From the Desk of


Last month, after 19 years in operation and running dangerously low on fuel, the Cassini spacecraft executed its final assignment: a death plunge deep into Saturn’s atmosphere where it was crushed and vaporized. At the time of its launch, Cassini’s mission was unprecedented in its ambitions but also in its risks, among them a treacherous pass through the asteroid belt. Yet the expertly designed probe proved a model of reliability over its nearly two decades of service, allowing scientists to extend its mission a total of three times.

In some ways, investors too began a journey into the unknown after the great financial crisis in 2007-2008. And if only we were so fortunate as NASA engineers in applying a rigorous set of scientific principles to timing the economic cycle, we would all be very wealthy indeed. But, alas, the journey of each economic expansion has unique characteristics and unpredictable timetables that are resistant to precise forecasting.

The minds at the Federal Reserve Bank are perhaps the world’s best. However, not once since it was founded in 1913 has the Fed been able to accurately forecast the next recession a year before it materialized. In fact, Fed officials are notorious for being behind the curve. As investment managers, this is all the evidence we need that the better approach is to assess risks and, when they are high and rising, take appropriate steps to mitigate some of those risks where we can.

Despite eight uninterrupted years of growth, and after a 346% rise in total equity returns to new record highs, our analysis indicates that the economic expansion is not yet in peril of ending from natural causes. However, it certainly can end from unnatural causes, like self-inflicted geopolitical problems, or unanticipated hikes in interest rates by the Fed.

As the nearby chart shows, a lower 2.1% average growth rate over this expansion has led to economic slack being eroded much more slowly than in previous business cycles. In fact, the current output gap is not projected to close until sometime in 2018. This suggests that the economy is in no danger of overheating and that modest growth can continue for some time before excesses build that could lead to the next recessionary downturn. This is also a reason why equities are rising strongly this year. Investors are optimistic because they expect that continuing economic growth will support improving corporate profits over the next several quarters. We agree.

3Q17-GRD Letter Chart 1 500px

Measuring risks is a process and is statistically supported through rigorous analysis. In thinking about what stage of the current economic expansion and equity bull market we are in, we like to rely on forward-looking indicators and financial market data that has historically been useful as a gauge. Our asset allocation committee continually assesses when risks have grown too high to sustain full exposure to an asset class.

Below are some of the indicators we monitor and where each stands.

  1. Leading Economic Index. While the lead time between when the Conference Board’s Leading Economic Indicators turn negative and when a recession begins has historically been highly variable, the index has done a good job of signaling when an expansion is in jeopardy of ending. Recently, the LEI has been improving, indicating that modest growth should continue and that near-term recession risk is low.
  2. Equity Valuations. Valuations of U.S. equities are now at levels that historically have been categorized as high. However, all this really means is that risks related to valuation are elevated, not that the bull market will end soon. Analysis reveals there is not much correlation historically between valuation levels and the equity market’s return over the next 12 months. In fact, valuations can stay at high levels for years, without stocks correcting.
  3. Margin Debt. The higher the level of margin debt, the more investors are confident enough to borrow money to buy stocks and bonds. While confidence is high today, we are watching to see if margin debt goes to levels of excessive speculation. So far, it has not.
  4. High-Yield Debt Interest Rate Spreads. The excess return from investing in lower-quality bonds versus Treasuries totals 5.35% YTD. The present level of HY credit spreads is near a three-year low. However, this relatively low level can persist for years, as was the case from 1994 through 1998 and more recently from early 2004 through mid-2007.
  5. Leveraged Loans. In the senior secured loan market, the amount of lending currently being made to medium- to low-credit-quality companies without covenants is 75% of new issuance (up from 24% in 2012). This means that borrowers are being granted relatively inexpensive financing without the standard covenant packages and therefore lenders have weaker controls over borrower operations.
3Q17-GRD Letter Chart 2

While we are confident this economic expansion will not last the almost two decades that Cassini did, if it continues for 22 months more, it will be the longest in U.S. history. Given the highly uncertain geopolitical environment, we might have to navigate an asteroid belt of our own over the next year to get there, but our best estimate is that modest economic growth will continue through 2018. Still, rather than try to predict what is not predictable, we believe assessing risks and investing in high-quality companies with improving future earnings prospects, adaptive management teams, and strong balance sheets remains the best way of sustaining your investment portfolio and achieving long-term investment goals. 

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

Index Definitions

The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a nongovernmental organization, which determines the value of the index from the values of ten key variables.

The Goldman Sachs Financial Conditions Index (GSFCI) is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable.

The Standard & Poor’s (S&P) 500 Index represents 500 large U.S. companies. The comparative market index is not directly investable and is not adjusted to reflect expenses that the SEC requires to be reflected in the fund’s performance.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.