October 03, 2018

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Cutler Investment Group Q3 2018

Market Commentary

The third quarter provided a strong return for domestic stock markets, with the S&P 500 index gaining over 7% and the Russell 2000 small cap index gaining over 3% for the period.  Investors maintained interest in risk-based assets even as concerns remain about the impact of tariffs imposed on China and other major trade partners, and as the Federal Reserve continues the path of measured increases in the Federal Funds rate.  That rate has increased from 0.25% to 2.25% since 2015, as the Fed Board has implemented eight quarter-point raises over that time.

The quarter provided solid returns across many stock sectors, with sizable gains in all sectors except for Energy, Materials, Utilities, and Real Estate.  Those latter two in particular are sensitive to interest rate changes, and the Fed implemented the latest rate increase right near quarter-end.  The Energy sector endured notable volatility in the quarter, with a Brent crude barrel going from the high $70s down to around $70 before closing the period above $80.  The S&P GSCI commodity index gained just over 1% for the quarter, as its overweight to energy relative to other benchmarks helped offset a drop in the price of gold.

Near quarter-end, the S&P 500 underwent reconstitution in several of its underlying sectors.  Key stocks within the Consumer Discretionary and the Technology spaces (both primary aspects of the Growth-style investment universe) have been transitioned to the Communication Services sector.  For example, Facebook and Alphabet (parent of Google) have been moved from Technology, while Disney and Netflix have been moved from Consumer Discretionary.  This transition made sizable reductions to the Tech and Consumer Discretionary sector weights in the S&P 500 and can have a significant impact on returns going forward, particularly with so much buy/sell activity being done via sector-based funds.
 
Here is a brief overview of the changes derived from this sector repositioning.  Note that the Telecommunications sector has been renamed to Communication Services:

Sector Name		Previous Weight		New Weight		Change
Communication Services		2%		10%		8%
Technology		27%		21%		-6%
Consumer Discretionary		13%		10%		-3%

 
These are the only three stock sectors impacted by the index transitions.  (The change does not net out to zero on this chart due to some rounding errors.)

Meanwhile, non-domestic stock indexes had a mixed quarter with the broad developed EAFE index gaining about 1.5% while Emerging Markets continued to struggle; although Emerging Markets did finish the period only slightly negative for the full quarter.  International equities continue to be dragged by trade concerns, and the strength of the U.S. dollar.   While returns in non-domestic stocks have broadly been disappointing, these classes also show much lower average valuations and higher yields than the domestic counterparts. 

Fixed income was broadly flat for the quarter, with the Barclays Aggregate domestic bond index down slightly and the Barclays U.S. Investment Grade Corporate index up about 0.7% for the period.  High Yield provided stronger returns, with a gain of over 2% for the period as investors continue to favor risk-based bond assets.  The 10-year Treasury yield also continues to rise, finishing the quarter at just over 3%.  As bonds continue to work through the impact of rising rates, CDs have benefited from the rate increases as 1-year CDs are now available with yields of around 2.5%. 

Another area highly impacted by rate rises is the mortgage market, with the average national 30-year mortgage rate climbing to nearly 4.7%.  By historical standards this is still low, but it can impact the willingness of prospective homeowners to purchase.  This trend is one to watch for investors, and might start to impact broad economic results going forward.

Looking ahead, we believe that volatility will remain elevated as investors consider the impact of mid-term elections, trade issues, valuations, and the impact of slowly but steadily rising interest rates; however, investors have thus far shown willingness to stay invested despite these and other issues.  In the third quarter we saw sizable gains throughout many sectors. It was not simply Tech and Discretionary carrying returns as we have seen in recent years; we also saw solid gains in both Mid Cap and Small Cap domestic stocks, showing investor willingness to invest in smaller, often more volatile asset classes. 
 
Equity Income Commentary
It has been speculated for some time that market leadership will shift from Growth to Value. While Technology continues to be a leading sector, the recent quarter demonstrated more breadth of returns. Cutler Equity Income Strategy had a gross return of 6.68% (6.53% net) versus 5.70% for the Russell 1000 Value. The S&P 500 continued to post strong returns of 7.71% in the quarter.

Qualcomm, Inc. was the best performing holding in the quarter, up 29.45%. After a high-profile lawsuit with Apple, anti-competitive fines in South Korea, a failed takeover by Broadcom, and a failed acquisition of NXP Semiconductors (phew, that’s quite a list!). The market seems to be forecasting better times ahead for Qualcomm. Should the Apple lawsuit be resolved favorably, this could be a nice additional catalyst for the stock.  Merck (+17.66%) and Microsoft (+16.41%) were the next strongest performers in the strategy. Perhaps more than any other portfolio holding, Microsoft’s stock performance reflects the economic trends and market momentum and has benefitted from the growth of its cloud computing business.

On the negative side, Schlumberger (-8.37%), Blackrock (-4.93%), and Intel (-4.26%) were the worst 3^rd Quarter performers. Intel’s losses were at AMD’s gains, which has improved their technology and gained competitiveness in the semi-conductor space. We will continue to monitor Intel’s market positioning and our overall semi-conductor exposure accordingly.

We made one position change in the period, selling National Fuel Gas (NFG) and replacing it with Republic Services (RSG). This was a quality upgrade, as NFG is a regional utility company and RSG has a national footprint. NFG had increasingly gravitated toward natural gas exploration and production, which was a shift from the distribution model of a utility. The stability of cash flows of RSG and the company’s market position as one of the two largest waste disposal firms in the country fit nicely with our investment approach and the strategy’s defensive objectives.

Net performance is pre-tax, net of advisory fees and transaction costs and includes the reinvestment of dividends. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be profitable or suitable for a particular investor's financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.

Source: Morningstar

All opinions and data included in this commentary are as of October 3, 2018 and are subject to change.  The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase or sell securities. This information should not be used as the sole basis to make any investment decision.  The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.  Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

TOP 5 AND BOTTOM 5 HOLDINGS BY PERFORMANCE - AS OF 9.30.18
Best Performing Securities	Average Weight (%)	Security Contribution to Portfolio Return (%)
Qualcomm Inc.	2.61	0.72
Merck & Co. Inc.	2.62	0.45
Microsoft Corp.	5.03	0.81
Medtronic PLC	2.43	0.39
Union Pacific Corp	2.01	0.31
		Security Contribution to Portfolio Return (%)
Worst Performing Securities	Average Weight (%)	Security Contribution to Portfolio Return (%)
Schlumberger Ltd.	1.14	-0.10
BlackRock Inc.	4.13	-0.22
Intel Corp.	3.30	-0.15
M&T Bank Corp.	3.17	-0.09
Chevron Corp.	3.41	-0.09
The holdings identified do not represent all of the securities purchased, sold, or recommended for the adviser's clients. To obtain the calculation methodology or a list showing the contribution of each holding in the representative account to the overall account's performance during the measurement period, please call 1-800-2CUTLER or send a request to info@cutler.com

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