Q4 Note & Commentary

By Jason Lesh, Managing Principal


I hope the holidays treated you and your loved ones well. It is always a busy time for me what with family commitments and closing out the year but I always appreciate the opportunity to pause and reflect on the past year and look forward.

Brief Overview of Last Year and 2018:

2017 was a great year for our portfolios. And while the rising tide should hopefully raise all boats, we feel exceptionally proud of what we owned last year and where returns came from.

But change is on the horizon and an evolution is beginning in the portfolio that we are both excited about and preparing for. Jeremy Grantham, the co-founder of GMO, highlights this change that Nick will dive into much deeper in his report:

“Be as brave as you can on the EM (emerging markets) front. Be willing to cash in some career risk units. Bravery counts for so much more when there are very few good or even decent alternatives.”

We are preparing our portfolios to respond well whether we continue to muddle along or see inflation rise quicker than most are forecasting. Read more in Nick’s quarterly commentary.

I can confidently say that I am proud of our job managing risk and reward while also being thankful for the clients we work for. I sleep well at night knowing their investments are well positioned to continue to grow while preparing for a potential change in the markets.

Here’s to a happy, healthy and prosperous 2018.

Warmest regards,

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Jason Lesh




Quarterly Commentary

By Nick Fisher, Portfolio Manager

As you are aware of, we have not constructed  “conventional portfolios". Because these are definitely not conventional times. The purpose of this is not to beat the market this quarter or next, but to provide you with the best after-tax, risk-adjusted returns over the next many years.

Joe Granville, a market technician of many years ago was famous for saying about markets, “What’s obvious, is obviously wrong.” Jeff Gundlach, one of our bond managers, has modified this statement saying, “What’s obvious about markets, is obviously priced in.” So what’s obvious about markets currently?

  1. Synchronized global growth
  2. Tax Reform
  3. Low Inflation
  4. Steady moderation of monetary policy
  5. Strong price momentum in stock markets

All signs point to a goldilocks scenario! Not too hot and not too cold…and it’s obviously priced into markets.

Upside from investing in this environment is limited (at least in US stocks and likely bonds too). When expectations are so high, any unexpected event is likely to surprise to the downside: inflation above expectations is an example that we are keeping our eye on.

To review, we have always thought that a dual approach of taking risk on one side and being very cautious on the other side was warranted. This has produced fantastic risk-adjusted returns over the last 2 years. As the mathematician, Thomas Bayes suggested in his mathematical theorem some 300 years ago, when additional information becomes available we must adjust our scenarios of probability. Most investors consistently miss the mark on this basic necessity.

The possibility of inflation and interest rates (above expectations) is a higher probability event than most investors believe. As a result, we are reducing cash in favor of assets that will be safer in an inflationary environment; namely, commodities and emerging markets.

Tax Reform

Undoubtedly the values of US stocks have been impacted by tax reform. It would not be a stretch to say that an enormous amount of the benefit of recent stock market gains is a result of recent tax legislation. Consider that under the previous law the, the US Government had a 35% claim on all profits of US corporations, leaving 65% to shareholders. With a 14% decline in the US Governments claim (35% rate down to 21%), the value of private shareholders claim on profits has increased by 21% (from 65% to 79%). As of the time of this writing large cap stocks have increased in value by approximately 21%. In other words a one-time event is responsible for much of the recent gains. If this is true, where will future stock market returns come from?

Asset Class Forecasts

The US Stock market is currently very expensive. According to a recent Bloomberg report, for every dollar invested you get a mere 4 cents in earnings and 43 cents in sales. This represents the second lowest value in history. Contrasted with the fact that emerging market stocks get 50% more earnings for every dollar invested. Furthermore, risk-free Treasury bond yields are approaching a yield similar to the dividend yield of the S&P 500. It would seem that the alternatives to US stocks are much more attractive in general.


We have previously discussed commodities and commodity producers as an often-overlooked asset class. As this late cycle investment environment plays out with potentially higher inflation, I wanted to emphasize again the benefit of having exposure to commodities.

For diversification purposes, commodities prices can move significantly different than stocks. The chart below shows the relative return of commodities (represented by the Goldman Sachs Commodity Index) compared to the S&P 500. Presently, the commodities index returns are sitting at a relative low, making commodities fairly attractive.

equities vs commodities gundlach.jpg

At this late stage in the economic cycle, commodities typically perform quite well and are highly correlated with interest rates. The notion of higher interest rates bringing an end to most recessions is sound, but a better explanation likely exists. That is to say, higher prices (commodities) bring about higher interest rates by central banks in an attempt to hold down inflation. Therefore, commodities are likely a leading indicator and may be the best hedge against inflation as the cause and effect relationship becomes clear. The chart below shows the late cycle relationship with commodity prices and recession. Notice how well commodities perform and may actually be the cause (as mentioned above) of the recession.

commodity prices vs recessions.jpg

Emerging Markets

A repeating theme we have touched on is the potential for emerging markets. With global growth due to changing demographics and a burgeoning middle class, as well as relative valuations, emerging market stocks may be the most unique asset class due to their prospective all-scenario performance. In other words, whether we see high inflation, high growth or low inflation, low growth or somewhere in between, emerging market stocks are likely to do much better over the long-term than US stocks. The biggest reason is that they are simply a lot cheaper.

Below is GMO’s forecast for asset classes. Their forecast takes into consideration both growth and valuation with a healthy respect for risk management. The returns are net of inflation or “real” returns. To get what we commonly refer to as returns (“nominal” returns), simply add back inflation of 2-3%.

global real return.jpg

According to GMO, emerging market value will likely earn between an 8.7-9.7% nominal return. With such low prospective returns in US stocks, it is our belief that the greatest risk in the market is the distinct possibility that investors don’t achieve their investment return goals. The conventional 60% stocks and 40% bond portfolio (60/40) has an incredibly low probability of success. And, if we were allocating money conventionally and earning near zero returns for 5, 6 or 7 years, you would want to find a new advisor (as you should).

With emerging market stocks (especially value) one of the few areas offering a respectable return, it should be no wonder why we have been allocating more capital toward them. With the inevitable volatility associated with emerging market stocks (typically around 20%) we will likely take advantage of pullbacks when they happen.

Knowing all of this, how much exposure can you take in an individual asset class (especially one that can be volatile)? This is the question we are forced to ask ourselves when allocating the long-term portion of our portfolios. In an environment where conventional wisdom is almost certain to fail, how brave can we be?

Best regards,

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Nick Fisher