The investment markets were all over the board during the second quarter, and volatility was the name of the game. Most market indices finished the turbulent quarter higher, except for Foreign Stocks and Core Aggregate Bonds. The strongest performing asset class during the quarter was Real Estate, which was up 9.99%. It was also the worst performing class during the first quarter when it posted a negative 7.43% return. That is an example of how volatile the markets have been so far this year. For the quarter, domestic stocks fared better than their foreign counterparts did. Small Capitalization U.S. stocks did quite well, posting returns of 7.75%. Large Capitalization U.S. stocks rebounded nicely from their negative first quarter, posting a positive return of 3.43%. Foreign stocks were down with a negative return of 1.24%. U.S. Short Term Bonds were slightly positive for the quarter, while Core Aggregate Bonds were slightly negative. Similarly to Foreign Stocks, Foreign Bonds were also down for the quarter [1]. Most of the volatility was related to the markets adjusting to the eroding of open trade and the uncertain economic environment that lies ahead.

Part of the reason Small Cap U.S. stocks outperformed their larger counterparts is because they are more insulated from the trade-related volatility. The Dow Jones Industrial Average (Dow) is widely cited as a measure of Large Cap U.S. stocks. Of the 30 stocks in the Dow, over half of the companies get more than 50% of their revenue from outside of the United States. Large Cap U.S. stocks cannot be thought of as just representing the United States – they are global companies. Few companies can be considered more American than McDonald’s and Coca-Cola. To help put in perspective how global these American companies are, consider that McDonald’s receives almost 65% of its revenue from outside the U.S., while Coca-Cola is just over 58%[2].

The markets have been concerned about the growing trade tensions and political uncertainty. A potential trade war between the U.S. and most of America’s trading partners could be the catalyst for derailing the global economic expansion. As mentioned in past letters, we are not proponents of restricting trade. There are times when it is necessary though, such as the case with China. Although a very influential economy, China has routinely used unfair trade practices and theft as a means of advancement. Specifically targeting these practices is prudent. Placing trade tariffs

and other restrictions on long-time allies under the pretense of national security is disappointing. We believe this positioning by the administration is simply a poorly thought out ploy to leverage a better trade arrangement. Restricting trade will only lead to U.S. consumers paying more for goods.   

As expected, the Federal Reserve Bank (Fed) raised its benchmark interest rate for the seventh time since 2015. Despite the increases, interest rates are still at historically low levels and below what the Fed would consider normal. The Fed continues to be optimistic about the economic outlook. Although inflation is starting to pick up, it continues to be in a range that the Fed considers healthy. The Bureau of Labor Statistics reported in May that the unemployment rate fell to 3.8%, which is a continuing sign of economic strength. Over the last year, the unemployment rate has decreased by 0.50%. This is a continuation of the steady decrease since peaking in October of 2009 at 10%. Despite the stout labor market, there has not been much increase in real wages. We suspect this will change in the near future. Take note of all of the help wanted signs you see. When there is a shortage of labor, prices (in the form of wages) will increase as companies try to incentivize labor to move.        

While our concerns are increasing, and we certainly have more worries than a couple of quarters ago, we believe the economy is strong enough to continue to produce healthy growth and robust corporate earnings in the near-term. Some of our concerns have been offset by a continuation of very good corporate profits that have certainly been aided by the Tax Cuts and Jobs Act passed at the end of 2017. The tax cuts are a fiscal stimulus, which will extend the current economic expansion. While we believe the tax cuts will help the short-term macroeconomic environment, we are worried that there will be insufficient additional growth created to pay for the cuts causing the budget deficit to grow considerably larger.  

The general consensus is the U.S. economy is entering the late stages of the current economic cycle. Although it is no longer improving, the fundamental environment is still really good. The current bull market in Large Cap U.S. stocks just hit 111 months, which is two months short of the record[3]. It has been a remarkable run; however, bull markets cannot last forever, and at some point in the not-too-distant future, it will end. Risks are rising, and we need to be more cautious. Caution will be something we talk a lot about in the coming quarters. We, nor anyone, can say with certainty when the markets are going to drop. What we can say though, is that markets will go up and they will go down. Trying to time the markets is futile. We believe in adhering to a disciplined investment process in which we focus on understanding your cash flow needs and personal situation to make certain we have your investment portfolio allocated appropriately. Having a properly allocated portfolio significantly reduces the possibility of having to sell assets during downturns at unfavorable prices. Making certain your investment allocation aligns with your financial plan is key to successful investing.

[1] Morningstar Office: Large Cap U.S. stocks as measured by the S&P 500 Index, Medium Cap U.S. stocks as measured by the S&P Mid Cap Index and Small Cap U.S. stocks by the Russell 2000 Index. Foreign stocks as measured by the MSCI EAFE ND Index and the Emerging market stocks measured by the MSCI EM ND Index. Fixed Income/Bonds as measured by the Barclays U.S. Aggregate Bond Index, Barclays Municipal Index, and the Citi World Government Bond Index. Real estate as measured by the Dow Jones U.S. Select REIT Index. Commodities as measured by the Bloomberg Commodity Index. Inflation as measured by the U.S. BLS Consumer Price Index All Urban SA 1982-1984.

[2] Wall Street Journal 07/02/2018 Page R1 “Dow Slips Back into Red for Year” by Michael Wurstorn

[3] JP Morgan Guide to the Markets 06/30/2018

The opinions voiced in this letter are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth in this printing may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Stock investing involves risks, including loss of principal. Bond values will decline as interest rates rise and bonds are subset to availability and change in price. There is no guarantee that a diversified portfolio will enhance overall return or outperform a non-diversified portfolio. Diversification does not protect against market risk.