughout the month as investors sought safer assets. Even with the prospects of continued rate hikes in the near future, other uncertainties in the market are causing investors to reassess the risks in the market.  A similar trend was seen in the price of gold.  The widely traded GLD ETF increased by around 4.5% over the same time period. As optimism around the Presidents policy initiatives begins to wane, this will be a very interesting space to watch.

Presidential Pessimism: The optimism around the Presidents pro-business agenda has been the driving factor behind the market’s success since the election.  This optimism helped to push markets to all-time highs and led to a few sectors making huge returns. More importantly, this optimism prevented investors from fully factoring in other potential risks within the markets.  We have seen investors shrug off other bad news, geopolitical risks and interest rate questions.  Over the last month, however, we have started to see some chinks in this armor of optimism. Optimism, political rhetoric and campaign promises can only shape investor behavior for so long. Eventually, reality needs to be factored in.  Companies need to start being priced based on their fundamentals and not just based on the prospects of deregulation or corporate tax cuts in the future.

I am not trying to imply here that I think the markets are going to see a huge pullback, even though some sort of pullback would be healthy.  I am simply observing that we are starting to move in the direction where the President’s policy optimism is not the only thing the markets are trading on and that is a very positive thing for the markets.  The potential for these policy changes can still be factored in but I think it is important to more realistically assess the various outcomes of these policy debates and how they impact individual companies.  Until this point, it has seemed that prices were reflective of all of Trump’s policy initiatives being implemented without any hiccups and in short order.  This is just not realistic, especially with the political divide that currently exists in the country and the other geopolitical risks that can very easily become a distraction from any policy debate.

Geopolitical Risk: With the Trump optimism that I discussed above it has seemed that geopolitical risks have easily been shrugged off. With some of this optimism beginning to waver I think it is important to understand the potential tail risk events that could occur in the current environment.

Over the last month, our relationship with Russia has become more strained than it has been in years. This relationship has been made more tenuous following Syria’s chemical attack on its people and the US’s response.  Russia has strong ties within the country and to the Assad regime.  I think our measured response was very much impacted by our hope to avoid continued conflict with Russia.  While Russia is not the power it was during the cold war, re-stoking the flames of the past could be very detrimental to global politics and be a huge distraction from more important domestic policy initiatives.

We have also continued to see saber rattling from North Korea.  They continue to defy the world community by testing missiles and potentially preparing for another nuclear test.  Their unpredictability poses one major unknown. Additionally, their close ties with China also puts us in a very difficult situation as we attempt to renegotiate trade agreements and rules.  The majority of the world is unified against North Korea so I feel that any aggressive action would be met by a pretty unified response.  The risk for the market more lies in the relationship with China. China is a huge trade partner and with trade talks already beginning to intensify, any additional variables only complicate the process.

Earnings: Earnings season is just getting started but so far we have seen 75% of reporting companies beat earnings.  It is a very small sample size so far but positive earnings news seems to be helping to support the market and minimize any increased risks.  I think this will be a very interesting earnings season as we are starting to move away from the election overhang that can sometimes mute the impact earnings has on investor valuation.  My hope is that fundamentals return to being the driving force behind this valuation.

Strategy Commentary

I have continued to maintain most of my equity exposure and am still cautiously optimistic on the markets as a whole.  I do think risks have increased a bit and we may start to see some sector and individual stock divergence as companies begin to be more valued on individual fundamentals rather than sweeping policy generalities. I will continue to watch the rush toward safer assets as this could provide some buying opportunities in the months to come.

I reduced my overweight to financials.  I am still positive on the sector if trump can accomplish some of his policy initiatives around tax reform and deregulation but I think the sector ran a little too far, too fast, based solely on optimism of what could be accomplished. I am comfortable waiting on the sidelines for now.  I am maintaining my overweights to industrials and technology. Out of all of the President’s campaign promises, infrastructure spending is the one issue that he has the most bipartisan support so the risk of it failing is much lower than other areas.  Although small-cap has underperformed over the last few months, I am still positive on the space and am maintaining an overweight.

I have also increased my emerging markets allocation.  EM has made quite a recovery since an initial post-election pullback and I think this can continue.  I am not fully overweight in this space but have brought it back to a more neutral allocation.

In the fixed income space, I have been wrong over the past few months.  Fundamentally, I am still negative on the space and if there is a continued rush to safety I could miss out on some opportunities.  I think the risk/reward profile is still not great but I continue to be surprised. I am maintaining my underweight and am still happy to hold more cash as a replacement.  The increased cash allocation will also be helpful if there is any pullback and any buying opportunities present themselves.

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Robo-Advisors Revisited: The Client Still Wins

Over the last few years, the robo-advisor model has changed the landscape of financial planning.  This landscape is still evolving and the full impact of robos on the industry is still far from being understood.  What started as a simplified, cheap, automated way to manage your investments and savings has grown to a platform that offers a wide range of services and advice. Larger, bulge bracket firms continue to roll out their own robo-solutions and a wide range of robo offerings for advisors are continuing to come to market.

I previously discussed the impact of robo-advisors on the industry and my conclusion was that this impact would be positive for everyone, especially the client.  This assessment continues to hold true. Even in the short time since that post, robo-advisors and traditional advisors have begun to evolve and this evolution has benefited the client and the industry as a whole.

Robo-Advisors

At their core, I would categorize the traditional robo-advisor as a customized, tax efficient, target date fund. Mutual fund companies have been offering target date mutual funds for years. These funds adjust their allocation based on the time frame to a specific goal.  Robo-advisors have taken this concept a step further and integrated a few other variables to create investment solutions that adjust and change based on the profile and investment goals of the client. This is done at a much lower cost than mutual funds and with the flexibility to integrate more tax efficient strategies like tax loss harvesting.  However, most robos still lacked the personalization, customization and holistic approach that comes from a human advisor.

More recently we have seen a shift for many robo-advisors.  They identified that their solution only covers the investment side of the equation and clients are often looking for more than that.  There is much more to financial planning than just portfolio management.  Some of the robo-companies are accomplishing this by adding or integrating automated financial planning solutions that cover such things as budgeting, tax planning and goal tracking. Others have taken a different approach and are offering human planning options to those client that reach a certain asset threshold. Betterment, one of the early standalone robo-advisors, has taken this approach. They recently announced that they would give their clients an option to have access to a human advisor for a slightly increased fee.  This follows similar announcements from Charles Schwab.

Human Advisors

Human advisors have traditionally offered portfolio management services as their core solution. Other financial planning strategies were also offered but most advisors differentiated themselves by their investment acumen. The introduction of automated investment solutions was a direct attack on this traditional value proposition.  As a response, we have seen a major shift from the traditional, human advisor.  Rather than challenge the new robo model, human advisors have embraced it to help improve their own client offerings.  Advisors are integrating various robo-advice solutions into their practices to streamline certain tasks.  This frees up their time to focus on a wider breadth of service offerings, expanding their value proposition away from just investment management to many other tertiary services.

Rather than serve as an impediment to growth these robo-technologies can and should be used to increase efficiencies for advisory practices.  This will lead to more efficiently run practices that have a better ability to service and communicate with their existing clients while also having more time to focus on growth.

I think this trends in the human advice industry will continue and we will see the emergence of three types of human advisory firms.  There will be one group that decides to continue to focus exclusively on investment management. They will live and die based on their investment performance and continually be forced to justify their investment value and fee structure.  There will be a 2nd group that will embrace a wider offering of financial planning solutions. They will utilize some robo-technologies and look to expand their value proposition outside of just investment advice. This will be the bucket most firms fall into.

I also see a third type of firm emerging out of this.  I like to call this group “Concierge Advisors.”  This offering goes beyond just offering financial planning services.  These practices will provide full outsourcing of all financial aspects of a person’s life. The offering will look very similar to a family office service. This type of offering used to be reserved for a small group of high and ultra- high net worth clients but with the efficiencies that come with the integration of robo-technologies this type of offering will be available to a much wider group of clients.

The Client Still Wins

Overall we have seen a convergence of robo-advisors and human advisors.  Robo-advisors are moving away from just offering robo-advice, integrating a wider array of advice solutions and even a human touch. Human advisors are integrating more robo-technology into their own offerings and expanding their planning solutions. I don’t see the two models meeting right in the middle but looking out to the future I think most clients will be serviced by a combination of human advisors and robo-technologies. As was the case when I originally wrote about this topic, the big winner in this entire debate is still the client.  The client now has more options, lower costs and a more streamlined client experience.