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Investment Strategy Update - The Waiting is the Hardest Part

“The waiting is the hardest part
Every day you see one more card
You take it on faith, you take it to the heart
The waiting is the hardest part.” Tom Petty 1981

I would assume that most of you had multiple influences that shaped your musical tastes. Family, friends, and time periods all serve to bring us to a place where we can say what we like and don’t like when it comes to music. I guess those influences for me were so many and so varied that I can honestly say that I like every form of music, except rap. I have a crazily eclectic mix on my iTunes and Spotify accounts. I have seen Van Halen and the New York Philharmonic in concert (not together of course and about 35 years apart). I love Sade and Led Zeppelin and Alan Jackson’s gospel album. See, I told you. Now I’ve given our resident jokester David more reasons to tell people how weird I am!

Tom Petty, who I quoted above and who died recently, wasn’t one of my favorites but he had a few awesome songs. “The Waiting” was one of them, and I use the refrain above as a theme we are seeing in the investment markets this year. What are we waiting for? Well, no one really seems to know. After an incredible year last year with historically low volatility it seemed that we were on a rocket ship for what’s known as a blow-off top. Meaning a straight trajectory up, perhaps 20% or more, followed by a painful correction. January gave some of the blow-off top proponents a sense that it was really happening. Then, boom, the market fell 10% really fast and is still, as of today, down over 5% from the top reached over three months ago. So what gives?

Since the January correction, a lot of market pundits thought the markets were waiting to see what would happen when the ten-year treasury bill crossed over the 3% yield mark. And many of them expected there to be negative consequences. But now that we’ve danced around that level closing above and below it, we are now sort of “been there, done that, where’s my tee shirt?” Perhaps the recent inching back up in our domestic stock markets is because the negative consequences predicted haven’t materialized so people are looking for what’s next.

“Every day you see one more card”

Every day since the correction back in January, the cards being turned over are mostly positive. Earnings growth, one of the main things stock prices should be driven by, has been nothing short of incredible this late in an economic cycle. At the end of the first quarter, the consensus anticipated year over year growth rate in S&P 500 earnings was almost 23%. Let that sink in for a second. Large American companies now growing 23% per year! From 2012 through 2016 there was NO consensus that earnings would grow above 8%, and now we are over 20%. The market should be screaming right now, right? Well, maybe but not necessarily. The “maybe” would be historically , the “not necessarily” is given the proper context. What I mean by that is when the markets are priced at reasonable valuation levels then 23% earnings growth should make stocks go much higher. However, we aren’t in a time of reasonable valuations. Using the Shiller P/E, a long-term inflation-adjusted measurement of the markets’ health, we have been in an extended period of above average to way, way above average valuations. The long-term average of the Shiller P/E is 16. As of the end of April, the index stood at the whopping sum of 31. The peak in the index prior to the financial crisis? It hit 27 a few times in 2007.Oh and by the way, it went over 30 only two months leading up to the market crash and Great Depression in 1929. I guess we can at least take some solace that we are below the all-time high of 44 in December of 1999. Despite the market getting creamed after that, it wasn’t until November of2008 that the index even touched its historical average of 16. It went to 13 in March of 2009 (when much of the financial sector still appeared it could be heading off a cliff) and has been steadily rising since then. So the “not necessarily” helps us understand that markets sometimes do act as they should. But in this case it’s only in the short-term, so what about looking out further?

“You take it on faith, you take it to the heart”

The faith that investors take “it” on is that the markets go up over longer periods of time. Over really long periods of time, you take it to the heart and to the bank. But there have been several periods where the return of the U.S. stock market over ten years has been a big fat zero. Or less. And, if history is a reasonable guide, at the levels of the Shiller P/E currently, the long-term forward-looking returns for stocks do not look great.

The reason that matters is that some of you reading this commentary have retired or will be retiring soon. The sequence of returns for people like you is significant. If I have ten years, well actually eleven as scary as thatsounds, before I turn 65, then my sequence of returns over the next ten years isn’t as important. Now for some folks, who can afford a withdrawal rate of say less than 3%, even if you are retiring soon the sequence of returns isn’t as important either. But many people retire and immediately begin to withdraw funds to live on and those withdrawal rates exceed 3, 4 or even 5% or more. Those are the types of people we are concerned about. Especially the ones like that who don’t work with us and have a very traditional portfolio that is heavily invested in stocks. Over the last fiveyears money has flooded into index-based products like ETF’s. We are concerned that in the next significant market downturn, especially if it comes sooner than later, many people like that will have their retirement lifestyle negatively impacted. Unable to stomach the rollercoaster ride of a bear market, many people will make the call and get some or all of their life savings out of the market. This will alter the amount of funds available to live on for the rest of their lives.

What I just said above is, I believe, extremely important for you and others to know. But it doesn’t mean I think something bad or really bad is getting ready to happen. No, in fact, despite the market being barely positive for the year, I still believe what I said back in a February commentary. And that was, “overall, we remain hopeful that 2018 will be a good year for the markets and our clients.” I also said, “Yet we do see rising risks and don’t think we will have another year like 2017.” You may say “duh” to that last sentence but do remember we have over seven months left in this year! The reason for the earlier pronouncement was simply to remind you (and myself) that reasonable expectations are required to be good investors. As much as I would love to see the market average 10% per year for the next decade, I just don’t think it will happen. It would truly be a “this time is different” market, and having confidence in that can have dire consequences! A multitude of reasons including rising rates, an economic cycle that will ultimately adjust and include a recession which always negatively impacts earnings growth and the stock market, geopolitical concerns that cause instability and uncertainty, and a debt load that hasn’t been addressed will make the next decade of returns a struggle to repeat the past ten years and historical averages. I like asking people in our business responsible for other peoples’ money what keeps them up at night. For me, it would be an environment where both stocks and bonds are out of favor. We’ve been talking about this for several years, and I earnestly hope we aren’t heading there sooner than later.

“The Waiting is the Hardest Part”

Ok, so with that said, now what? Tom Petty was right that in this moment the waiting is the hardest part. Sure, you can find bulls and bears at any point in market cycles. But right now is a bit different. I told a group this week that if I went on CNBC or Fox Business and said that despite some great earnings reports and a strong economy, things are a bit murky right now and I see the market muddling along while waiting for some clarity on other things, I probably wouldn’t be asked back. They want the shock factor and right now I’m not the guy to bring it. I’ll leave the pontificating and predicting to others and simply suggest you turn off the TV, go outside and enjoy the nice weather. I don’t look for entertainment value when it comes to managing peoples life savings, and I trust you don’t either.

Our Investment Committee held its quarterly meeting recently and decided not to make any changes to our strategies at this time. While that meeting is scheduled for three hours, this last one lasted six. Why? One reason was that during the meeting we participated in a conference call that HighTower arranged with a top Macro strategist (who by the way is quite bearish). While we always drill through a lot of layers before we make decisions about our client portfolios, with so much uncertainty the drilling took a lot longer this quarter. We debated a couple managers that aren’t meeting our expectations so far this year, but after several hours we conclude that our expectations weren’t completely reasonable. An example of that is multi-asset income funds. We initiated small allocations to two managers not that long ago. The premise is that as interest rates rise the effect on longer-term bonds will be negative. That part is true and has started to play out, as the Barclays Aggregate bond index is negative this year. However, the diversified income funds haven’t benefitted (yet) because some areas of the market where they go for yield have simply not done well, like energy transfer companies. Other higher dividend companies have also struggled despite this being, in our opinion, a good environment for strong dividend payers.

We also looked at our exposure to floating rate loans (which in the right environment don’t go down in value as interest rates rise), as some pundits are nervous that increasing interest rates will overwhelm some of the lower rated companies that have floating rate loans on their books and cause a wave of defaults. We talked through that extensively and concluded that while that may be true, it’s a bit early to get out of this area that is serving us well right now and because our exposure is fairly limited.

On the equity side, we reviewed our real estate exposure as it has underperformed our expectations. Last year we exited traditional tradedreits (real estate investment trusts), including a low-cost ETF, because of multiple concerns. That has served us well because the manager we switched to has an impressive track record and invests primarily in “new economy” real estate like data centers, cell towers, etc. However, the fund is down for the year and we don’t want this fund to be “guilty by association” with its more mainstream peers. But we decided to wait and see how this plays out because we want to see if a growing economy and an uptick in inflation will allow the companies in the portfolio to grow their earnings at a faster rate than other areas of the market.

So far, our increased weighting in international markets has gone well for us. The timing of the changes we made back in January and February wasn’t the best, but our overall premise of the possibility of an extended period of outperformance overseas versus domestically seems to be on track. But that is a theme that we will have to monitor and wait (and yes it could be the hardest part) for several years.

The Search, Boston, and Half Time

We are constantly looking at our existing managers and searching for ways to participate more in the upside and protect on the downside. Our affiliation with HighTower gives us more tools to consider, and we are actively looking at strategies that they offer from heavily vetted third-party managers. We also do a ton of due diligence on our own. We meet and speak with portfolio managers frequently, both here at our office and sometimes their offices. Other ways include conferences where managers speak, and ones like David is attending in Boston this week. We call it “speed dating for managers.” David will meet with 15-20 managers over a day and a half. He drinks through a fire hose better than I do so I let him go and bring back the two or three best ideas and we start due diligence on them. Sometimes, after months or even years, that ends up with a manager being added to our roster. However, most eventually get eliminated as they don’t make it through our process. Managing the life savings of our clients and families is just that important.

If you are still reading this and don’t work with us a) I’m flattered and b) we want to let you know that we would like the opportunity to meet with you to see if we can add value to your situation. One way may simply be to point out areas where you might be taking unnecessary or unknown risks with your wealth. Other ways include the many services we provide our clients who hire us to be their personal CFO. It’s a role we love to serve for those who work with us.

Finally, I want to encourage all of you to attend our Half Time event this year. We’ve moved it up a bit this year to July 26th since much of my August will be spent getting my youngest daughter Sarah English ready for her freshman year at Samford University in Birmingham. And that’s after she spends ten weeks as a camp counselor this summer! I can’t believe our third bird (of four) is leaving the nest. You will be hearing more about Half Time soon. I hope to see you there!

Stephen C. Coggins
Chief Investment Officer

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IronGate Partners is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

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