09 Jul Q2 2019 Market Commentary
Director of Investments Todd Jones, MBA, CAIA®, weighs in on the current financial environment, critical market trends to watch, and what it all means going forward.
Here’s what Todd is talking about this quarter:
How the US equity market has unfolded since Q1 and what that could mean going forward;
Distinguishing between the “noise” and the “true signals” coming from equity and bond markets;
Asset price volatility provides opportunities to rebalance account strategies;
The prudent course of action needed now to prepare for more challenging times ahead.
Please Fasten Your Seatbelts. Turbulence Ahead.
In our Q1 Market Commentary (available here), we advised that the US equity market would be range-bound, barring a resolution to the ongoing trade dispute between the US and China. This chart demonstrates our Q1 thinking, as this has unfolded for the reasons we identified in our previous Market Commentary, with air pockets becoming more frequent.
Cutting Through the Noise
Currently, there seems to be more “noise” in equity and bond markets than at any time since the financial crisis. There are no shortage of opinions, from the Federal Reserve issuing observations on US economic activity to the US President espousing his beliefs related to the economy and capital markets on TV and Twitter. Given this environment, as an investment firm, we spend a lot of time trying to distinguish what is a true signal and what is noise. Depending on which one (signal or noise) influences your investment process, outcomes can be very different.
On one side of the spectrum is the “noise” (or the short-term). The Gratus investment team does not place a heavy emphasis on short-term price movements or low probability event risk, as the short-term can change rapidly. Given that the short-term can change so quickly, few investment firms can benefit from trying to predict these changes. We believe, however, that our effort should be spent trying to identify short-term changes that could have (potential) long-term impact. After all, the long-term trend is really just the summation of multiple short-term periods.
On the other side of the spectrum is the “signal,” which is defined as the longer-term (5-10 years) trend in a market or economy. This longer-term trend acts as the guidance from which we can formulate relative valuation assessments for all asset categories, including stocks, bonds, and real estate. Since this perspective is viewed in years, it can take time for the long-term trend to change. Gratus Capital has utilized a long-term approach in our investment process and philosophy since the company’s earliest days.
What are the signals telling us today? The signals we continue to receive remain consistent to those in 2018: low (yet stable) global growth, a maturing business cycle in most developed markets, and slightly elevated valuations across many risk assets.
Our translation of these signals is: (1) the environment for equities remains supportive; and (2) yields on bonds (particularly those in the US) could grind lower.
Rebalancing Where Needed
While the signals remain consistent, this does not mean that asset prices have avoided volatility. In fact, total price movement of the S&P 500 from April 1st to June 30th was 17.41% (April, +4.05%; May, -6.35%; June, +7.01%). Furthermore, movement within asset class categories was divergent in the second quarter (US versus International, Large versus Small), providing opportunities to rebalance account strategies.
Proven to be valuable over time, rebalancing as a portfolio management strategy is a contrarian process that attempts to take advantage of this portfolio performance variance. While we do receive client questions as to why we are reducing positions within the portfolio that are outperforming other positions (in this case, equities), it is important to remember that the process of rebalancing an account can add ~0.35% annually to an account return, according to a recent study by Vanguard.
We believe now is the time to rebalance. Given this information, the potential for sudden changes in volatility grows greater as bond yields move lower, due to stock prices’s sensitivity to interest rates. Clients should expect more frequent price volatility, similar to that seen in December 2018 and May 2019.
 Source: Morningstar
Increasing Cash/Cash Equivalent Holdings
As part of the rebalancing process mentioned above, we would highlight our intention to simultaneously increase our cash equivalent level. In essence, we’ll be modestly trimming select equity holdings and adding to cash positions. Why are we doing this now? The simple way to answer this question is to use the analogy of a tower grain silo.
In ancient times, agrarian societies constructed their social order around a reliance on farming in order to make a living and survive day-to-day life. Most farming was undertaken on a small scale. As such, small farmers would plant in the spring, harvest in late summer, and store in the fall. In the winter months, families would survive by drawing out grain from the silo, until they could plant anew.
From 2009 until today, Gratus has been gradually drawing out grain (cash) from our tower silo as investment opportunities have arisen. We were drawing down cash levels to take advantage of opportunities in equities, fixed income, or private investments. We believe the prudent course of action now is to begin refilling the silo (cash) in preparation for more challenging times ahead.
Using this strategy, it’s important to note that we are not sacrificing a significant amount of potential return in a cash equivalent versus a fixed income position. Since the shape of the yield curve is relatively flat, short-term yields are not meaningfully different from long-term yields, which earns a respectable return in our cash equivalent holdings while waiting for new investment opportunities. When opportunities finally arise (e.g. lower prices), we’ll be ready to act, and we won’t have to sell one investment to fund another.
The Gratus global position is to continue to remain invested in our equity holdings in-line with long-term portfolio targets. Longer-term economic “signals” provide supportive conditions for equities, while the movement in bond yields provides less potential for price appreciation. Valuations in equities prevent any aggressive positioning in this segment, but leave us positive on our holdings.
While rebalancing accounts may seem counterintuitive to the comments above, we believe that trimming back equity positions and adding to our cash holdings will give our client portfolios better optionality when the next downturn in markets inevitably arrives.
 The phrase “flat yield curve” refers to the occurrence in the bond market where short-term interest rates are equal in yield to long-term interest rates.
Todd Jones, MBA, CAIA®
Gratus Capital is an SEC-registered investment adviser. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of April 2019 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. Examples provided are based on current market conditions, and there is no guarantee that any applicable condition will remain in place. Portfolio holdings are subject to change at any time and may differ materially in the future from case studies presented. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.