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Global Market UpdateOctober 1, 2018
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Global Market Update
The Economic Backdrop: Rates. Growth. Inflation.
Interest Rates. On September 26th the Federal Reserve raised a key interest rate and, in their statement,
made clear through the use of the word “strong” five times, that the economy is on strong footing, job gains
are strong, unemployment is low and that household spending and business investment have grown strongly.
Fed Chairman Powell downplayed the feared trade wars with China and Europe citing that inflation has not
shown up in prices yet.
The Fed has signaled that interest rates are likely to continue to increase. We STILL believe that the Fed is
telling the truth.
There is an old adage that says, “Three hikes and a stumble,” meaning that when the Fed hikes for the third
time, the stock market typically falls. This has not held true so far as the Fed has raised rates eight times since
the end of 2015 and the equity markets have been very resilient – even hitting new highs in September. (That
may say a lot about overly simple rules of thumb!) That rates are going up is not terrible news for equities
because we’ve been at such low rate levels. However, higher yields on bonds will mean stocks have more
competition and it’s not good news for bond prices.
The bond market had Halloween come early and stay around. It’s been scary for bond investors. Consider that
an interest rate increase of 0.50% on the 10-year bond means a loss of more than 4% of the current market
value of that bond. With that bond’s yield currently hovering around 3%, that means a loss of more than a
year’s worth of interest.
In this environment, many income investors will need to look to dividend paying equities and alternative
income classes for current income. Business Development Companies (BDCs), Senior Loans, Master Limited
October 2018
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Partnerships (MLPs) and even High Yield Bonds may add yield and help mitigate against a rising rate environment, despite recent rallies in those areas. Investors must be aware that getting yield from alternative asset classes may pose different risks than traditional bonds.
Given a healthy economic backdrop and that interest rates appear destined to rise, a situation that will virtually continue to ensure principal losses in investment grade bonds, these non-traditional income instruments may continue to get attention as they are less interest rate sensitive than the traditional investment grade bonds in the Barclay’s Aggregate Bond Index.
Growth. The economy is growing, hitting on all 10-cylinders with no misfires. While it’s difficult to quantify
the impact of decreased regulations, we see that the environment for starting or running a business has
improved dramatically. While tax cuts have helped, the dramatic reduction in federal regulation and red tape
has had a tremendous positive impact on business activity. As a result, Fed policymakers have raised their
prediction of GDP (Gross Domestic Product) growth to 3.1% annually.
Companies have reported good earnings and consumers are spending. In fact, consumers are starting to rack
up debt again, which shows us that the economic cycle is still alive. Believing that there is nothing new under
the sun, debt will be a problem again at some point. In fact, in the developed world, Greece is the only
country where consumer spending is a larger percentage of the country’s GDP than the US – and there, only
by 0.1% (68.8% vs. 68.9%). You can see the seeds of a future crisis and contagion being sown today.
Inflation. There is no real inflation. An investor need look no further than what’s happening in TIPs
(Treasury
Global Market UpdateOctober 2018
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Inflation Protected Securities). They have traded down since 2012, which indicates the smart money is not
concerned about inflation. Gold, another asset that works well during times of high inflation, has been in a
bear market since 2012 and is at the same price as 2010. Buy-and-hold gold investors have not made money
for eight long years. As we mentioned years ago, when you see a “Cash-For-Gold” store crop up on every
corner, that might be the sign of a market top (for gold). In our area, one of those stores was just torn down
and a new high-rise office building is replacing it.
While some would argue we are at full employment which, traditionally, would signal rising inflation, the Fed
Global Market UpdateOctober 2018
is being proactive by
raising rates while
inflation sensitive assets
are not showing signs of
any substantive
inflation.
We do see inflation in
the price of a cup of
coffee and that may
eventually work its way
into the system. But as
of today, people are
finding other ways to
offset the cost of that
latte.
U.S. Inflation Rates 1914 - 2017
Source: https://inflationdata.com/Inflation/Inflation_Rate/HistoricalInflation.aspx; used with permission.
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Market Outlook:
THE Ts: TRUMP, TRADE AND TARIFFS
The equity markets, while flirting with all-time highs in the US, appear to be headed higher. The Ts, the threat
of Trump, tariffs and trade wars continue to have some a wet towel effect on the global equity markets with
emerging markets hit especially hard. While tensions over potential trade wars and the impact of tariffs have
moderated in recent weeks, there has been significant impact on emerging Asian markets.
No one knows what effect the mid-term elections will have on the markets and, if history has anything to show
us (and it may be the only guide we have), it won’t likely matter in the near-term. Markets have done well
under Republicans and Democrats. Policies, not party, lay the foundation for faster or slower growth.
Emerging Markets – and their double-digit correction this year – are the big downside story. And it may
take some time to make up lost ground.
And here’s why: The MSCI emerging markets index is comprised of roughly 33% China. Until there is
resolution to tensions on trade, this investment type is unlikely to be capable of a full recovery to old highs or
higher. While Chinese markets continue to make new lows, markets in Brazil and South Korea appear to have
stabilized. This correction in emerging markets is driven by concerns over future actions that may or may not
materialize. Right now, it is a game of chicken – and not the good, Nashville Hot kind of chicken.
So far this year, as of 9/26/18, the Brazilian stock market is down more than -29%, the Chinese large cap
index down more than -20% and South Korea down more than -15%.
Global Market UpdateOctober 2018
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Despite the headwinds or crosscurrents, our strong commitment to Emerging Markets since 2016 is still intact.
Earlier this year, we reduced our commitment to developed International markets. That helped de-risk our
portfolios. And while both have been losers year-to-date, the developed International markets have lost much
less than Emerging Markets. Since hindsight is 50/50 (as Yogi Berra said), we would’ve been better off to also
reduce our Emerging Markets exposure. But we didn’t.
Here is what we know: Emerging Markets (EM) make up roughly 25% of the world’s economic output
(GDP), but in a typical portfolio in the US, they account for less than 4% of the average US investor’s
Global Market UpdateOctober 2018
portfolio. And while they are
about 35% more volatile than
US stocks, they are far less
expensive than US stocks by
several measures. Compared
to US stocks, EM stocks are:
• 30% less expensive based
on earnings (past P/E ratio),
• 40% discounted on
projected earnings, and
• 60% lower based on price-
to-book valuations.
This quilt-chart shows the annual return and rank of the U.S. market (red) compared to the other 19 top 20 global markets for the last ten years. Source: Luken Investment Analytics and Morningstar Direct.
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That doesn’t mean these markets can’t go down a lot from here. They can. Sometimes they do. According to
our proprietary risk indicators, there have only been three times in the past decade and a half that the risk
has been this low in these markets. The same systematic, disciplined approach that kept us out of EM in
2014-15 and directed us to outsized commitment in 2016 is clear today. And while that certainly does not
ensure a gain, those indicators give us continued confidence – which is why we have not eliminated EM from
the portfolio.
Most investors in the US have a strong home country bias in investing and that is understandable. As
economic growth has spread throughout the world, the US becomes a smaller percentage of the global
economy (GDP). Today, more than ever, it makes sense to at least consider investments beyond our borders.
We believe technology stocks still have a bright future in US markets. Despite valuations being on the high
side, earnings have been solid. Technology stocks tap into the human spirit for innovation and increased
efficiency and effectiveness. As we have said for the past three years, we continue to believe small cap stocks
are a bad bet. Tech stocks are better positioned than small caps at this point in the economic cycle and will
continue to offer more return for similar risk.
Contagion Risk. We believe contagion risk has increased dramatically. Over the past five years, there
has been an accelerating trend toward passive strategies, including index funds. According to Morningstar,
more than 85% of incoming money in 2017 and the first quarter of 2018 went into passive strategy funds. We
believe this underscores a general lack of risk management due to the intrinsic passive design aspect of
passive strategies.
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Our current allocations and investment changes reflect the best of our thinking based on the evidence we
have today filtered through our disciplined screening process.
So while the longest bull market in US history flirts with all-time highs, the Wall Street Journal publishes
stories about impending recession and as politics becomes more discussed and more polarized, the need for
proactive risk-management has rarely been more pronounced. We are devoted to moving investors forward
toward the goals they are passionate about. The set-it-and-forget-it approach to investment management is
not likely to fare well in the next downturn, whenever it occurs.
We know that no form of risk management is perfect, however, having a good game plan for how to invest in
good markets and in bad will give our clients and ourselves the best chance for financial success.
Luken Investment Analytics (“LIA”), or its employees, may actually hold some of the securities discussed in our
portfolios or the portfolios of our clients. This creates a conflict of interest. In order to resolve this conflict, we disclose
that we do own the securities discussed, however, the company is not an investment banking client of the firm and no
members of our firm or personal households are an officer, director or board member of companies discussed.
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Trend, Strength, and Risk Signals
Trend
Solid line is the short-term trend indicator. It signals a positive short-term trend when it moves above the zero
line. This is primarily used to increase or initiate asset class exposure. The histogram is the long-term trend
signal. The long-term signal is used to signal reductions or an exit of an asset class when it drops below the
zero signal line. This asymmetrical view of trends makes it easier to enter asset classes than to exit, creating a
bias toward staying invested.
Strength
The strength indicator is a proprietary indicator of the underlying strength of an asset class’ trend. Increasing
levels or levels that are generally High indicate high strength. A downward trending strength line shows that
the asset class is losing strength. There are intermediate (line) and long-term (histogram) strength signals.
Risk
Decreasing levels of this indicator indicate risks are decreasing. Higher levels of this indicator indicate risk
levels are high. Again there are intermediate (line) and long-term (histogram) signals.
How to interpret the indicators on the following pages
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U.S. Broad Market IndicatorsMost Recent Quarter as of 9/30/2018
Representative indices include: Morningstar US Large Val TR USD, Morningstar US Large Core TR USD, Morningstar US Large Growth TR USD,Morningstar US Mid Val TR USD, Morningstar US Mid Core TR USD, Morningstar US Mid Growth TR USD, Morningstar US Small Val TR USD,Morningstar US Small Core TR USD, Morningstar US Small Growth TR USD. It is not possible to invest directly in an index. Source: Morningstar.
V a l u e C o r e G r o w t h
L a r g e 6.94% 9.90% 7.16%
M i d 2.37% 3.99% 7.86%
S m a l l 1.86% 1.39% 7.61%
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U.S. Broad Market IndicatorsYear-to-Date as of 9/30/2018
Representative indices include: Morningstar US Large Val TR USD, Morningstar US Large Core TR USD, Morningstar US Large Growth TR USD,Morningstar US Mid Val TR USD, Morningstar US Mid Core TR USD, Morningstar US Mid Growth TR USD, Morningstar US Small Val TR USD,Morningstar US Small Core TR USD, Morningstar US Small Growth TR USD. It is not possible to invest directly in an index. Source: Morningstar.
V a l u e C o r e G r o w t h
L a r g e 4.08% 7.74% 20.38%
M i d 3.29% 3.52% 17.03%
S m a l l 3.19% 4.70% 20.07%
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Global Broad Market IndicatorsMost Recent Quarter as of 9/30/2018
1
Dow Jones Industrial Average Nasdaq 100 Russell 2000
DevelopedInt’l Markets
EmergingMarkets
Barclays Aggregate Bond
Real Estate Investment Trusts Commodities Managed
Futures
U S S t o c k s 9.63% 8.61% 3.58%
I n t ’ l S t o c k s
U S B o n d s1.42% -0.95% 0.02%
O t h e r s -0.25% 1.70% 0.20%
Representative indices include: DJ Industrial Average TR USD, NASDAQ 100 TR USD, Russell 2000 TR USD, MSCI EAFE GR USD, MSCI EM GR USD, BBgBarc US Agg Bond TR USD, Cohen & Steers Gbl Realty Majr NR USD, DBIQ Optimum Yield Div Comdt TR USD, Credit Suisse Mgd Futures Liquid TR USD. It is not possible to invest directly in an index. Source: Morningstar.
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Global Broad Market IndicatorsYear-to-Date as of 9/30/2018
1
Dow Jones Industrial Average Nasdaq 100 Russell 2000
DevelopedInt’l Markets
EmergingMarkets
Barclays Aggregate Bond
Real Estate Investment Trusts Commodities Managed
Futures
U S S t o c k s 8.83% 20.18% 11.51%
I n t ’ l S t o c k s
U S B o n d s-0.98% -7.39% -1.60%
O t h e r s -0.75% 8.71% -7.71%
Representative indices include: DJ Industrial Average TR USD, NASDAQ 100 TR USD, Russell 2000 TR USD, MSCI EAFE GR USD, MSCI EM GR USD, BBgBarc US Agg Bond TR USD, Cohen & Steers Gbl Realty Majr NR USD, DBIQ Optimum Yield Div Comdt TR USD, Credit Suisse Mgd Futures Liquid TR USD. It is not possible to invest directly in an index. Source: Morningstar.
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Disclosures
Luken Investment Analytics, LLC ("LIA") is registered with the Securities and Exchange Commission ("SEC") as an Investment Adviser.
Registration does not constitute an endorsement of the firm nor does it indicate that the adviser has attained a level of skill or ability.
LIA provides non-discretionary subscription advisory services to other registered investment advisers and investment adviser
representatives and does not provide advice to underlying clients of those firms and representatives to which it provides subscription
services. LIA provides discretionary advisory services to retail clients of LIA.
Information presented herein is for educational purposes only and does not intend to make an offer or solicitation for the sale or
purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. This
information does not address individual situations and should not be construed or viewed as any type of recommendation. Be sure to
first consult with a qualified financial adviser, legal and/or tax professional before implementing any securities, investment or
investment strategies discussed herein.
The data shown was obtained from sources deemed reliable and then organized and presented by LIA. Different types of investments
involve varying degrees of risk and there can be no assurance that any specific investment will either be suitable or profitable for a
client's investment portfolio. Economic factors, market conditions and investment strategies will affect the performance of any
portfolio, and there are no assurances that it will match or outperform any benchmark. Investing in non-traditional and international
investments involves additional risks that are not generally associated with investing in domestic equities.
Benchmarks: The index / indices shown herein have not been selected to represent an appropriate benchmark to compare an
investor’s performance, but rather are disclosed to allow for comparison to that of certain well-known and widely recognized indices.
Indices are not available for direct investment, are unmanaged and do not incur fees or expenses.
It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities
included herein.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Not FDIC insured. All investment strategies have the potential for
profit or loss.