Second Quarter 2017 Economic & Capital Market Summary

The early optimism that President Trump would be able to reinvigorate domestic economic growth has faded as Congress struggled to pass health care legislation and confusion exists around Trump’s political agenda. There is a growing divergence between the fundamentals supporting the domestic economy and company valuations in the domestic equity market. We believe that in the absence of meaningful tax reform and financial regulatory reform, the economy will likely slow dramatically.

Yet, the bond market and the domestic stock market are telling investors two different things. As equity prices climb higher, the market has focused on a mixed bag of earnings growth and has ignored most negative news. At the same time, bond yields remain low and we do not see much of a breakout higher as the Fed signals further tightening in monetary policy. It appears that stock prices are discounting economic prosperity while bond prices are discounting a slowing economy.

It is truly puzzling to us that the geo-political events including the increased tensions with North Korea, China, Russia and the Middle East combined with the uncertainty around Great Britain leaving the European Union are not impacting market volatility or appear to be discounted in equity prices. As a clearing house for the price of risk, markets can be either efficient or inefficient in that pricing function.

Given the divergence between stock and bond valuations coupled with the coordinated simulative monetary policies of the global central banks, we are uncomfortable with the sustainability of the current elevated equity valuations.

As we review our portfolio structure and the investment opportunities in the market, we are struck by another observation. From a more macro perspective, we are living through tectonic shifts in corporate America that will impact revenue models in specific companies and sectors for decades to come. This is making the investment analysis and investment decision more difficult because the uncertainty around the sustainability of a company’s business model. For those who can remember, think about how quickly typewriters became obsolete in our offices and home.

Today, one of the most obvious examples of this paradigm shift is the increased use of on-line shopping which is impacting the profitability of brick-and-mortar stores. The traditional retail sector is going through a harsh decline in foot traffic and sales as more and more consumers shop on-line. In a similar vein, electric cars are a growing part of the domestic auto market, and consumers have embraced electric and hybrid autos as a cost-effective alternative to traditional carbon burning engines. Changes in how media content is delivered to the home is also going through massive changes today. The traditional cable provider is being challenged by “skinny bundles” through services like Apple TV and Sling. In addition, subscription services from companies like Netflix and Amazon Prime are now providing original content which historically was provided by the networks. The increased popularity of Airbnb is having an impact on the hotel industry. And, the growing popularity of Uber and Lyft are having a negative impact on the traditional car rental business like Hertz and Avis. Many of these established companies are now challenged to adapt to the changing competitive landscape. As investors, we have to recognize these shifts and understand how management is adapting to the changes in the marketplace. Where management has been slow to adapt, shareholders have suffered.