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The Brave Report: Market Commentary for August 2017

Click here for PDF version of this report: The Brave Report-August 2017

Chaos as the norm. For a normally slow time of year in the news cycle, the past month has given us quite a few fireworks. As with past political surprises or issues that I have discussed in this commentary my discussion will try to focus on the business and market side of things and not on the moral abomination that we saw from the President over the past few weeks.

With that said, it seems the markets have resigned themselves to chaos as the norm in Washington. There is a general feeling that nothing is going to get done anytime soon. This is causing investors to not react to much of the news or rhetoric coming from Congress or the President and instead try to focus on company fundamentals. Any market reactions, however brief, seem to be based on how a comment or tweet will impact the ability of Congress and the president to work together on anything and not the comment itself.  With that said, we are entering a normally busy time in Washington and for the markets.  September and October are historically the two most volatile months for the markets. It will be interesting to see if this trend continues or if the markets just continue to shrug.

Market Overview

The markets have been a bit choppier than we have seen in previous months, especially over the past two weeks.  As of the close of trading on August 18th, the S&P was down 1.95% and the NASDAQ gave back around 2.64% over the previous 30-days. Almost all of this negative performance can be attributed to the last few trading days. The DOW Industrial Average was able to squeeze out a slight gain, increasing by 0.16%.  The interesting dispersion over the past month is between large and small-cap stocks.  While the large-cap indexes were flat or down a few percent, the small-cap Russell 2000 lost almost 6% over the last month. This index normally does experience more volatility but this shows a large bias toward larger, quality stocks.  It seems that investors aren’t ready to sell all their equity positions, but are much more comfortable moving to the more stable large cap names.

It is interesting to note, however, that we are starting to see some weakness in the large caps as well. Around 20% of S&P 500 stocks are currently in bear market territory, meaning they are down more than 20% from recent highs.  On top of this, around 40% are in correction territory, giving back more than 10%.  I am not pointing this out because I think we are entering a large-scale pullback.  I simply point it out because it is easy to just look at the performance of the large-cap indexes and think everything is powering forward. However, if you look below the surface there are definitely some cracks and some areas that are experiencing some natural consolidation.

Even with the uptick in volatility in the last few weeks, we didn’t see a huge dash into safety.  The fixed income space actually remained relatively stable.  The 10-year bond did drop to a yield of around 2.19% but this is only down slightly from the 2.26 we saw to start the month.  Investors may be looking for safety in other areas but the rush into treasures that we have seen during volatile times over the past few years has not happened.

Earnings: By almost all measures this has been a very good quarter.  With just over 90% of the S&P having already reported results, more than 75% have met or beaten their earnings estimates. This adds to our conclusion that the fundamentals of the economy are strong. Companies are performing well and we are seeing them grow both top and bottom-line results. Even without the benefit of new reforms coming out of Washington, the stage is set for continued growth for the remainder of the year. If Washington can actually follow through with some of their promises then we should continue to see robust earnings growth moving forward. My one concern is that valuations have become relatively stretched as we continue to test all-time highs. While earnings results should help temper some of these overbought fears I would not be surprised with a pullback as investors look to book some of these profits.

I spoke briefly last month about the Amazonization of the economy. This has continued to be a major topic in earnings calls and investor days over the past few months.  In the months of May, June and July Amazon was mentioned 635 times on earnings calls or other corporate events.  To put this in perspective, Trump was only mentioned 162 times.  In July alone Amazon was mentioned 165 times to 32 for Trump.[i] We have seen what Amazon has done to the retail space, which had one of its worst quarters in history, and is trying to do in the grocery space.  CEO’s in numerous industries are being forced to address this threat and it seems that Amazon’s impact is far more important than anything coming out of Washington. It will be interesting to see how this story continues to play out but what is certain is that Amazon is forcing companies to examine their businesses from a much different perspective.

Geopolitical Tensions: In previous reports, I have discussed my worry about tail risk events not being properly priced into the markets.  We got a taste of this over the last month. Tensions with North Korea intensified over the course of a few days.  Analysts confirmed some of the country’s missile and nuclear capabilities. This was followed by a public back and forth between Trump and Kim Jong Un.  While previous presidents have chosen not to engage with Un publicly, that is not Trump’s MO. The market reaction was a brief selloff and a spike in volatility.  While this spike was short-lived, it showed how quickly things can turn.

I don’t think we ever were close to a real conflict but North Korea is very unpredictable.  Throw on top of this the unpredictability of our President and a simple conflict could easily escalate.  With market valuations already stretched I expect we will continue to see swift reactions to any potential geopolitical events.  This market seems to be resilient and bounce back quickly from these events but no one wants to be around if one of these such events escalates.

Trump:  The President reached new lows this week from a moral standpoint and we have rightfully seen many politicians and business leaders distance themselves.  The markets reacted with some brief volatility but I think the financial ramifications could be felt for the remainder of his presidency.  The issue at hand had nothing to do with financial or regulatory policy but the President is rapidly alienating members of his own party. This puts in jeopardy many of the policy initiatives on the president’s agenda. Following the election, it seemed that, with control of Congress, many of Trump’s campaign promises would quickly become law. Tax reform, infrastructure spending, regulatory reform all seemed all but guaranteed.  However, as more and more Republicans distance themselves from the president, the timeline for these reforms has become much more clouded.  No one, on either side of the aisle, wants to associate themselves with anything Trump. The end result is the slowing down of an already stagnant congress.

Further complicating the issue, following Trumps recent comments members of his economic and manufacturing councils began stepping down causing the councils to be disbanded.  While these councils have no real authority, they represented the business interests of the country.  They were the “smart” people in the room that Trump would turn to help shape some of his policy initiatives.  The scary part now is that the President is becoming even more of a lone wolf. The financial world was hoping that these councils would be a guiding voice to the president. However, now the president is left to his own devices to shape policy and that hasn’t seemed to work very well so far.

There is a positive side to all of this though.  It seems that the markets have resigned themselves to chaos in Washington being the norm.  There are few expectations of anything groundbreaking getting accomplished.  This has shifted the focus back to companies and their actual performance.  This has proved to be good for the markets.  It seems that the period of uncertainty about what the new administration was going to do following the election has given way to the certainty that nothing is going to get done. Company results and forecasts now become less clouded by what might happen in Washington. While I do think many of Trump’s proposed reforms could be positive for the economy, uncertainty around them was not.

Strategy Commentary

Over the past few weeks, I have reduced my overall equity exposure. Even with a positive earnings season, stretched valuations, rising geopolitical fears and disarray in Washington have added to the overall risks in the markets. Add to this the Feds plan to start reducing their balance sheet over the next few months and reducing exposure seems prudent.  I am not expecting a huge selloff but am happy with the recent performance so I am also comfortable taking some of my chips off the table. The market could very easily keep marching higher but I like to tell my clients: “you can’t lose money taking a profit.”  If the market does pull back or market risks are reduced then I will look to re-enter some of these equity positions.

While I have reduced the size of some of my equity positions, domestically I have maintained my equity allocation.  My shift away from small-caps a few months ago has paid off as large caps have outperformed small-caps by almost 4% over the last month. Technology continues to perform well and I am maintaining that overweight.

We are still maintaining our international exposure as well. Germany has underperformed recently and I will continue to monitor the position very closely moving forward. Emerging markets and other developed international markets still have a strong valuation story compared to the US markets so I continue to maintain those allocations as well.

I am still negative on the fixed-income space.  We have seen a little bit of a rush to safety as volatility has increased over the last week which has pushed rates down but I think on the long run rates will rise. I am maintaining my underweight to the space and again am more comfortable holding cash as a replacement.

[i] https://finance.yahoo.com/news/executives-more-worried-amazon-president-150716489.html

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