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  • Writer's pictureBill Bullock

2017 Fourth Quarter

I hope your new year is off to a healthy and happy beginning. The “Tax Cuts and Jobs Act” was signed into law by President Trump on December 22nd, 2017. While the stock market rallied for many reasons throughout the year, the rally into 2018 had a lot to do with this bill’s passage and the savings corporations will receive as a result. That leads to the million dollar question after a booming year like 2017: When is the stock market going to go down?

It seems 2000-2002 and the Great Recession of 2008-2009 are still very fresh on investors’ minds – and for good reason. We did not make much money in that first decade and a generation of investors thought twice before investing in the market after that experience. There was a silver lining to that time period. I would argue that anyone investing in the stock market now is more aware - due to the investment performance during that “lost decade” - that investing in stocks carries with it a lot of risk. You CAN lose money and there is NO guarantee until you sell.

I think there is something different about today’s market. First, the hot money seems to be on the mirage that is Bitcoin and the other crypto currencies. Oh…almost forgot. I have New Year’s tip for you: Stay away from Bitcoin. Bitcoin is pure speculation and it almost certainly will not end well. Anyway, back to my point. Record stock prices are being matched with record earnings. Besides the solid earnings numbers, Warren Buffett has come out earlier this week and said that he doesn’t think the market is wildly overvalued when you take into account that we are within shouting distance of record low interest rates. So while I am concerned about the stock market’s valuation, I am more concerned about making sure each one of you has the appropriate asset allocation for your current stage in life. Please call me to review your current allocation.

Let’s spend some time reviewing our holdings. I should mention that not everyone will have the funds listed below.

Fixed Income: The two categories I have most of you invested in within this asset class are short-term and intermediate-term bonds. The intermediate portion performed quite well due mainly to the huge outperformance of PIMCO Income – a fund with an unbelievable track record. Typically, one hopes an intermediate bond fund can beat the bond index by 1% per year on average. Dan Ivascyn and Alfred Murata, PIMCO Income fund’s managers, have succeeded in beating the Bloomberg Barclays US Aggregate Bond Index by an average of 5.15% per year over the past 10 years. They have recently shortened the average duration of this fund to 2.3 years (which basically makes it a short-term bond fund in my book) no doubt preparing for the inevitable rise in interest rates. We have short-term bonds in the portfolio for two reasons. The first reason is to buffer our fixed income when rates rise. The second is to allow for a “safe” bucket to draw from in case you need to make an emergency distribution during choppy equity markets. Our intermediate bonds were up about 4-5% on average while our short-term bonds were up 1-3% in 2017. We have recently added to our PIMCO Income position.

Large-Cap Domestic Equities: Our large-cap equities did extremely well in 2017. Our boring index fund, Schwab Total Stock Market with its ultra-low expense ratio of 0.03%, set the bar with a positive 21.06% for the year while our Berkshire Hathaway holding returned a slightly better 21.62% return. Vanguard Dividend Growth fund, which I consider a “defensive play” (more on that later) was up 19.33%. The two Primecap funds I use interchangeably, Vanguard Primecap Core and Primecap Odyssey Growth, were up 26.23% and 32.05% respectively. I believe our large-cap holdings delivered everything we could have hoped for in 2017.

Mid and Small-Cap Equities: After having a great year in 2016, Royce Special Equity had a difficult year. While it still beat the Russell 2000 Value index by a mere 0.03%, it was only up 7.87% for the year. If this fund does not improve in the first half of 2018, I will most likely sell it and go into the Vanguard Tax Managed Small-Cap fund. Schwab US Small-Cap ETF (SCHA) managed a 14.93% return. The small-cap funds all rallied late in the year as the tax-cut passage became more certain. Vanguard Selected Value was up 19.51% beating its best-fit index by 6.17%.

Foreign Equities: Several years ago I added Oakmark International to our foreign stock holdings because I was concerned our defense-oriented First Eagle and IVA International were going to have a tough time keeping up with the index in a big bull market. 2017 was a break-out year to the upside and sure enough Oakmark delivered with a 29.75% return while First Eagle Overseas was only up 14.37% and IVA International was up 17.25%. With the US market rally this year, overseas stocks seem a little bit cheaper and, thus, where there wasn’t a big taxable gain, I moved Oakmark Equity & Income to Vanguard Global Wellington. Not only will this fund add some overseas exposure to both our stocks and bonds (it is 65% stocks and 35% fixed income – very similar to Oakmark Equity & Income), but it will also lower our overall expense ratio. For those where I did not make a change, I did not believe this change justified paying 15% of your capital gain to Uncle Sam. We will watch both funds and continue to make changes where appropriate.

In conclusion, think of your favorite college or NFL football team when you think of your portfolio: We have our OFFENSE: Schwab Total Stock Market Index (our quarterback), the Primecap team, Schwab US Small Cap Index, Oakmark International. Our offense will run alongside the market during bull runs. And then we have our DEFENSE: Our fixed income (our defensive line), Berkshire Hathaway, Vanguard Dividend Growth, Vanguard Selected Value, Royce Special Equity, First Eagle, IVA International, Oakmark Equity & Income and Vanguard Global Wellington. In an ideal world, I would like our defense-oriented equity positions to go down 50% of their respective benchmark during corrections and bear markets, but provide 75% or more of the upside during bull markets. The defense needs to hold their own during difficult times. If that defensive line (our fixed income) fails…look out. Just like in football, while it is the offense that scores the points and gets the glory, it is usually the defense that wins the championships.

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