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Februrary 2018 Performance Review

March 2, 2018

The problem with a fast climbing market is that sometimes it falls just as fast. This was the case in 1929, 1987, and 2000. Valuations like P/E ratios are relevant to long-term returns but don't mean much when facing extreme short-term volatility. Investors want to make money during sharp rises but don't want to get caught without a chair when the music stops; they tend to leave quickly and in droves at the first hint of a downturn.

February's dramatic drop was briefly more than 10% and technically qualified as a "correction". Almost immediately after the drop, the market rebounded sharply. Then in early March, on new trade war fears that could also impact prices in America and cause an economic drag, the market dropped anew.

We are now in a pretty volatile market after many months of relative stability. Everything fell in February (including bonds) as future interest rate increases where the major concern. Inflation investments like TIPS, gold, and commodities, perhaps even Bitcoin to some, didn't do well so this narrative is a little suspect. Because our short positions have dwindled in size relative to the portfolio after a long rise in stocks, and our longer--term bond funds were hit almost as hard as stocks, we fell along with the markets. Our combined portfolio returns only did about as well as our total portfolio Vanguard benchmark.

Our Conservative portfolio fell 2.39% in February. Our Aggressive portfolio dropped 3.35%. Benchmark Vanguard funds for February 2018 were as follows: Vanguard 500 Index Fund (VFINX) down 3.70%; Vanguard Total Bond Market Index Fund (VBMFX) down 1.03%; Vanguard Developed Markets Index Fund (VTMGX) fell 5.23%; Vanguard Emerging Markets Stock Index (VEIEX) down 4.73%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, dropped 2.74%.

As discussed last month, this is a bit of a too much of a good thing crash all around — tax cuts into a strong economy sending inflation and interest rates high enough to lead the Federal Reserve to (potentially) over react and raise rates too high, causing a recession and growing debt issues as the government refinances debt at higher rates, all while a tax cut reduces federal revenues.

The best- broad 'style box' category in the U.S. was larger--cap growth funds which fell just 2.6%. The worst was small-cap value category funds — down 4.8% on average. The gap in one year returns between these two categories at the opposite ends of the style box is stark: large-cap growth is up about 24% in the last twelve months while small-cap value is up just 4%. This is the why we were in larger-cap funds and shorting small-cap stocks: because this would have created a nice lower risk return in a low yield environment not tied to rate fluctuations with limited stock market downside as you earn the gap between these two performance streaks. Even with the costs and problems of these inverse funds, a simple portfolio with the S&P 500 ETF and an inverse small-cap fund a year ago would have delivered a positive return of about 6% over the last 12 months with a sub 1% downside in the February slide. An actual large-cap growth ETF and an actual short position in a small-cap value ETF (where you borrow the shares and sell them) could have delivered a higher return with an almost market neutral risk profile — especially just looking at the capital invested in the long position minus any margin fees and borrowing costs.

Riskier bonds and longer-term bonds were both hit in February; down 1%-3% typically. Only cash and very short-term bond funds were near flat. There was really no fund category up for the month with heavy losses in energy funds, down just over 10% for the month. Energy is now the second worst traditional category of funds over the last five years down 7% per year on average (with only precious metals funds down more at over 8% a year on average). The whole dividend value/ foreign stock/real return /commodity focus that was popular in recent years has really underperformed a late 1990s style tech and growth portfolio.

While we were right to be short gold and energy related stocks gold the metal which we short hasn't done as poorly as gold mining stocks which are what makes up most of the precious metals fund category holdings. That plus the costs of shorting often make right calls so to say less profitably than they should be especially over longer periods of time which is why mere avoidance of hot areas is the main goal for most investors — but it is difficult in this index focused world.

Our shorts (unsurprisingly) led the way in February with ETRACS 1xMonthly Short Alerian MLP (MLPS) up just over 10% thanks to a drop in energy and related stocks. Our shorts made up our five best performers this month as would almost be expected in a down month for everything. Shorting gold in theory shouldn't have worked if we really have rising inflation fears but again that story is taking the blame a bit for just a collapse in speculative euphoria.

Our performance problem last month is our longer-term bond funds Vanguard Long-Term Bond Index ETF (BLV) and Vanguard Extended Duration Treasury (EDV) were down between 3.13% and 4.29% respectively last month and our other stock funds mostly underperformed the S&P 500.

We were too value and interest rate oriented in this growth dominated market where tech funds were among the least hurt by the slide down — down just 1% on average after their rebound late in the month. The current most pressing fear continues to be inflation. and tech companies are presumably the most insulated from higher interest rates and inflation. Of course, these presumptions by investors have a way of coming undone rapidly when the money really starts evaporating. You can expect the best performing areas (and hence those that attracted the most money) to fall the hardest regardless of whether they are insulated from the current economic issues.

Stock Funds1mo %
ETRACS 1xMonthly Short Alerian MLP (MLPS)10.49%
Proshares Ultrashort NASDAQ Biotech (BIS)9.48%
Proshares Ultrashort Russel2000 (TWM)7.18%
PowerShares DB Crude Oil Dble Short (DTO)4.92%
Gold Short (DZZ)4.37%
Artisan Global Equity (ARTHX)-3.02%
iShares Mortgage REIT (REM)-3.23%
[Benchmark] Vanguard 500 Index (VFINX)-3.70%
Vanguard Utilities (VPU)-4.11%
Homestead Value (HOVLX)-4.30%
Vanguard Value (VTV)-4.44%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-4.73%
Vanguard Europe Pacific ETF (VEA)-5.11%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)-5.23%
Vanguard Telecom Services ETF (VOX)-5.72%
iShares MSCI Italy Capped (EWI)-6.13%
Vanguard European ETF (VGK)-6.15%
iShares MSCI BRIC Index (BKF)-6.94%
Bond Funds1mo %
Vanguard Mortgage-Backed Securities (VMBS)-0.66%
SPDR Barclays Intl. Treasury (BWX)-0.75%
Artisan High Income Fund (ARTFX)-0.93%
[Benchmark] Vanguard Total Bond Index (VBMFX)-1.03%
Vanguard Long-Term Bond Index ETF (BLV)-3.13%
Vanguard Extended Duration Treasury (EDV)-4.29%