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Quarterly Commentary – Q2 2019

One for the Record Books

The current U.S. economic expansion is now officially the longest in history, having just entered its 121st month. Shortly after the end of the second quarter, stock markets also hit all-time record highs. These milestones are juxtaposed against another less thrilling record: the current economic expansion has also been the weakest recovery since World War II.

While it is impossible to know how long the current expansion will last, economic data is flashing warning signs. Growth was already on course to slow this year as the fiscal stimulus boost associated with last year’s tax cuts has faded. The bigger drag, however, is stemming from the U.S. administration’s erratic trade policies, which has introduced further uncertainty in business investments.

History of U.S. Economic Expansions

Source:  National Bureau of Economic Research & Bloomberg

Synchronized Asset Class Appreciation

All asset classes, both risky and more conservative, surprisingly, have rallied strongly in the first half of the year.  This rally has occurred against a backdrop where global economic growth has slowed, trade tensions have persisted, large tech companies have faced regulatory scrutiny, and financial market distortions have deepened.  As we pointed out in our first-quarter client commentary, the most obvious explanation for the appreciation of asset classes across-the-board has to do with central banks’ renewed willingness to cut interest rates, thus raising virtually all asset class valuations.

The first half of the year saw a historic policy U-turn from a well-advertised “policy normalization” to a significantly more dovish stance by the U.S. Federal Reserve, which has also been adopted by the other three major central banks (European Central Bank, Bank of Japan and People’s Bank of China).  While history will tell the tale of the record-breaking U.S. economy and stock markets, it may fail to show how reliant financial markets have become on extraordinary accommodative monetary policies (i.e., zero or negative interest rates and multiple rounds of quantitative easing, or money printing) from the central banks.  The table below summarizes the second-quarter and year-to-date (YTD) performance for selected indices.

Source: Bloomberg. Please see important disclosures at the end of this commentary.

“History May Not Repeat Itself, But It Often Rhymes”1

Over the past decade, financial market participants have become conditioned to associate extraordinary monetary policies and central bank liquidity with higher asset prices.  This has in turn led to heightened speculation, as reflected in the surge of recent IPOs with negative earnings and the increasing number of “zombie companies” (companies whose interest expenses are larger than their earnings) in the market.  The result has been tremendous asset price inflation and steep valuations as prices have well outpaced the fundamentals.

Most investors are familiar with the concept of P/E (price-to-earnings) ratios as a reflection of stock market valuations.  When a stock goes up in price, it either does so as a result of improving fundamentals (i.e., increasing earnings) or based upon investor sentiment or expectations.  If the latter is the case, that stock is said to appreciate because of multiple, or P/E, expansion.  As illustrated in the chart below, in the current stagnant earnings growth environment, P/E ratio expansion has accounted for 92% of the year-to-date rally in the U.S. equity market.  Goldman Sachs research indicates that P/E expansion has also been responsible for nearly 30% of the bull market return since March of 2009.

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1 Attributed to Mark Twain

S&P 500 Price Return Attribution

Source:  FactSet, Goldman Sachs Investment Research

Given the headwinds mentioned above, it is unreasonable to expect either earnings growth or multiple expansion to continue at such a pace, which suggests that investors cannot expect such strong returns over the next several years. In our opinion, central bank liquidity, low interest rates and passive investing in mega-cap U.S. growth stocks have pulled forward future investment returns.  We concede that no one can accurately predict the timing of an economic recession or stock market decline.  What we can do, however, is identify environments where investors face heightened risks and adjust our portfolios accordingly.  If equity market valuations revert to historical norms, investors who are only relying on traditional assets to meet their goals may face a very challenging path forward.  Our approach is to mix in strategies that exhibit less dependence on global economic growth in an attempt to provide more consistent returns for our clients in an otherwise uncertain world.

Please do not hesitate to contact your Morton Capital wealth advisory team if you have any questions or would like to review your portfolio or financial plan in more detail.  As always, we appreciate your continued confidence and trust.

Morton Capital Investment Team

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Disclosure Update

MCM recently filed an amendment to its Form ADV Brochure with the Securities and Exchange Commission to reflect some material changes since our last filing in March. Please click the link for a full copy of the amended ADV Brochure:
https://mortoncapital.egnyte.com/dl/vn7uYGXjaY.

This commentary is mailed quarterly to our clients and friends and is for information purposes only.  This document should not be taken as a recommendation, offer or solicitation to buy or sell any individual security or asset class, and should not be considered investment advice. This memorandum expresses the views of the author and are subject to change without notice. All information contained herein is current only as of the earlier of the date hereof and the date on which it is delivered by Morton Capital (MC) to the intended recipient, or such other date indicated with respect to specific information. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information. Any performance information contained herein is for illustrative purposes only.

Certain private investment opportunities discussed herein may only be available to eligible clients and can only be made after careful review and completion of applicable offering documents. Private investments are speculative and involve a high degree of risk.

The indices referenced in this document are provided to allow for comparison to well-known and widely recognized asset classes and asset class categories. Q2 returns shown are from 03-31-2019 through 06-28-2019 and the year-to-date returns are from 12/31/2018 through 06-28-2018.  Index returns shown do not reflect the deduction of any fees or expenses. The volatility of the benchmarks may be materially different from the performance of MC.  In addition, MC’s recommendations may differ significantly from the securities that comprise the benchmarks.  Indices are unmanaged, and an investment cannot be made directly in an index.

Indices:

Past performance is not indicative of future results.  All investments involve risk including the loss of principal. Details on MC’s advisory services, fees and investment strategies, including a summary of risks surrounding the strategies, can be found in our Form ADV Part 2A. A copy may be obtained at www.adviserinfo.sec.gov.

Fourth Quarter 2018 Commentary

What a Difference a Year Makes

While the stock market correction in the fourth quarter dominated headlines, the real news in 2018 was that the vast majority of asset classes produced negative returns. According to a Deutsche Bank study, 90% of the 70 asset classes they track delivered negative returns for 2018—the highest percentage as far back as 1901, when they began tracking the data. This is in stark contrast to the prior year when almost all asset classes had positive returns.

While these extremes in performance are dramatic, the most important takeaway, in our opinion, is that most traditional asset classes moved in the same direction in both years. We have often talked about the ineffective diversification that traditional (i.e., stock and bond only) portfolios have provided in recent years and may potentially provide going forward. This lack of diversification benefit is welcomed by investors in years like 2017, when everything is up, but less so in years like 2018, where everything is down without there really being anywhere to hide.

The Dual Narratives of 2018

Looking more closely at 2018’s performance, two polar opposite narratives dominated the beginning and the end of the year. The U.S. markets began 2018 with high hopes that tax reform and deregulation would drive an acceleration in the rate of capital investment, thus improving productivity and bolstering economic growth and corporate earnings outlooks. According to Bloomberg, while tax reform has been positive on the margin for capital spending, a large share of the tax windfall has been allocated to corporate share repurchases (i.e., financial engineering). While tax cuts contributed to the rally in the first nine months of the year, it was short-lived as earnings slowed as a result of the lack of investment in productivity. Most indices severely corrected in the fourth quarter and ended the year down or flat. The one bright spot for in the quarter was gold, which acted as an effective hedge during this period of market stress. The table below summarizes the fourth quarter and year-to-date (YTD) performance for selected indices.

We have frequently been asked to comment on what caused the U.S. market’s swoon in the fourth quarter. There was certainly no shortage of potential problem areas: the Fed raised interest rates by 25 basis points (0.25%) for the fourth time in the year, trade tensions with China continued, global economies started showing signs of slowing down, the Democrats took control of the House but the Republicans maintained their majority in the Senate, the White House experienced continued personnel turnover, and there was even a partial government shutdown late in December. None of these events, in our opinion, were significant enough to be considered a catalyst for the market downturn, however. Interest rates have been on the rise for the better part of three years, trade tensions dominated headlines for much of the year, and political uncertainty has been evident almost on a daily basis. Rather than pointing to any one event as the cause of the downturn, it seems most likely to us that markets simply got ahead of themselves in 2017 and the first nine months of 2018. Looking forward, we anticipate that there could be further volatility as the stimulus from tax cuts and government spending wanes and both economic and corporate profit growth rates decelerate.

Morton Capital’s Approach

In our year-end communication regarding the recent market volatility, we emphasized our core beliefs as it pertains to developing long-term plans and managing our clients’ portfolios. Undoubtedly, the markets become more difficult to navigate late in the business cycle, as markets search for new equilibrium and more rational valuation levels. Our core beliefs have helped guide us through challenging markets in the past, and we believe will do so again going forward. Our core beliefs encompass the following:

    • Risk Management

    Investors have to take risk to make money, but deciding what type of risk and how much to take given certain environments can be key to long-term success. In the current environment, where we believe valuations are elevated, the key is finding investments where we have conviction that the return potential justifies the risk being taken. Over the last few years, we have been reducing our exposure to traditional asset classes as euphoric investors have bid up prices and chased yields. These allocations have typically gone to more lending-related strategies, where we believe investors can make relatively attractive returns without having to suffer through stock-like volatility. Where appropriate, we have also increased our allocations to private alternative investments, where there can be a premium for taking on illiquidity.

    • True Diversification

    We define a truly diversified portfolio as one with multiple drivers of return. If stocks and bonds have the potential to move in lockstep during a downturn, then a broader and more dynamic alternative approach to diversification is necessary to be effective. While lack of access and due diligence expertise may keep other firms from investing in alternatives, Morton Capital has been at the forefront of incorporating innovative asset classes such as real estate equity, private lending and reinsurance into our clients’ portfolios. These asset classes should not move in lockstep with the market and should better manage risk if we encounter a sustained correction.

    • Cash Flow

    In designing our client portfolios, we have always shown a preference for investments that can generate immediate or reasonably fast cash flow. While long-term buy-and-hold strategies can be successful, we prefer to be paid while we wait. In the current low-interest-rate environment, we have tilted our public stock portfolio to more dividend-paying stocks and have sought higher levels of cash flow in the private lending space as a replacement for traditional low-yielding bonds. We believe these cash flow-focused assets, especially in the private lending space, will generate more attractive and consistent outcomes for our clients while simultaneously supporting their lifestyles.

Follow Your Plan—Reacting Can Hurt Performance

At some point or another, we have all experienced the frustrating gridlock on the 405 or 101 freeways during rush hour. While traffic is slow for everyone, some drivers keep changing lanes hoping to get ahead. We, on the other hand, stay in our lane and end up passing them a little down the road. Given the heightened levels of volatility and the associated uncertainty, it is understandable that emotions may run high, causing investors to make changes to their portfolios. It is widely studied that one of the costliest mistakes investors make is to sell some of their riskier holdings and hope to buy them back later when things get “better.” Dimensional Fund Advisors has performed a study on the returns of the S&P 500 Index from 1990 to the end of 2017 to prove that market timing is a futile practice. As illustrated in the graph below, if investors missed the 25 single best days in the market during this timeframe, their annualized return would have dropped from 9.81% to 4.53%. Such underperformance will undoubtedly have a major adverse impact on an investor’s financial plan.

Forecasting the future path of the markets or the economy is never easy, and we are not in the business of predictions. As your partner and advisor, we can, however, encourage you to stay disciplined and not overreact to short-term volatility in the markets. In developing a plan to meet your financial goals, we have considered your objectives, income, cash flow requirements, and tolerance to assume risk. Maintaining a diversified portfolio and target asset allocations consistent with our philosophy is an important discipline. While there is an urge to want to be active and make changes, the reality is that every decision is an active decision, including a decision not to make changes.

Please do not hesitate to contact your Morton Capital wealth advisory team if you have any questions or would like to review your portfolio or plan in more detail. As always, we appreciate your continued confidence and trust.

Morton Capital Investment Team

 

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Disclosures: This commentary is mailed quarterly to our clients and friends and is for information purposes only. This document should not be taken as a recommendation, offer or solicitation to buy or sell any individual security or asset class, and should not be considered investment advice. This memorandum expresses the views of the author and are subject to change without notice. All information contained herein is current only as of the earlier of the date hereof and the date on which it is delivered by Morton Capital (MC) to the intended recipient, or such other date indicated with respect to specific information. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information. Any performance information contained herein is for illustrative purposes only.

Certain private investment opportunities discussed herein may only be available to eligible clients and can only be made after careful review and completion of applicable offering documents. Private investments are speculative and involve a high degree of risk.

The indices referenced in this document are provided to allow for comparison to well-known and widely recognized asset classes and asset class categories. Q4 returns shown are from 09-28-2018 through 12-31-2018 and the 2018 Year-To-Date returns are from 12-29-2017 through 12-31-2018. Index returns shown do not reflect the deduction of any fees or expenses. The volatility of the benchmarks may be materially different from the performance of MCM. In addition, MCM’s recommendations may differ significantly from the securities that comprise the benchmarks. Indices are unmanaged, and an investment cannot be made directly in an index.

Past performance is not indicative of future results. All investments involve risk including the loss of principal. Details on MCM’s advisory services, fees and investment strategies, including a summary of risks surrounding the strategies, can be found in our Form ADV Part 2A. A copy may be obtained at www.adviserinfo.sec.gov.

Market Overview August 2015

“In the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.” – Howard Marks, Oaktree Capital

The global equity markets have been in full retreat since China devalued its currency (CNY) relative to the U.S. dollar (USD) on August 11th. Since then, more than $5 trillion has been erased from the value of global equities on fears that the slowdown in the Chinese economy is worse than expected. As a result, there is now widespread belief that the U.S. Federal Reserve (Fed) will not be in a position to raise interest rates in its September meeting as had been expected. The table below summarizes the year-to-date performance of the S&P 500 (U.S. large company stocks), MSCI EAFE (developed international stocks) and MSCI EM (emerging market stocks) indices. While the equity market drawdowns have been more dramatic in the emerging markets, the S&P 500 Index has also entered a correction phase – defined as a decline of over 10% – since reaching an all-time high in mid-July.

YTD Financial 08.2015

As is evident from the graph below, the S&P 500 Index (green) has enjoyed a relatively calm climb with little to no volatility since late 2011. The Volatility Index (white) measures the 30-day volatility of the market. It is often referred to as the “Fear Index”. A low level of this index is a sign of too much optimism in the equity markets. The psychology has now changed dramatically, as the current selloff has raised many concerns with respect to currency wars, global growth, valuations of the equity markets, and whether the global central banks – stuck on ZIRP (Zero Interest Rate Policy) for almost 7 years – have any ammunition left to battle a global economic slowdown.

Market-Overview-August-2015-Large-Blog-Image
Source: Bloomberg

While U.S. markets have somewhat stabilized this morning, our concern going forward is that the poor underlying fundamentals could finally derail this resilient bull market. We have been articulating the risks associated with the global monetary policies for some time now and have reduced our equity exposure in recent years in response to escalating valuations. Just in July, we published a position paper detailing our thought process with respect to expensive global markets and the rationale behind including an allocation to gold as a hedge against depreciating paper currencies. We encourage you to read this paper and have included a link to our website below.

https://mortoncapital.com/uncategorized/the-case-for-gold-in-an-uncertain-world/

If you would like to discuss this paper, the financial markets, or your portfolio in more detail, please don’t hesitate to contact us.

Sasan Faiz
Co-Chief Investment Officer