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Bogue Asset Management’s Quarterly Investment Letter In this quarters commentary, I discuss why the performance in US stocks is unsustainable and better valuations and opportunity exist in emerging market stocks..........[See More]


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Third Quarter 2018 Key Takeaways


Larger-cap US stocks hit new highs in late September and gained 7.7% for the quarter, while smaller-cap US stocks gained 3.6%. S&P 500 operating earnings per share grew 27% year over year in the quarter—compared to their 6% long-term annualized growth rate. A record high 80% of S&P 500 companies reported earnings that beat the consensus expectations. Record levels of share buybacks (estimated by Goldman Sachs to reach $1 trillion for 2018) were another pillar of support for the US market. 


Developed international stocks gained just 1.2% in the quarter, while emerging-market stocks (EM) fell 1.7%. Foreign stock markets were impacted by poor sentiment, and a rising US dollar was a further drag on returns for dollar-based investors.


In fixed-income markets, the 10-year Treasury yield rose to 3.05% at the end of September, flirting with a seven-year high. Consequently, the core investment-grade bond index had a negative return in September and was flat for the quarter. 


Credit-sensitive segments, on the other hand, performed well, with floating-rate loans gaining 1.87% for the quarter. This was good news for balanced (stock/bond) portfolios, as my tactical allocation to floating-rate loans has returned over 4.2% for the year compared to a nearly 2% loss for core bonds (from which they are largely funded).


Active bond managers have also outperformed the core bond index for the year. I expect these positions to outperform over the next several years as well, particularly as interest rates continue to rise. The Federal Reserve has raised rates three times so far this year with a fourth teed up for December. Policymaker forecasts call for three more increases in 2019.


Balanced portfolios also continue to hold liquid alternative strategies funds that I believe improve long-term risk-adjusted return potential. Lower-risk arbitrage strategy funds were flat, in line with core bonds and outperforming foreign stocks but trailing US stocks. My position in a diversified basket of trend-following managed futures funds had a small positive return for the quarter.


In 2018, US stocks have strongly outperformed EM stocks, but this level of divergence is not unusual. Still, given the negative headlines surrounding emerging markets, I highlight several points this quarter that indicate EM stocks remain attractive and their long-term growth outlook is intact. On the other hand, US stocks look expensive, and there are reasons to think the near- and medium-term outlook for them is not so rosy. The overvaluation of the US stock market represents one of the biggest risks to portfolios, which is why I maintain a meaningful underweight to US stocks.

Third Quarter 2018 Investment Commentary


Market Recap

Market trends in the third quarter were largely an extension of what we have seen so far this year, with a stark divergence in return between US stocks and EM stocks. The US market was propelled by continued strong profit growth, thanks in large part to the Trump corporate tax cuts, beating emerging markets by roughly 20 percentage points year to date through the end of September. 


This level of divergence in relative performance is not unusual. It is common for US


 stocks or EM stocks to outperform the other over 12-month periods as shown in the chart to the right. Just last year, EM stocks gained 31.5% and outperformed the S&P 500 by roughly 10 percentage points. That has sharply reversed this year. 


Reiterating My Outlook for EM and US Stocks



While there are always multiple factors behind short-term market moves, there were two dominant headwinds facing EM stocks in the third quarter: the intensifying trade conflict between the United States and China, and the strength of the US dollar. While neither of these factors presents new or material threats to my analysis of EM stocks, they have impacted short-term returns given the magnitude by which they have lagged US stocks so far this year. 


However, there are several points worth highlighting that give me confidence in my assessment that EM stock valuations are cheap and their attractive long-term return potential remains intact: 


* My base-case continues to be that a full-fledged trade war is unlikely as it is in neither countrys best interest, despite the fact that we may be living in a world with an overhang of trade tensions for a while. It is also not clear US stocks would be less impacted than EM stocks given the formers global presence.

* US dollar strength has hurt dollar-based foreign stock returns, but longer term, there are reasons to think this will reverse. I believe the fiscal stimulus of tax cuts at a time when the US economy is strong will cause fiscal deficits and debt levels to rise—both potential headwinds for the US dollar. 

* Economic crises in Argentina and Turkey have made headlines, but these countries economies and financial markets are small. I see little risk of contagion to other emerging markets. In contrast to previous EM crises, the fundamentals of most other EM countries are much healthier in terms of debt levels, trade balances, dependence on foreign capital, foreign exchange reserves, etc.

* Within my normalized-earnings framework, I apply the historical discount EM stocks have traded at compared to US stocks and they are still attractive. EM stocks are even attractive after adjusting for sector differences between US and EM markets.



As for US stocks, no one knows exactly when this confounding, record-longest US bull market will end. Despite their unattractive fundamentals, it is certainly possible US stocks will continue to be favored by investors over the short term. However, S&P earnings growth expectations are now exceedingly high, and the US economy is operating at or near full capacity and full employment. These are unsustainable conditions, and the direction in which they will move next is likely negative for stocks. 


My tactical underweight to US stocks is based on conclusions drawn from my fundamental research on historical stock market valuations, earnings growth, and corporate profit margins. From current price levels, my base-case expectations for US stock returns over the next five years are nearly zero percent. To put these estimates in historical context, since 1950, the S&P 500 has generated an 11.1% average annual five-year (60-month) return. 


No matter how I slice it, my analysis suggests the US market is the most expensive major stock market in the world. As a result, it presents one of the biggest risks to portfolios. This is why I have diversified stock exposure by investing in foreign markets that, in contrast, look significantly cheaper and offer a much stronger medium- to longer-term growth outlook. But these positions come with additional shorter-term risk, as we have seen so far this year. 


Outside of traditional markets, I have added lower-risk alternative investments to portfolios for their risk management and portfolio diversification benefits. I expect them to shine when US stocks experience their inevitable periods of poor returns. I think these strategies can generate annual returns that are attractive relative to what I currently expect from a comparable mix of stocks and core bonds.  


In Closing

I strongly believe that a key element of my investment process and edge is my discipline in maintaining a multiyear perspective rather than over-reacting to short-term price volatility, performance swings, daily news flow, and other behavioral triggers. It is easier said than done, though, especially amidst an unprecedented stock market run and a seemingly unending string of unnerving geopolitical headlines. Rest assured, I remain ever-vigilant in analyzing new data and information, and if my analysis warrants a change in my views or portfolio allocations, I will act. 


Thank you for your continued confidence and trust. 

—Jeff  (10/09/18)


Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Bogue Asset Management LLC with permission.  Reproduction or distribution of this material is prohibited and all rights are reserved.