Update – Winter 2018

To Be (20)17 Again

Review
Most markets closed 2017 at record highs, and strong economic fundamentals played a
large part in getting them there. The synchronized global growth trend continued during
the year; all forty-five countries monitored by the OECD (Organization for Economic Co-
operation and Development) were on track to have grown economically in 2017, the first
time in ten years. Importantly, thirty-three of these, including the US, Japan and
European countries, witnessed accelerating growth from the previous year.

The latest revisions have world GDP growth moving toward +3.7%, a multiyear high. A
key byproduct of this global growth has been record corporate profits. In the US,
earnings are expected to close out the year growing over 10% with forward earnings
expectations marching even higher. The S&P 500 posted back-to-back quarters of
double-digit earnings growth in the first and second quarters of 2017 for the first time
since 2011. While third quarter profits were adversely impacted by the hurricanes, the
fourth quarter should see a return to double-digit growth. Better demand for products
and services are the main catalyst, but a weaker dollar, higher energy prices and tax
reform have all contributed.

The macro backdrop was dominated by geopolitics and tax reform. Congress defied the
policy skepticism that prevailed throughout much of the year and passed a $1.5 trillion
tax overhaul in December. The legislation was particularly favorable for businesses,
lowering the corporate tax rate from 35% to 21%. Higher tax paying companies, the
biggest beneficiaries, rallied significantly at the end of the year.

In what seems to be a recurring theme, geopolitical tensions failed to have had any
meaningful impact on risk sentiment. Despite the increased North Korea tensions,
investors largely ignored the escalating rhetoric and used the related dips as buying
opportunities. Market corrections were few, the largest being only -3%.

Interest rate and inflation discussions were never far off the radar. Outgoing Fed chair
Janet Yellen said low inflation was the “biggest macro surprise” of 2017. For stock
markets, sluggish inflation was largely viewed as a positive as it kept long-term interest
rates low in the face of the Fed’s tightening campaign (the Fed raised interest rates three
times last year). With the Fed raising short-term rates, the bond yield curve, a closely
watched recession signal, continued to narrow.

The technical foundation of the market also held firm last year. Low volatility was a
constant theme in 2017 with no 2% daily moves in the S&P 500, and only eight 1%
moves. This compares to an average of forty 1% moves during a typical year historically.
In fact, the S&P 500 is approaching a record length of time since its last -5% drawdown,
and market volatility was roughly half of levels it has experienced historically.

Outlook
Barring a sudden recession, the current economic expansion will be the longest in US
history if it lasts until July of 2019. Yet, it’s important to remember that while the US
expansion is chronologically old, it is not economically old. The recovery from the
bottom of the great recession has been more of a steady climb than a sharp increase.
Stock markets have responded to that historic economic run with their own momentous
advances. More gains should come in 2018, and the market has already climbed an
additional 5% during the first 3 weeks of the new year, but a period of lower-returns may
be in store at some point in the not too distant future. Volatility will likely creep higher
as investors grapple with higher interest rates, inflation and market valuations.

Investors will need to work harder to find opportunities for growth by taking more
calculated risks and being more selective in their portfolio holdings. Encouragingly,
markets are currently stable and recession risks are low. The length of the market
advance is not concerning as expansions don’t die of old age, but they do suffer
common illnesses, typically reflected in the breakdown of several fundamental, technical
or macro drivers. Those disciplines define a constructive economic outlook, and so far
these drivers remain positive towards year end.

Fundamentals should keep playing a more prominent role as we approach the later
stages of the business cycle. Typically in these stages, the market tends to get more
selective and fundamentals are often the differentiator. Fortunately they remain healthy.
US earnings should grow double-digits again in 2018, with the international outlook
even brighter. With modest wage growth and record-high profit, revenues should be the
key metric to monitor this year. Sales growth will likely mirror the expanding global
growth backdrop. Market valuations are high, but they also have further to run before
they become a speed limit for returns; so long as earnings are increasing and sales
growth is healthy, market corrections should be well-contained.

The credit cycle will also be important to watch as 2018 progresses. US high-yield
spreads to US Treasuries are a key metric and they are currently showing little signs of
stress. In fact, quite the opposite, as those spreads are the tightest they have been in the
post-crisis era. In other words, credit liquidity is ample and the risk of companies not
meeting their capital commitments is low. Market internals are, in aggregate, in good
shape. Momentum is clearly strong with the number of new highs set last year being
one of the strongest on record.

2018 should see more volatility than 2017. Interest rates and geopolitics will remain
highly influential to the macro narrative. If inflation remains low and central banks
continue to shrink the global supply of safe assets, financial conditions will remain loose
and assets globally will continue to benefit. A sudden spike in interest rates is the main
threat to this dynamic, particularly in late 2018 as central banks end their bond buying
programs. While this could potentially cause significant volatility in global markets,
prompting a correction in asset prices, investors should remember that there are also
‘good’ (bullish) reasons to think interest rates are close to an inflection point.
Geopolitical headlines will likely stay tense, but provided the synchronized global growth
backdrop remains supportive, investors should continue to ignore them. The market has
consistently demonstrated a lack of interest in the controversies (perceived or not)
surrounding the White House as well as flare-ups like the North Korea missile launches.
Investors should focus more on growth than headlines.

The start of the year looks very busy with a new earnings season, a budget and debt
ceiling debate, trade and tariff deadlines, Fed meetings and geopolitical events. This
generates an optimistic, but prudently guarded, outlook, particularly as it relates to the
effect of interest rates on markets and the broader economy.

Transformative Growth Leaders Strategy Update

This new strategy was implemented during the second quarter of 2016 and involves a
focused basket of stocks (roughly 12-15) with the expectation these companies’
underlying growth will be faster and superior to that of the overall economy and the
specific markets they operate in. These companies in some way have fashioned new
products and innovative offerings, spawned new industries and sparked change in
consumer and business habits and practices. Most of these companies are household
names, have dominant brands, are leaders in their respective markets and industries,
and in many ways are part of, and indeed have changed, our daily lives.

To manage risk, the “Transformative Growth Leaders” segment of the portfolio has no
more than a 10% overall allocation.

Since implementation of this stock portfolio, this basket of stocks has gained 33% in
value, nicely ahead of the broader market, as evidenced by the S&P 500, which has
generated a 27% return over the same time period. A performance table is listed below:

12/31/2017
Purchase Close Return%
Amazon $716.46 $1,169.47 63.2%
Apple $93.08 $169.23 81.8%
Costco Wholesale $139.71 $186.12 33.2%
Disney $97.80 $107.51 9.9%
Google (“Alphabet”) $704.98 $1,053.40 49.4%
Mastercard $89.25 $151.36 69.6%
Netflix $90.84 $191.96 111.3%
Nike $57.44 $62.55 8.9%
Starbucks $55.92 $57.43 2.7%
Tesla Motors $210.20 $311.35 48.1%
Under Armour $26.40 $14.43 -45.3%
Ulta Beauty $245.43 $223.66 -8.9%
Visa $74.25 $114.02 53.6%

Performance gains have been paced by Netflix, Apple, Amazon, Alphabet (Google) and
Tesla, each of which have dominant technologies, innovative products and service
offerings, and are rapidly disrupting and introducing new ecosystems which are being
well received and quickly adopted by consumers and end users across various markets.
Looking forward, while many uncertainties exist in the economy and markets, the U.S.
and global economy is still expanding, inflation and interest rates remain low and
numerous companies are still growing their earnings. Even in this challenged
environment, really strong market leaders continue to grow and increase earnings.

Amin Khakiani
January 25, 2018