2018 Second Quarter

With all of the talk of tariffs and trade wars, the large-cap stock index - as represented by the S&P 500 - and the small-cap index - as represented by the Russell 2000 - were both up during the second quarter 3.43% and 7.75%, respectively. International is still taking it on the chin through all of the trade discussions – the MSCI EAFE index was down 1.24% during quarter two. With our bond funds flat for the quarter, most client portfolios will be breakeven for their year-to-date total return.

After a strong 2017, but still deeply discounted when compared to the US stock market, I thought the overseas stock markets would outperform the US market heading into 2018. After a rough first six months and with all of the recent trade war talk, I have decided to drop our overseas investments to 25% of our equity exposure from about 28%. While not a huge deal, I can’t help but think overseas stocks will be impacted to a greater extent than the U.S. should trade negotiations continue to falter.

As I have emphasized in previous letters, corporate earnings need to remain strong and so far they have. The forward price/earnings ratio for the S&P 500 is actually lower today than it was one year ago. As earnings (the denominator in the P/E ratio) increase – as they have this year - while the price (numerator) stays flat, the overall ratio decreases which would mean stocks are less expensive. The lower the P/E ratio, the cheaper the stock(s). In their April 30th semiannual report to shareholders, the PRIMECAP team mentioned that the “S&P 500 trades at a forward price/earnings multiple roughly in line with its 25-year historical average (16.1x).” As the economy continues to chug along and with the corporate tax cuts boosting earnings, stocks are looking a little better than one would think after the run-up we have experienced over the past several years.

I have also checked your fixed income allocation to make sure we are approximately 50% short-term and 50% intermediate-term bonds. The intermediate bonds were hit a little harder in the first half of the year than our short-term bonds and in many of your portfolios I wanted to add PIMCO Low Duration Income (PFIIX) – the short-term, higher quality version of PIMCO Income fund (PIMIX), which has had a tremendous track record.

Hang in there with all of this tariff talk. While I am not a fan of tariffs, the argument goes that threatening with tariffs will place the US in a better position when it comes to trade negotiations. Time will tell as to any potential long-term damage done to our trading partners.