2018 First Quarter Review

At Virtue Asset Management, we believe that the first quarter of 2018 introduced us to stock market vigilantes who are selling the stock market to try and influence the decisions of President Trump and the US Government. These selling actions have contributed to the rise in volatility.  We expect increased volatility and low returns for 2018. We continue to recommend that investors maintain their stock exposure at the lower end of their target ranges. We recommend that investors match upcoming cash flow needs, including required minimum distributions, with high quality bonds that mature at the time of the cash flow needs.

For the first quarter of 2018 the S&P 500 returned -.76%. This small loss hides the volatility the S&P 500 exhibited for the first quarter. After the January 26th close, the S&P 500 was up 7.05% year to date and during the trading day of February 9th the S&P was down as much as 5.62% year to date. For the first quarter, the S&P 500 Growth Index returned 1.93% versus a loss of 3.57% for the S&P Value Index. Over the last 8 years, the Growth Index has returned 14.59% a year versus 11.34% a year for the Value Index. We continue to recommend value oriented stocks because of their valuation and the expectation of a reversion to the mean for performance.

In the first quarter, the other equity indexes behaved in a similar manner to the S&P 500 with high volatility and low returns. For the first quarter, the S&P 500 MidCap returned -.77% and the S&P SmallCap returned .57%. International Large Cap, as measured by the MSCI EAFE Index returned -1.72% for the first quarter. Emerging markets Index returned 1.15% for the first quarter, powered by China which returned 1.71% for the quarter. India returned -6.94% for the quarter. Despite this underperformance we still favor India over China – considering the possibility of future tariffs by the US Government.

The combination of the Federal Reserve raising interest rates in the first quarter and inflation fears after the January jobs report created a negative environment for fixed income. The Barclays US Aggregate Bond Index returned -1.46% for the quarter. The futures market is forecasting two .25 percent interest rate hikes by December 2018. This would move the benchmark lending rate to a range of 2 percent to 2.25 percent. The futures market is currently forecasting a 31% chance of a third .25 percent interest rate hike in December. The upcoming interest rate hikes and inflation worries is why we recommend a shorter maturity for fixed income holdings. Longer maturity holdings will see a more significant price decrease in a rising interest rate environment.

From October 1993 to November 1994 the 10-year U.S. Government yields climbed from 5.33% to 7.96%. Commentators referred to bond vigilantes who were market participants that were selling bonds to force the government to control spending and lower the deficit to avoid inflation. A better term would have been inflation vigilantes who used the bond market as their tool of protest. From 1994 to 1998, the U.S. Government lowered the deficit as a percentage of Gross Domestic Product (GDP) from 64% to 60%. At the end of 1998, yields had dropped to 4.64%.

The fixed income markets continue to be distorted by central bank policies. Given these fixed income market distortions, it may be easier for inflation vigilantes to use the stock market to protest policies that they believe will lead to an increase in inflation. This strategy could be more persuasive given the importance the President has put on a rising stock market.

The January jobs report showed average hourly earnings increased 2.9% on an annualized basis. For the market, this report combined with the upcoming tax cuts increased the worries of inflation. The first quarter saw increased spending bills from the US Government and the introduction of tariffs. Both increased spending and tariffs could lead to higher prices and inflation. In fact, five of the worst six days in the first quarter for the S&P 500 correlated to higher inflation fears:

• February 8th, 3.87% decrease. This was the day the Senate struck a two-year budget deal with increases in spending to both defense and domestic federal programs.
• February 5th, 3.36% decrease. The Monday after the January jobs report which showed average hourly earnings increased 2.9% on an annualized basis.
• March 23rd, 2.21% decrease. China unveiled tariffs on $3 billion of U.S. imports.
• March 27th, 2.06% decrease. Uber fatal crash brings down technology stocks.
• March 22nd, 1.77% decrease. Trump administration announced tariffs on approximately $50 billion worth of Chinese imports.
• February 2nd, 1.67% decrease. The January jobs report which showed average hourly earnings increased 2.9% on an annualized basis.

There was good news in the first quarter for S&P 500 companies, both earnings reports and future earnings estimates were very strong. Analysts estimates of 2018 earnings for the S&P 500 have moved up to $147 a share. This is an increase from the $135 at the beginning of the year. The ten-year trailing P/E ratio from the end of 2017 was 17.83. If we use a P/E ratio of 17.83 with $147 in earnings, the S&P 500 index would be at 2621 or a 1% drop from the end of first quarter levels. Analysts estimates tend to be overly optimistic and we are currently using a more conservative estimate of $130 in earnings. Using our $130 estimate with a 17.83 P/E ratio would put the S&P 500 Index at 2318 and a 12% drop from current levels. Our view is that a 12% drop is the lower range scenario for the S&P 500 Index.

Investors had been willing to pay a hefty 23.7 P/E ratio for earnings at the end of 2017. However, inflation fears, increased government spending and a possible trade war have lowered the confidence of investors. Our upper range scenario is using a 20 P/E ratio and $140 in earnings. This creates a target of 2800 and an upper range return of 6%.

Our upper range scenario for the S&P 500 Index is an increase of 6% and our lower range scenario is a decrease of 12%. Given this outlook, we recommend that investors maintain their stock exposure at the lower end of their target range. With this market uncertainty, we recommend that investors match upcoming cash flow needs, including required minimum distributions, with high quality bonds that mature at the time of the cash flow needs. This strategy would protect the overall portfolio from selling equities at a low price to fund upcoming cash flow needs.

Investing involves risk, including the possible loss of principal and fluctuation of value.  Past performance is no guarantee of future results.

This letter is not intended to be relied upon as forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.  The opinions expressed are as of the date noted and may change as subsequent conditions vary.  The information and opinions contained in this letter are derived from proprietary and nonproprietary sources deemed by Virtue Asset Management to be reliable.  The letter may contain “forward-looking” information that is not purely historical in nature.  Such information may include, among other things, projection and forecasts.  There is no guarantee that any forecast made will materialize.  All information is illustrated gross of investment advisory fees. Reliance upon the information in this letter is at the sole discretion of the reader.  Please consult with a Virtue Asset Management financial advisor to ensure that any contemplated transaction in any securities or investment strategy mentioned in this letter align with your overall investment goals, objectives and tolerance for risk.  Additional information about Virtue Asset Management is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure, which are accessible online via the SEC’s investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using CRD#283438.

Virtue Asset Management is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.