Global Opportunities Class Commentary Q1 2017

Market Overview: Equities

The S&P remains near record highs despite a modest pull back most recently. The only period when stocks were more expensive was during the days of the dotcom bubble.

On a historical basis, it is hard to argue that equities are anything other than expensive. However given the fact we see no systematic risk factors today, we believe they will remain expensive and likely get more expensive based on traditional methods.

However, valuing equities is a complicated issue. When one examines a broad array of valuation indicators, we begin to see a slightly different message; U.S. stocks are expensive in absolute terms, but are less stretched relative to both other asset classes and other equity indexes.

When we decompose the index into three major components, earnings, balance sheet metrics and yield it shows a somewhat different story.

(a) Earnings – excluding the Tech bubble the S&P is at historical highs.
(b) Balance Sheet – when we look at market value of equities relative to corporate net worth again we are near highs.
(c) Yield – of the three groups, this area give a less expensive reading.

While stocks are expensive on an absolute basis, they become more appealing on relative terms, when we compare the yield on stocks vs other asset groups. Stock yields are well above real corporate bond yields, cash and treasuries. As long as this continues we believe that equity returns should outperform treasuries, cash and high quality corporate bonds over the next year or so. It is a relative game at the end of the day. Would I rather own cash at less than 0.5% Treasuries at 0.75 to 2.3 or equities 2.5% plus. Until these measures reverse we are likely to see this continued tug or war.

In the Portfolio

The first quarter of 2017 was one of the best in history for the U.S. markets with the S&P up 5.5% and NASDAQ up 9.8%. While many would credit Trump (he certainly will) for the move, we believe the U.S. economy was already accelerating before the election as we outlined in our Economy section. We believe we are finally normalizing the economic environment. The FOMC increased rates in March and seems more intent on raising rates. The sector now focuses on the level of rates and the Fed’s balance sheet. The U.S. is basically at full employment so the Fed has reached their target. Housing is now at levels that we experienced historically – 1.4 million starts per year. Not too hot, not too weak. Volatility has also been reasonably in check, while consumer confidence is at new highs. Therefore unless growth deteriorates materially, rate hike expectations should trend higher, providing new term support for the U.S. dollar, short treasuries and Financial stocks.

During the quarter the Fund registered a return 6.33%. After a difficult start last year, we welcome a better number. Our focus remains on growth and we have been more focused on stock picking rather than sector calls (which hurt us last year). The portfolio is much more balanced relative to sectors and has basically been fully inverted since the election. Its largest exposes has been Financial, Technology and Consumer Discretionary. It still maintains a higher exposure to large capitalized companies and liquidity. Going forward we are unlikely to change our strategy with the exception of increasing our energy weighting slightly.

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The opinions expressed herein reflect those of the individual portfolio manager. These opinions are subject to change at any time based on market or other conditions, and Front Street Capital disclaims any responsibility to update such views. These opinions may differ from those of other portfolio managers or of Front Street Capital as a whole.

These views are for informational purposes only and are not intended to be a forecast of future events, a guarantee of future results or investment advice. All data referenced herein are from sources deemed to be reliable but cannot be guaranteed.

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