Capital Formation Group, Inc.

3rd Quarter 2018 Market Commentary

“We live in a rainbow of chaos.”

- Paul Cézanne (1839-1906); French artist

Everything Works Until It Doesn’t

October 2018 is a perfect example of one of my father’s favorite sayings, echoed poignantly and pointedly through the years by an old investing partner, and oft-repeated in this space: Everything works until it doesn’t. I had a client meeting at the end of September and the closing question was, “Do we own enough Amazon?” I mean, I didn’t take offense, it was a good question. Do you realize the trailing 10-year annualized return for Amazon (ticker: AMZN) as of October 31, 2018 was +39.50%? Again, that’s per year. I’ve pointed out many times in the past that Amazon, Apple, et al., have been the powers behind the amazing performance of the S&P 500 since the lows of March 2009. The technology sector has been the driving force of both the S&P 500 and the growth investing style for a decade. But, again, everything works until it doesn’t.  In October of 2018 Amazon returned (-)20.22%, with the S&P 500 down (-)6.84%. Would this client, or any client, be willing to accept a month like October in exchange for the previous ten years’ worth of return? Of course, who wouldn’t? But now that we’re here I can’t guarantee those ten years will happen again. Lots of stocks have amazing near-decade runs and then fall off. Southwestern Energy (ticker: SWN) had an annualized return of +48.48%, which translated to a cumulative return of +5,108%, in the ‘00’s decade. Now? The trailing 10-year annualized return of Southwestern as of October 31st was (-)17.28%. Again, to emphasize, that’s per year. That’s not to say Amazon is Southwestern, an exploration and production natural gas company that hasn’t been run particularly well and ran into a natural gas glut. I don’t believe for one second Amazon reverses course and becomes Sears in the next ten years. I’m merely pointing out that finance has cycles, and great companies don’t always make for great stocks. Hence, my response to the client on our Amazon weighting was simply that: The principles of diversification of our investment program are defined by not chasing performance with all your money and having pockets of the portfolio that lie fallow but will help when market cycles turn. Keep in mind, I didn’t really say that. I wish I had that been eloquent in person, off the cuff, but you get the gist.

So, some of our areas of research that appear less sexy in the good times managed to work well last month. The consumer staples sector exchange traded fund (ticker: XLP) that we’ve owned for a while was positive at +2.00% for the month. Our value investments, coming off nearly a decade of disappointment in the shadow of their growth counterparts, outperformed, albeit still to the downside. Our short-term fixed income investments, much maligned and worried over as they stare into the teeth of a Federal Reserve hell bent on raising rates, all managed to eke out a positive month. It’s not that we didn’t have negatives in our portfolios in October. We did. But, we avoided the worst of the downdraft by sidestepping the most crowded and overbought sections of the market, like technology. The technology sector exchange traded fund we most commonly track (ticker: XLK) was off (-)8.00% for the month. We’ll address other asset classes below, but this kind of rotation into unloved market areas when investors flee the “hot stocks” is precisely why we have the portfolios set up as they are.

The Economy: Real Gross Domestic Product quarter-on-quarter growth appears to be positive but still decelerating in the United States. The 2nd quarter came in at +4.2%, and the Bureau of Economic Analysis advance estimate for the 3rd quarter is +3.5%. Historically, the 4th quarter of a given year is lower than the 3rd, so no matter how you spin it there is a decelerating pattern for the overall economy to close the year. Optimists may say that the lower 3rd quarter growth reflects a downturn in exports that may be more a function of the current administration’s combative trade policies which are hopefully temporary in nature. Also, even though the 3rd quarter declined, those middle eight months for 2018 would mark the best two-quarter stretch in four years. On the employment front, pay and benefits both bumped up for the quarter, perhaps a sign that low unemployment is beginning to stoke some wage inflation. Although inflation certainly has some negative effects, a hike in wages would be a welcome change for many workers that have not seen salaries noticeably move in a decade.

Large Cap Equities: As mentioned, a rough month for the S&P 500, down (-)6.84% in October. This is particularly head-snapping as it followed a 3rd quarter that saw a +7.71% return, and not a single sector in the index posting a negative performance. Additionally, during the 3rd quarter, we had zero (0) +/-1% moves in a single day, contrasted by 23 such moves in the 1st quarter alone. Overall, it was the worst month for domestic large companies since September 2011’s (-)7.03% wipeout. At one point, the difficult frame eliminated all gains for the year but a relief rally at the end of the month brought the year-to-date total for the index back up to +3.01%. It’s only the third negative month for the index this year, but all the down months have been sharp and particularly volatile on an intra-day basis. Rising rates and an increasingly murky geopolitical backdrop would seem to be obvious culprits for increased volatility. I also believe that investors are increasingly looking for reasons to buy risk assets, as opposed to selling them, as the bull market has reached historic proportions in length and strength, and a natural breathing period would seem to be required by common sense at some point.

Small Cap Equities: The small company U.S. Russell 2000 index did not escape the carnage last month. The small company tracker returned a brutal (-)10.86% in October. Much like the big caps, this followed a positive 3rd quarter performance of +3.58%. The Russell 2000 has also had three negative months this year, all sharply negative, although not to the same extent as October. Last month managed to wipe out all gains to put the index at a (-)0.60% deficit year-to-date through the 31st.

International Developed Equities: All things being equal, the general rule of international investing is you want the currencies of the countries you’re investing in to appreciate against your home currency. The opposite has happened all year as the dollar has notably appreciated against a basket of global currencies. The pain this has caused, coupled with a global sell-off of risk assets, is plainly seen in the developed market MSCI EAFE index. The EAFE was off (-)7.96% in October, booking it’s fifth negative month this year. This was after a positive 3rd quarter that saw the index tally a +1.36% return. Year-to-date, the index is off (-)9.28% through the end of October, a complete reversal of two straight years of positive gains for stocks in developed countries. The sell-off was indiscriminate, but it did leave us with a potentially interesting opportunity set in Japan, where earnings remain strong, the market remains relatively inexpensive, and the economy continues to heal. We will look for an opportunity to add to our extant Japanese holdings.

Emerging Market Equities: To little surprise, the MSCI Emerging Markets index couldn’t escape the month without damage. Dollar strength, the developing Chinese trade war, and the general risk-off environment sent the index tumbling (-)8.71%. It was the sixth negative month out of ten for the year for the emerging countries and has turned around what was a tremendous two-year return. The 3rd quarter was similarly negative with the index posting a (-)1.09% number. Year-to-date through October the index finished down (-)15.72% and now posts a (-)12.52% trailing twelve-month number. The strong two years at least brought trailing ten-year numbers into firmly positive territory. Brazil’s election of an autocratic strong man during the last month gave a boost to markets hoping he could curb corruption and the regulatory morass of Brazilian business.

Fixed Income: With the Federal Reserve doggedly sticking to their plan to normalize interest rates, despite Presidential opprobrium, the Bloomberg Barclays US Aggregate bond index did not prove to be an absolute haven during October. The index returned (-)0.79%, posting it’s sixth negative month this year, a very neat and interesting parallel to the performance of emerging market equities and commodities. Year-to-date, the index is off (-)2.38% through October, although the 3rd quarter was slightly positive at +0.02%. Again, this isn’t a shock; the Fed has been clear and consistent in the desire to raise a historically low nominal interest rate environment that translates to negative real rates with budding inflationary concerns. Budget deficits are ballooning instead of shrinking during a revived economy, and we are bringing more and more debt to auction that the world’s investors may at some point lack an appetite for. It is important to remember during this budding trade war with China that the single largest external holder of United States debt is…China. They need our consumers, we need their money. The ultimate solution to this pointless row, and the reason I believe it eventually gets swept away quietly, is that both countries need each other. Badly.

As always, thank you for your continued belief in our investment strategy at Ingalls & Snyder. If there are questions, comments or concerns please contact me at Ingalls, or any member of the Capital Formation Group family.

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