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Market Commentary — 3rd Quarter 2017

In a very similar fashion to 2017 as a whole, the third quarter continues to chronicle a tale of two cities. On Wall Street, the celebrated prospect of real tax reform, growing earnings, and a favorable regulatory framework sent both large- and small-cap stocks to record highs. Meanwhile, out on Main Street, a hopeless sense of divisiveness amongst social classes and racial groups has dominated the narrative. Presidential tweets and kneeling football players serve as the fodder driving this message forward. We believe that equity markets accurately reflect the promise of continued economic expansion, and we hope that the societal divisions we continue to hear about will soften over time.

Moreover, two major hurricanes on the East Coast and rampant wildfires out here in the west failed to stall equity markets during the quarter. In fact, the S&P 500 continued its upward march to close at an all-time high of 2,519 after breaching 2,500 for the first time in September. With a quarterly gain of 4.5%, the S&P 500 is now up 14.2% in 2017. Meanwhile, the Dow Jones and the Russell 2000 both outperformed the S&P 500 with each gaining 5.6%. For the year, the two indices are up 15.5% and 10.9%, respectively. Although the S&P 500 continues to post large gains, a disproportionate source of the outperformance is coming from a relatively narrow group of companies in a few sectors such as technology. As the economy continues to push forward, we expect the equity rally to broaden across a wider group of industries. Simultaneously, in response to a weakening dollar, increased inflation expectations, and a Federal Reserve that is likely to increase rates later this year, bond yields jumped during the quarter as the ten-year treasury yield touched a recent high of 2.36%. We expect this to continue as economic growth accelerates and increased wages begin to push inflation expectations modestly higher.

Although the S&P 500 continues to post large gains, a disproportionate source of the outperformance is coming from a relatively narrow group of companies in a few sectors such as technology. As the economy continues to push forward, we expect the equity rally to broaden across a wider group of industries. Simultaneously, in response to a weakening dollar, increased inflation expectations, and a Federal Reserve that is likely to increase rates later this year, bond yields jumped during the quarter as the ten-year treasury yield touched a recent high of 2.36%. We expect this to continue as economic growth accelerates and increased wages begin to push inflation expectations modestly higher.

Clearly, the largest macro factor driving equity valuations since the presidential election late last year was the promise of meaningful tax reform. The prospect of this becoming a reality was bolstered this quarter with the release of the plan outline from the Trump administration and the congressional Republican leadership. If implemented as described, after-tax corporate earnings would increase by an estimated 10% in 2018, and the proposed increased individual deduction as well as a flatter tax rate schedule would likely have the effect of creating a substantial wage increase to middle-income earners. Of course, all of these provisions are subject to debate, and despite all the doubt coming from many news services, we believe that most of the major reforms will ultimately be implemented. As we have stated in the past, we tend to focus on market-based indicators as a more accurate forecasting tool than statements made by the pundits in the media.

While current equity valuations remain somewhat elevated by historical measures, we continue to remain constructive on the near- and medium-term outlook. A key tenet contributing to our sanguine outlook is our belief that tax reform will be passed into law late this year or early next year, but several other developments bode well for future economic growth. Firstly, regulatory reform is reducing the compliance costs for many industries. This effect is particularly acute in small and mid-size companies that are disproportionately burdened by the cost of excessive regulations. We see this manifesting itself in the consumer and business confidence numbers that continue to improve to multi-year highs. For the first time in several years, business owners are increasingly allocating capital towards additional capacity and expansion as opposed to managing costs and regulatory compliance.

This optimism is leading to improved hiring trends, which is helping to boost economic growth toward 3% from the anemic 1.5% to 2% that we have witnessed over the past several years. In addition, we are also starting to see some wage growth, further bolstering our constructive outlook. While damage and delays from the hurricanes may temporarily stunt third quarter GDP growth, we believe that the trend is clearly positive and we expect this to improve if tax reform is actually passed.

With elevated market valuations, however, we are cognizant of increased downside risks and the potential for sharp sell-offs. High valuations alone, however, are rarely cause for a market correction. In most cases, a negative catalyst combined with lofty equity prices drives investors to push the sell button. While a black swan event can occur at any time, we do not pretend to foresee these which, by definition, are unpredictable. A war with North Korea, tax reform failing or trade wars rapidly escalating are just a few of the unlikely but not-impossible events that could thwart the bull market in equities.

We continue to believe that the largest risk facing equity markets is the potential for a rapid rise in interest rates. Low interest rates are a key component supporting current equity values. As long as the Federal Reserve remains tempered and deliberate in their current tightening cycle, we expect to see rates rise slowly and methodically. This type of move would be supportive of equities as it would foreshadow ongoing economic growth and a stable dollar. A sudden jump in rates, however, would tend to indicate rising inflation and a slowing economy.

Any market correction would likely be exacerbated by the recent rise in popularity in exchange-traded funds (ETFs). These are similar to mutual funds in that they hold a basket of securities, but they trade on the exchange like an individual stock. Over the past five years, ETF assets have grown exponentially, and these passive investments have never been battle-tested by panicked selling. If ETF investors begin to abandon their shares in reaction to a normal market correction, we could see an outsized move downward as ETFs are forced to sell stocks to meet liquidity demands, potentially initiating a vicious cycle of stock selling. Against the current economic backdrop, however, we would expect any correction to be relatively short-lived as investors would quickly see value in declining stock prices and start buying shares aggressively. Despite the fact that we are nine years into a bull market, we see very little on the horizon that points to an economy that is beginning to weaken (other than the possibility of a true black swan). On the contrary, we foresee growth actually accelerating into the end of the year.

Market Commentary 2nd Quarter 2018

Market Commentary 1st Quarter 2018

Market Commentary 4th Quarter 2017

Market Commentary 3rd Quarter 2017