Time for a Mid-year Market Update 

Much has transpired in the past 6 months and it may seem to have gotten us nowhere.  I guess that all depends on how you look at it.  Brace yourself, I am about to use a $10 word...Bifurcation.  I am talking about disjointed market movements.  A market can be said to be bifurcated when various areas of the market that often move in a correlated fashion move in different directions.  To us at RAA, we like bifurcation because it creates anomalies and investment opportunities.  Recently, we have seen some evidence we would like to share.  Before we do, however, we want to provide a few factoids and some education.

The S&P 500 is up 1.87% so far this year.  The S&P is only a good barometer for super large US companies like Exxon, Disney and Microsoft.  The S&P is a Market Cap Weighted index.  That means that the larger the company, the bigger the weighting in the index.  For example, Apple is the biggest with just under a 4% weight.  Amazon and Alphabet (AKA Google) both represent approximately 3%.  On the other end of the spectrum are Goodyear Tire and H&R Block each holding a measly 0.02% weight.  As you can probably decipher, news on Apple, Amazon and Google is far more important than on Goodyear and Block.  Although a set of tires costs as much as an iPad...hmmmm

Quick trivia question:

How many stocks are currently in the S&P 500?

Hint: It's not 500

(jeopardy theme song playing)

The answer is 505 because 5 companies have 2 share classes of their stock.  Google is the best example with GOOGL (class A) and GOOG (class C) each with a weight of around 1.5%.  In case you are wondering what the difference is...class A has voting rights, class C does not.

The Dow Jones Industrial Average is down 1.88%.

That is a pretty dramatic variance when many see the Dow and S&P as very similar indicators.  The Dow is simply a compilation of 30 companies thought to be representative of the US economy.  One very important thing to note is the fact that the Dow is a Price Weighted index.  That means the stocks with higher share prices have a higher weighting.  Today Boeing has a share price of $336 and represents over 9% of the Dow.  Pfizer has a stock price of $36 and is currently the smallest weight at 1.01%.  So here is a shortcoming of the Dow in my opinion.  Recently General Electric was removed from the Dow after years of proud history followed by years of struggle.  I am sure many would have voted for Amazon or Google (both big players in the S&P) to be in the Dow since they certainly are very important in the overall scheme of our economy.  Here is the problem.  Because of the simple fact that both stock prices are over $1,000 (GOOGL at $1,116 and AMZN at $1,693), there would have no way to include them without having an overwhelming percentage of Dow's performance relying on one stock.  So, who did we get?  Walgreens.  Don't get me wrong, I love the corner of happy and healthy, but I was a bit surprised by that choice.  

Even though Large Cap stocks make up 75% of the market, we can't forget about Small Cap and Mid Cap (SMID) stocks. They make up the other 25% of the US stock market.  The Russell 2000 is the benchmark most often quoted when looking at SMID stocks.  The Russell 2000 has returned 8.16% for the first 6 months of 2018.  Not too shabby!  Here is a nice example of some bifurcation.  US Small Stocks are outpacing US Large Stocks by 6-10%.  The problem is that hardly anybody owns them or if they do, they certainly don't own much because that wouldn't be prudent because of their higher risk characteristics and lower weighting in the stock market as a whole.  At RAA, we are happy that we do own some that has added a little bit to the bottom line across the board.  One of our favorite mutual funds Akre Focus (AKREX) run by Charles Akre has continued to shine, up 8.58% YTD.  Nice work Charlie!

Now let's look at Developed Country Foreign stocks.  The most common benchmark here is the EAFA (Europe, Australasia and Far East) index.  So far this year, the EAFA is down 5.62%.   The other major segment of international investing is Emerging Markets.  Often referred to as BRICK (Brazil, Russia, India, China and Korea).  For 2018, the EM have lost 8.96%.  In a well-diversified portfolio, it is important to include foreign stocks both developed countries like Germany, France and Japan along with the emerging markets.  We tend to do so in a way that limits volatility and seeks to avoid some of the big losers.  For example, EFAV (iShares Edge MSCI Minimum Volatility EAFA) is down 3.51% vs. the pure EAFA index down 5.62%.  EEMV (iShares Edge MSCI Minimum Volatility Emerging Markets) is down 5.56% vs. the pure EM index being down 8.96%.  Quick math on that says we have only captured 62% of the downside this year.  We will take that any day.  We also believe wholeheartedly that active management can provide better than average results in times when the markets are in flux.  For example, our favorite international fund FMIJX (FMI International) is only down a fraction YTD in a down market.  Truth be told, the fund did under-perform last year.  However, we own funds like this because we would rather see a narrower band of volatility over time that will likely end us up in a similar or better long-term result.  Over the years FMI has done a great job for us.  Kudos to FMI !

Last but certainly not least, we need to talk about bonds.  We have been talking and typing about interest rates for quite some time now.  We are starting to see things come to fruition. One of the most widely held funds in managed accounts at the big box investment companies (Fidelity, Schwab, Edward Jones, etc..) is LQD (iShares iBoxx Investment Grade Corporate Bond).  The fund is very well diversified and carries a very low expense.  On top of the that the yield on the fund is 3-4%.  That all sounds great right?  Maybe not, the fund is down 6% this year.  That is a scenario that we really did not want to partake in and made a concerted effort to sidestep.  We chose to own FLOT (iShares Floating Rate Bond) with the money that would traditionally be allocated to a fund like LQD.  FLOT is also very well diversified and has a very low fee but has had a yield under 2% until just recently.  FLOT is up fractionally this year.  We will take a small gain in a down environment any day.  It may not be very exciting, but investment grade bonds are not supposed to be in a portfolio to lose value.  They are there to provide safety and income. 

Well, that's all for now.  We hope you learned something or we made you think about investing a little differently.  Send us an email to let us know how we are doing or if you have any questions. We would love to hear from you.  

We will leave you with this...

At RAA, we don't believe in reinventing the wheel.  The greatest minds in investing like Warren Buffet and Peter Lynch have taught us that we need to invest with a "margin of safety" and always "know what you own and why you own it".  That is what we do as we allocate the money that you have trusted us to oversee for you.  Please know that we treat your money as if it is our own and care very much that you are invested properly and kept informed along the way. 

Market and Economic Commentary

We would like to start by giving some praise to JP Morgan.  Last month we wrote about the best and worst sectors according to JPM research.  They pretty firmly believed that semiconductors were going to be the worst sector.  Well, since our last issue a month ago, semis were pretty much the worst place to be led by bellwether Intel down 10%.  We will be keeping our eyes on this trend to see how it shakes out.

We also discussed Alternative Investments last month.  One specific alternative we would like to highlight and take a deep dive into this month is commodities.

Let's start with the basics.  What are commodities and why should we invest in them?

A COMMODITY is a raw material or primary agricultural product that can be bought and sold, such as copper or coffee or oil. 

The most common reasons to invest in them are threefold. 

Reason 1: Inflation hedging.

Commodity returns have tended to pick up when inflation has been rising and decline when inflation has been falling, in contrast to both equities and bonds. Other asset classes which are typically considered inflation hedges, such as real estate and inflation-linked bonds, currently trade on historically very expensive valuations, unlike commodities.  There are signs that inflation is building.  Labor markets are tight and the 12-month core inflation rate, which excludes commodity prices, has been running above 2%. We would be complacent to ignore the dangers of inflation.  Therefore, we feel is may be prudent to include some investments in a well-diversified portfolio that have an opportunity to increase in value if inflation continues to rise. 

Reason 2: Commodities diversify equity risk

Commodities diversify equity risk but, given their intrinsic link with economic growth, it would be unrealistic to expect them to hedge so-called tail risks such as the economic downturn resulting from the financial crisis of 2008-09. In reality, the relationship between commodities and equities varies considerably.  At times there is a negative correlation, but on average they show a low but positive correlation. Nonetheless, so long as commodities are not perfectly correlated with equities, even a small allocation to an equity-heavy portfolio can result in a reduction in overall volatility.  Again, we feel compelled to include commodities in a portfolio to attempt to reduce volatility while looking to achieve long term growth.

Reason 3: Potential for more attractive risk-adjusted returns

So far we have argued that there is a case for a strategic allocation to commodities even if returns are relatively muted. In fact, however, current conditions suggest that they could actually be much better than that.  Broadly speaking, commodities look cheap compared with their long-term history, particularly against equities. Furthermore, research says that some commodities are trading below their costs of production, a key valuation anchor. They are one of the few global asset classes that can lay a claim to being cheap.  So, we would argue that there is a reason to buy commodities. However, effective implementation is key.  Passive investors tracking well known benchmarks are exposed to a host of undesirable costs and consequences which active or tactical managers can avoid or even profit from.  With prices low and many commodities poorly-researched, this should be an excellent environment in which active managers could add value.

Stay tuned for account alerts and updates as we work look to implement some commodity strategies into some of our portfolios.  

As always, if you have feedback or questions, please email us anytime.

BE SAFE !!