Q4 2017 Portfolio Commentary & Outlook – Second Half of the Chessboard

January 5, 2018

2017 is in the books. In comparison to other annual chapters that make up the thick tome of our financial history, a few items stand out and deserve mention. First, 2017 is the only year in which the S&P 500 did not record one down month; second, technology companies took back the limelight and drove returns across the globe; and lastly, subthemes of tax law changes and surging digital currencies created the air of a shifting financial framework.

While you’d be hard-pressed to find anyone complaining that U.S. markets were up 12 straight months in a row; it does mean that valuations are high and getting higher. A lower corporate tax rate of 21% (down from 35%) will help earnings in 2018 and should drive investment spending, potentially bringing valuations down a touch in the U.S. However, we would need stock prices to moderate or move sideways concurrently for valuations to meaningfully regress toward their mean.

Fortunately, not all stocks are at stretched valuations. We are still seeing better opportunities overseas, even after a strong showing in 2017. Until the risk/reward dynamic shifts to being unfavorable, we will maintain our overweight to foreign and emerging market stocks. Foreign stock outperformance, as measured by the MSCI EAFE index, tends to run in cycles. Due to the length of the latest period of U.S. outperformance (almost 10 years!), we may be in for a healthy run of foreign stocks leading the charge.

The BSW growth benchmark, the All Country World Index, was up a very respectable 23.97% in 2017. With solid stock gains in our portfolios from last year, we will once again be using our January rebalancing moves to harvest gains in stocks and reallocate to other asset classes.

Cashing in some of our chips doesn’t mean we’re getting any less sanguine about the upcoming year. On the contrary, we think there is more room for the synchronized global expansion to endure – with the technology sector continuing to lead.

It’s been 17 years since the market was this enamored with technology stocks. Unlike the tech bubble of 2000, corporate earnings growth and legitimate, high-potential advancements have underpinned this recent Silicon Valley rally.

Admittedly, this latest wave of technological developments has taken some time to come to fruition. This is partly because the computing power and backbone needed to run the latest applications had to play catch up, and partly due to the dynamic often described through the tale of a grain of rice and a chessboard:

The story goes something like this: A man creates a new game called chess and proudly presents it to his king. His king is so impressed that he offers a reward-of-choice to the inventor. The humble man asks only for one grain of rice for the first square of his board, two for the second, four for the third and continuing to double for the full 64 squares. The King happily agrees, believing the reward to be very reasonable. They start metering out the rice and at first, the amounts are tiny. As they keep doubling, soon the next square needs the harvest of a large rice field.  The king soon concedes defeat. Even his resources cannot deliver a mountain of rice the size of Everest.

Exponential growth looks small at first until it suddenly becomes almost incomprehensible.

Taking the above and applying it to technological advances, I believe 2018 represents the 3rd row of the board. In other words, things are about to take off, and quickly.

We are already seeing this in the way Amazon has disrupted the retail supply chain, how self-driving cars are now feasible, and the way artificial intelligence and machine learning is supporting advances in medicine and enabling solutions to heretofore unsolvable problems.

There will be clear winners and losers in this next wave of technological advances. This will be true not only across companies and stocks but across entire industries, social structures, and economies. It will pay to allocate to managers that understand which disruptive technologies have the best probability of creating lasting change and who grasp the ramifications of these changes. BSW has been challenging our managers to clearly elucidate their thought process around disruptive change and what investment actions they are taking within their mandates.

One technology that can no longer be ignored is blockchain and by extension, bitcoin. For the uninitiated, blockchain is an open, distributed digital ledger that is used to record transactions across many computers so that the record cannot be altered retroactively. Importantly, it can be used for almost any transaction and is efficient, cheap, verifiable and permanent.

Bitcoin is a cryptocurrency that is created through a computer “mining” process. Bitcoin are issued as a reward for verifying transactions on the blockchain. We could devote entire blog posts to the subject and may do just that in the future, but for now, let’s keep it at this high level.

Blockchain technology can alter how entire companies and industries do business. A silly, but pointed example of this was announced as I penned this piece. A publicly traded burger company, Chanticleer Holdings, will issue reward points on the blockchain to those who dine at their well-known (to some) Hooters franchises. These reward points will become a digital currency that can be redeemed for future meals, or traded to other consumers (A good analogy would be if there was a liquid and ready market for your hard-earned airline miles).

I’m not going to comment on the stratospheric rise of the price of Bitcoin, other to say that in its current form, it fits some (but not all) of the traditional definitions of a currency: a form of money used as a medium of exchange for goods and services and for the basis of trade.

One of the issues with Bitcoin has been that the primary users of the currency trading markets, big corporations, cannot transact in a medium of exchange that can be worth, for instance, $19k USD one day and $13k USD the next.

The nearly $6 trillion/day currency markets could certainly benefit from a digital currency that can be transacted anywhere around the globe cheaply and within seconds. Currently, transactions are routed through the SWIFT system, formed by international banks in 1974 (the same year as the G.I. Joe with the kung-fu grip came to market).  A speedy settlement through this arcane system takes two days!

It seems inevitable that governments will get into the digital currency game and issue their own versions. Russia, Japan, and Venezuela have already started down this road and the Federal Reserve is considering issuing the “Fedcoin.” Make no mistake; this is a gamechanger.

By pegging digital, government-issued cryptocurrencies to government-issued paper currency, the volatility of these sovereign cryptocurrencies would likely be much lower; low enough to offer large corporations a cheaper, faster, safer way of transacting. Paper money will be phased out over time. Who carries paper money anymore anyway?

Central bank issued digital currency will mean that the Federal Reserve will have more tools at their disposal to influence the economy. With a national cryptocurrency, whose supply is controlled by the central bank, negative interest rates can be more easily enacted. Imagine: central banks, with a single line of code, could deposit $1,000 into every citizen’s digital wallet if it looks like the economy was headed for a recession; rather than relying on banks to lend – if they feel like it.

Ironically, it may end up that government-issued cryptocurrencies make the Bitcoins of the world either worthless or, more likely, relegated to a niche segment of the economy. Governments, through their own cryptocurrencies, will be able to track every dollar spent, turning on its head one of the main reasons why Bitcoin has taken off – anonymity.

Change can be unsettling. Especially if the motivation behind it and the likely outcomes are not understood. BSW is looking at risks and opportunities through more lenses than we ever have before. In a world where the rice piles are almost skiable, it is a must.

Happy New Year!