Q2 Letter: All-Stars

The major league baseball season is in full-swing and, as I write this letter, our Milwaukee Brewers are in first place in their division and have the best record in the National League…not bad for a team that was in “rebuilding” mode only two years ago! Over the weekend, the MLB announced the players selected for this year’s All-Star Game. The starting lineups of 8 position players for both the National and American League teams are selected as a result of fan balloting. However, in order to fill the 34 roster spots for each team, there is a “Player Ballot,” through which another 16 players are voted in by their peers; followed by the selection of another 9 players chosen by the managers of each team (the managers of the two teams in the previous season’s World Series become the managers of the All-Star teams). Every team in each league must be represented by at least one player in the All-Star Game and it is the managers’ job to account for this stipulation. Finally, the last player is chosen for each team via the “Final Vote Ballot,” in which the fans get to vote once again among five candidates selected by the managers, with assistance from the MLB Commissioner’s Office. Then, of course, adjustments to each team must be made to account for players who are injured or unable to play at the time of the All-Star Game. Why would someone be unable to play? Perhaps an All-Star selection was the starting pitcher for his regular team on the final day before the All-Star break and would therefore be ineligible to pitch due to required rest days between starts. Or, perhaps a player was traded to a team in the opposite league before the All-Star Game (it has happened).

Quite a complicated process, isn’t it? In the end, I find it interesting that the starting lineup, as selected by the fan vote, often includes players that have performed at a level below that of players selected through the Player Ballot and/or the managers’ selections. This year, one of the players on the Final Vote Ballot (our own Jesus Aguilar) has better year-to-date statistics than any player currently selected for his league’s team. Clearly, the fan vote is as much about the popularity of the player as his stats, which is fine because the All-Star Game itself is (mostly) an exhibition game that is widely viewed by fans around the country.

In the investment world, the popular press touts the advantages of index funds with a steady drumbeat…so much so that a typical investor might think that professional money management has no chance to outperform index funds. Make no mistake, there are some advantages to indexing, with the primary benefit being low cost. Like the MLB All-Star selection process, index funds seem to be winning the popular vote, but players in the industry know that active management also has merits worth considering. I’ve written about this in the past with our sister company, Falcons Rock Investment Counsel, (see: https://www.falconsrock.com/passive-vs-active-management.htm and https://www.falconsrock.com/history-investment-manager-performance.htm) with my general conclusion being that indexing does very well during bull markets, but active management protects principal better during bear markets.

We spend a great deal of time at Prophecy Impact Investments conducting due diligence on money managers and mutual funds, with an objective of matching appropriate investment products to the asset allocations of our model portfolios. Our approach is designed to help us find investment products that have shown the ability to outperform their benchmark indexes and peers over time, with a reasonable expectation that they will continue to do so in the future. Key considerations in our due diligence process include the stability of the portfolio management team, portfolio manager investment in his/her product (“skin in the game”) and, yes, the expenses associated with the product. Even over the past 10-year period, which includes the current (very long) bull market, most of the investment products utilized in our model portfolios have generated returns in excess of their benchmark indexes and/or have demonstrated a reduced risk profile relative to their benchmark.

Of course, as in the careers of major league baseball players, past performance alone is not a valid predictor of future results, whether evaluating index funds or actively-managed funds. I believe that the popularity of indexing will be tested during the next bear market. Our research has found that well-managed active strategies, especially when integrating environmental, social and governance (ESG) criteria, can provide superior long-term returns while limiting volatility or other risks. We like finding the “all-stars” of the investment management world.

The MLB All-Star Game, in the opinion of many, is the best “all-star” competition among any of the major sports. It represents a great combination of fan involvement, player appreciation, and fun spectator events such as the Home Run Derby. I’ll be watching, especially for those players selected primarily based on their merits. Play Ball!

2018 Q2 Market Review

Market volatility continued in the second quarter of 2018, with some significant gains in certain asset classes and equally significant losses in others. The threat of inflation (due to historically low unemployment, trade wars, tax stimulus, spike in the price of oil) and rising interest rates persists.

For the quarter, small cap stocks continued their resurgence over large cap stocks and the growth style generally outperformed the value style (small cap value being the exception). The best performing sectors in the S&P 500 Index in Q2 included Energy (+13.5%), Consumer Discretionary (+8.2%) and Technology (+7.1%). The worst performing sectors during the quarter included Financials (-3.2%), Industrials (-3.2%) and Consumer Staples (-1.5%).

Non-U.S. developed stocks continued their retreat in Q2, and emerging markets stocks followed suit this quarter. For the quarter, the best performing countries included the U.K. (+2.9%), and France (+0.3%). Many regions around the globe did not fare as well, including Brazil (-26.4%), Russia (-5.8%), and China (-3.4%). The U.S. Dollar reversed itself and strengthened relative to most other currencies, detracting from returns for U.S. investors in international stocks.

The fixed income markets were mixed in Q2, but have produced mostly negative total returns year-to-date, as bond prices have an inverse relationship to the direction of interest rates. Short-duration bonds help protect principal in this environment. Cash (money market funds) yields are rapidly rising, as the Fed continues in its path of rate hikes.

Hedging strategies generally delivered small, but positive, returns in the second quarter, with the HFRI Composite earning +0.9%.

Here are the returns for select market indices for Q2 and year-to-date 2018 (as stated in US Dollars):

Here are the returns for select market indices for Q1 2018 (as stated in US Dollars):

Responsible Investing Corner

In May, I had the privilege of representing Wisconsin at “Hill Day” at the US SIF Conference in Washington, DC. I visited the offices of three of our state legislators, Senator Ron Johnson, Senator Tammy Baldwin, and Congressman Jim Sensenbrenner, to introduce them to the US SIF organization and the basic tenets of Sustainable, Responsible and Impact (SRI) investing. We discussed how integrating Environmental, Social and Governance (ESG) criteria into the investment management process can mitigate certain risks and deliver competitive returns. We also outlined the US SIF position on shareholder rights and discussed a few of the current bills that would restrict these rights. My sense was that the staffers of each of these offices were interested and receptive to learning about SRI and encouraged to learn that they have constituents that are investing in this manner.

At the US SIF Conference, I attended a screening of the Netflix documentary film “Chasing Coral,” as well as a presentation by Richard Vevers, Founder and CEO of The Ocean Agency, who was featured in the documentary. Vevers and a team of divers, photographers and scientists filmed vanishing coral reefs around the world and explained the scientific causes of coral bleaching. It is a powerful documentary illustrating a primary threat to our planet as a result of climate change and rising oceanic temperatures. I would encourage everyone to watch this film.

Finally, Jeremy Grantham, the co-founder and chief investment strategist of Grantham, Mayo, Van Otterloo (GMO), spoke at the Morningstar Investment Conference on June 12th. He is an investor with 50 years of experience in the markets and is widely recognized for predicting the asset bubbles that led to the 2000 and 2008 recessions. Grantham said he has 98% of his personal net worth allocated to two foundations dedicated to climate and toxic damage to the environment, and GMO has launched climate change mutual funds as well as other innovative institutional-level funds over the years. While Grantham is known as the “perma-bear,” many of the funds managed by this firm have generated strong risk-adjusted returns for their shareholders over the years. Grantham notes that fossil fuels have played a central role in the development of civilization, but that “fossil fuels will either run out, destroy the planet, or both” and that the way to avoid this outcome is to completely de-carbonize our economy. He believes this will be the most significant economic event since the Industrial Revolution. These are pretty strong words from a man who is known for dire predictions during his investment career. Here are Grantham’s four major predictions about climate change:1

1. We will have an abundant pipeline of cheap energy thanks to technological advances.

2. Natural disasters will increasingly impact markets.

3. Environmental toxicity will impact both markets and economies.

4. Our capitalist economies cannot deal with these environmental problems (due to short-termism).

This and That

• The global economy is doing well. The Moody’s Analytics estimate of global real GDP showed it was up 3% annualized in Q4 2017.2

• U.S. new home sales jumped in May and the trend is improving.2

• France is the leader in the number of tourist arrivals, with over 83 million in 2014. The biggest tourist spenders are from China at nearly $165 million. The largest (by far) tourists receipts are collected in the United States at over $177 million.

• Trade wars are bad for business. Compared with actual tariffs, Moody’s estimates that the currently proposed tariffs would have a modestly negative impact on real U.S. GDP; however, if U.S.-China brinkmanship escalates to 10% tariffs, we could see a reduction in real GDP of 1-2% and if the U.S.-China tariffs increased to 25%, we could see reduced real GDP of 2.5-3.0% in 2019. It would take a lot to derail the current economic expansion, but this could do it.3

• Wisconsinites enjoy our many lakes during the summer season. The largest lake on Earth is the Caspian Sea in Central Asia, with over 371,000 square kilometers (over 230,000 square miles). The second largest lake on Earth is Lake Superior in Canada/U.S. at 82,000 sq. km. Lake Huron is fourth at 60,000 sq. km. and Lake Michigan is fifth at 58,000 sq. km.4

In keeping with this letter’s original theme of adaptation, here is this quarter’s closing quote, from John Wooden, the great basketball coach at UCLA from 1948-1975: “Things turn out best for the people who make the best of the way things turn out.”

In keeping with this letter’s baseball theme, I close with a couple of quotes from the great Yogi Berra, former New York Yankees catcher:

Thank you for being part of the Prophecy Impact family…we are all helping to do our part to make the world a little better place!

Gregory D. Wait, President

Prophecy Impact Investments, LLC

1 “We Are Not Equipped to Deal with Climate Change,” Advisor Perspectives, June 28, 2018

2 Moody’s Analytics economy.com – spotlight

3 Moody’s Analytics economy.com – U.S Macro Outlook: Welcome to the Trade War, June 19, 2018

4 The Economist, Pocket World in Figures, 2017 Edition.