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With equity markets trading close to their all-time highs it would be easy to assume that most stocks in the S&P 500 are experiencing a similar performance.  After all, the index represents the market, right?  In our opinion, we are approaching a new phase of the current equity market cycle.  What follows are a few observations that characterize this new phase:

  1. Companies that have built shareholder wealth on “brand value” are having difficulty competing in a world where white label (especially in consumer products) is increasingly sought after.

     

  2. Companies generating little to no innovation in products are experiencing a much-deserved valuation adjustment.

     

  3. The potential negatives of corporate acquisitions are starting to show through. Management teams that cannot deliver on announced goals are seeing dramatic adjustments share price. Contrary to popular belief, not all acquisitions are beneficial.

     

These are just a few examples (of many) that need to be recognized when looking at equity investments in the current environment.  By no means are the companies depicted above unique.  To the contrary, there are many more we could show.

This brings us to the key concept of this article: investments that have the perception of being “safe” can no longer be relied upon as such.  In large part, I’m referring to consumer staples businesses.  These are companies that sell household consumer products, that advertise heavily to build brand value, and that have been relative outperformers when equity market conditions became difficult.

In our opinion, successful equity investing in the future will require an adjustment in thinking about what is safe and unsafe.  We are not alone in recognizing this subtle shift in mentality.  For those who have been following the annual Berkshire Hathaway meeting (held over the weekend of May 5th), the Oracle of Omaha highlights as much in the various comments he’s made throughout the conference.  In summary, Warren Buffett indicated that applying traditional “value” strategies once used early in his investing career would likely not result in the same positive outcomes today for a variety of reasons.  He goes on to say that value oriented investors need to remain vigilant against investing in “yesterday’s moats” (i.e., competitive advantage that is eroding).  With the pace of competitive dynamics quickening, ensuring company management teams evolve with the times is imperative.

Another insight we take away from the three points above is that intangible assets are less valuable than once thought.  Take brand value for example.  Some companies like Coca-Cola and Clorox have spent decades and hundreds of millions of dollars on advertising to establish a positive brand image.  Brand value is becoming less relevant in an era where (1) consumer purchases are increasingly migrating online, (2) retailers like Whole Foods Market/Amazon, Costco, and Kroger are placing an emphasis on private-label products versus branded products, and (3) stagnation in wage growth is driving consumer demand for lower-priced private label products.

In all, this article is not meant to be a call to action for our clients/investors to dump shares in consumer staples.  Instead, we draw a comparison between investing based on (potentially hazardous) rules of thumb and legitimate opportunities in the marketplace.  As we’ve always indicated, there’s no such thing as a “forever” stock.  We evaluate companies and their competitive positions at regular intervals to solidify our understanding of each position we own in our portfolio.  As you might expect, this takes a significant amount of time and effort.  We feel this knowledge will translate into a significant benefit if/when equity markets turn decidedly lower.  Until that time, we will keep our eyes open for new opportunities that may not fit within historical definitions, and we will be on alert for potential value traps.

Authored by:

Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of May 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  No graph or chart by itself can be used to determine which securities to buy or sell, or when to buy or sell them.  As with any investments, past performance is not a guarantee of future results.  There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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This quarter, we asked Gratus Capital Director of Investments Todd Jones, MBA, CAIA, to weigh in on the current financial environment and critical market trends.

Here’s what Todd is talking about this quarter. 

What are the biggest risks you see in the stock market right now?

There are four important risks to keep an eye on.

#1 – Rapidly rising interest rates due to an increase in short-term inflation. Recently, interest rates have been rising back to more normalized ranges, especially on the short end of the yield curve. This situation has the potential to make bonds competitive with equities at some point.

Clearly, we’re quite a ways off from that point. The long-term average for the 10-year bond yield is about 4.5%. Currently, the 10-year bond yield is 3%.  Another half percent could cause bonds to become competitive with equities.

#2 – A central bank policy error. The Fed and other central banks are getting too aggressive with their interest rate tightening programs.   Whether they’re raising interest rates on the short end via the discount window or running off their asset purchase programs at a faster rate than expected, a policy error would be problematic for financial markets.

Signaling the intent to raise interest rates and actually following through, with the slow wind-down of policies that were enacted years ago, will be critical to keeping stocks at their current levels.

#3 – Overconfidence of political figures and individual investors. On the government side, the tax bill (The Tax Cuts and Jobs Act of 2017) was just passed, and it may be followed by an infrastructure bill. While growth initiatives aren’t a bad thing, it’s very late in the cycle to be putting growth initiatives in place.

These initiatives would have been much better suited seven or eight years ago, but now that the economy is at full employment, the job market is going to become very competitive, which has the unsavory side effect of potentially creating inflation.

On the corporate side, share buybacks are set to hit their highest level ever. Typically, corporations have very poor timing for buying back shares. Usually, they buy the most at the peaks and don’t buy anything at the troughs. Corporations seem to be buying back a lot of stock—or probably too much—at prices that are not attractive.

#4 – Continued strengthening of the US dollar. A strengthening dollar has the effect of sucking liquidity out of the global financial system. If asset prices are built on increasing liquidity, then reducing liquidity should have the opposite effect. That’s what we saw in 2015 and ’16, when the US dollar rose dramatically, tanking oil prices and collapsing overseas dollar funding, which brought emerging market currencies down dramatically.

How is Gratus addressing these concerns on behalf of clients?

Generally, we are de-risking portfolios. Step one was trimming back our equity exposure to target over-weightings. We conducted a rebalance of many of our accounts in late January, reducing equity exposure and raising cash positions.

The second piece is that this is a great time to consider cash as an investment with a lot of optionality, especially now that interest rates have risen. Generally speaking, cash is rarely thought of as an investment. But now, investors are actually getting a decent rate of return in the money market. Holding cash isn’t necessarily as bad as it used to be, where the money market had an almost 0% expected return.

The third piece is, we’re adding more to what we consider to be our alternative bucket in our accounts. Typically, most of our portfolios are divided into equity, fixed income, alternative and cash buckets. We’re adding to the alternative bucket primarily, because we’re finding good opportunities.

Usually, alternative assets don’t depend on equity or fixed income markets to generate a return.  Instead, a typical investment in alternative assets is more focused on differentials. If we’re using a market-neutral strategy, buying good companies and shorting overvalued companies doesn’t require a high multiple or a low multiple to be successful. Additionally, in private markets we’ve been adding exposure to certain strategies that have an appropriate risk/reward.

Some investors fall into a trap, thinking that they have to make dramatic portfolio decisions when in fact the small ones are what can really pay off over time.

Are earnings likely to continue to grow this year?

The short answer is yes. According to FactSet, analysts estimate earnings growth in 2018 of 18% to 19%. Those estimates are showing up in company earnings reports.

We’re right in the middle of earnings announcements season for Q1, and most companies are exceeding estimates by a small margin. That’s part of the reason we’ve seen a bit of a snapback recently off the lows of February and March.

Most of these gains in earnings are coming from a one-time change in the tax rate, so we shouldn’t necessarily depend on this type of growth rate in the future. Migrating down to a much more stable growth rate from a combination of revenue growth plus productivity gains would get about 6% to 7%.

Can the stock market continue to rise if interest rates keep going up?

The short answer is yes, but the caveat is that it’s only a “yes” if the adjustments are gradual.  If the 10-year goes from where it is now to right around 4% in a couple of months, that would be toxic for equities. Not only would that rate of interest be competitive with equities, but also, funding markets such as corporate bond markets would be down dramatically — in the neighborhood of 10% to 15%.

A gradual re-rating of bonds allows equities to stay static and gives the P/E multiple time to decline as earnings growth accelerates.

What is Gratus’ approach to investing in international stocks?

We would need a compelling reason to deviate from our US bias. At Gratus, we fully recognize that investor biases come through in several different ways, one of them being home bias, and we’re certainly cognizant that we have a more US-focused portfolio.

That being said, there needs to be a reason to look outside the US, and non-US developed country indexes don’t currently present a compelling opportunity to invest internationally. As you might expect, we’re looking at active strategies in international companies.

We keep hearing an argument in the press about how international stocks are undervalued compared to US equities. On an absolute basis, international stocks are less expensive, but relative to historical ranges they are trading about where they should.  If we can’t find anything outside the US that’s not uniquely cheap or attractive relative to our US positions, then we’ll just maintain our US positions. We are a value-oriented firm across all asset classes, whether it be fixed income or alternative or equity, and if there’s no demonstrative value proposition, then it’s probably something we shouldn’t pursue.

Authored By:

Gratus Capital is an SEC registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request.  The opinions expressed are as of May 2018, and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities.  As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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On December 22nd, 2017, President Trump signed the Tax Cuts & Jobs Act (“the Act”) into law.  The bill passed Congress through the reconciliation process, thereby avoiding filibuster in the Senate but requiring revenue neutrality over a 10-year period.  As a result, many of the key provisions are scheduled to sunset at the end of 2025, assuming they are not sooner reversed or otherwise changed by a new administration or Congressional leadership. While the Act represents sweeping tax reform with significant changes to income taxation for individuals and businesses, the focus of this article is on the Act’s impact to estate planning. 

Under the Act, gift, generation-skipping transfer (GST) and estate exemptions doubled. Starting in 2018, each person may transfer $11.2 million free of transfer tax.  Married couples may effectively transfer $22.4 million due to portability of exemptions between spouses. Exemption amounts will adjust annually for inflation. The annual gift exclusion for 2018 is $15,000 per year per donee, and the unlimited education and medical exclusions remain so long as payments are rendered directly to the provider.

To the surprise of many, stepped-up basis remains under the Act. This means the tax basis of assets transferred as a result of death are stepped up to the asset value as of the date of death resulting in reduced future capital gains liability for beneficiaries. Basis step-up represents a significant planning opportunity in itself. For example, assets in a traditional credit shelter trust of the first spouse to die will not receive a second step-up upon the death of the second spouse. Reworking an existing estate plan or adding provisions to an existing plan may provide the opportunity for an additional step up at the second death. With fewer estates subject to the estate tax, basis planning may become a greater priority for many. Note that assets gifted during life do not receive a step-up; rather, gifted assets have carryover basis, meaning the gift recipient maintains the donor’s basis.

It is critical that clients review existing estate planning in light of the higher exemption amounts. Plans often use formulas based on the exemption amount to determine trust funding levels.  As you might imagine, this could result in inadvertently over or under funding trusts for a certain class of beneficiaries. For example, some plans fund trusts for the benefit of grandchildren to the extent of the GST exemption. With the much higher exemption under the Act, adjusting for the new exemption amount could result in little or no residual funding for the surviving spouse.

It is estimated that fewer than 1000 estate tax returns will be filed per year under the Act. As such, non-tax objectives such as asset protection, succession and legacy planning may be more relevant. Reviewing your plan in the context of the Act is also an opportune time to ensure designated fiduciaries (executors, trustees, guardians) are still consistent with your wishes.

For some, particularly couples with combined estates under $11.2 million and without extenuating circumstances, the new law may provide opportunities for simplification if previous planning had primarily been tax-motivated. For example, rather than automatically funding trusts upon the first death, a client may instead wish to leave everything to the surviving spouse with the ability for them to disclaim into a trust. Disclaimer trusts allow the surviving spouse (in conjunction with an attorney and other advisors) to determine whether to fund a credit shelter trust when their spouse passes based on circumstances at the time of death. If the trust is not needed, it does not have to be funded; but, if it makes sense to fund the trust, the spouse can disclaim their inheritance into the trust. Nonetheless, the benefits of simplification should be weighted against the more protective nature of traditional trust planning.

For clients with estates that were taxable under prior law (over the $11.2MM married threshold and $5 million for single clients), the Act provides a window of valuable planning opportunity. The Act’s higher exemption levels translate to tax savings of 40% of the value of an estate between $11.2 million and $22.4 million per couple – for a $22.4 million estate, that’s an almost $4.5 million gift from the government. . .but only to the extent assets are transferred while the exemptions remain at this level. Since it is hard to predict when we will die, it is arguably prudent to use the higher exemptions now via lifetime transfers. Another benefit of lifetime transfers is that subsequent growth of assets transferred occurs outside of your estate. To the extent leverage can be infused into the planning, e.g., through sale of assets to trusts or transfer of discounted assets, the tax savings can be amplified. If you are eager to capitalize on the higher exemption amounts but uncomfortable parting with significant assets, non-reciprocal spousal limited access trusts, aka SLATs, (or self-settled domestic asset protection trusts, aka DAPTs) for single clients, might be advisable. These strategies are too complex to cover in a couple of sentences but may warrant further exploration with your advisor. 

Regardless of your wealth level, as existing estate plans are reviewed, it is important to weigh the pros and cons of prior planning. Just because a strategy may no longer seem relevant, formalities such as required payments between entities or administrative procedures cannot be ignored. Many clients may be wondering if their life insurance trusts are still necessary; we recommend a thorough evaluation of available options before acting. For example, perhaps the policy could be modified to a paid-up policy, or a large gift could be made to the trust to facilitate future maintenance of the policy while eliminating the need for future annual Crummey notices; or alternatively, the policy could be terminated with cash surrender value distributed among beneficiaries. Before deciding to unwind strategies that may be in place, consider the potential for laws to change again.

A couple of final thoughts – with higher exemptions, it may seem unnecessary to file an estate tax return for a nontaxable estate. However, a return must be filed to preserve the unused exemption of a deceased spouse. This will be particularly critical if exemption amounts decrease in the future. And regarding incapacity planning (powers of attorney, revocable trusts) for higher net worth clients, it might be advisable to allow your agent or trustee to make transfers up to the exemption amount to ensure maximum planning opportunities if you were to become incapacitated prior to a provision sunset.

Bottom line – it is prudent to review your estate planning in light of the new tax law. And, as with many things in life, flexibility is key. 

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you our your business.

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Every year, Gratus team members organize and participate in quarterly volunteer events.  After each event, the team completes a survey and votes to determine which one had the biggest impact on the Gratus team and the community.  In 2017, Gratus hosted an event for Make-A-Wish®, volunteered on the farm at Camp Twin Lakes, planned a carnival for Children’s Healthcare of Atlanta℠ Scottish Rite Hospital, and helped families Christmas shop at MUST Ministries Marietta.  The events helped provide resources to those in need and aimed to make a difference.  Although all four events were successful, the Gratus team voted and decided the event at MUST Ministries Cobb Toy Shop made the greatest impact overall.

MUST Ministries Donation

In March, a few team members visited MUST Ministries Marietta to deliver a donation acknowledging the impact of their event.  The donation will go towards the services MUST Ministries provides including groceries, job training, housing options, and meals.  Donations to MUST Ministries help 30,000+ clients they serve each year.  For 47 years, MUST Ministries has worked to fulfill their vision of connecting people who have a desire to help with those who need it most.

For More Information

Taking the time to invest in our communities is an important belief for team members at Gratus.  In addition to being fun team-building experiences, these events provide an opportunity to pause and put others first.  To get involved with MUST Ministries, please visit their website at www.mustministries.org.  If you are short on time, please consider making a financial donation online or contributing much-needed items from their Amazon wish list.

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On March 20th, members of the Gratus team enjoyed a community garden workday with the Atlanta Community Food Bank. The ACFB Community Gardens project supports a local movement designed to give all residents of Atlanta access to fresh, organic fruits and vegetables. The program develops and maintains more than 100 gardens around the Metro Atlanta area by offering expertise, seed donations and coordination of volunteers and community members.

Our Giving Garden in Mableton

At Our Giving Garden, volunteers work together to grow and sustain affordable and healthy food.  Our goal was to help prepare Our Giving Garden in Mableton for the growing season.  During our time at the garden, we built pallet shelves to house the compost, weeded, dug trenches between beds, and prepped pea seedlings for a bamboo trellis. Team members went home tired, dirty and full of appreciation for the effort that goes into maintaining these great community assets.

Our Giving Garden was established in October of 2016.  Since then, they have donated nearly 600 lbs. of organic produce to the Sweetwater Mission Food Pantry.  All proceeds are used for maintaining the land the garden uses or to provide donations within the community.

For More Information

Our Giving Garden has several ways to get involved. We encourage you to explore volunteer opportunities or to make a donation.  To learn more about the Atlanta Community Food Bank or Our Giving Garden, please visit their websites at www.acfb.org and https://ourgivinggarden.org.

 

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We’re proud to say that our Director of Investments, Todd Jones (CAIA), was recently quoted in the Forbes article “3 Lessons Traders Can Learn from Investors.” He was the article’s primary source.

The Forbes article details the dangers of emotionally charged investments, the importance of keeping a balanced portfolio and the difference between risk and volatility in investments.

Todd is quoted on the importance of keeping a balanced portfolio (which we cover a lot in our insights, including this one on the benefits of alternative investments and portfolio diversification).

On the issue of short-term traders selling quickly in times of stress, Todd says, “To me, this makes no sense, as the need to rebalance should be based on the returns of each asset class as they relate to each other. This prevents unnecessary trading/capital gains and maintains a consistent risk profile.”

As for volatility, “It’s just noise,” says Todd. Invest in your own knowledge of fundamentals: it’ll help you understand if there is a risk in sudden stock surges or dips or if it is simply the natural highs and lows of the market itself.

At Gratus Capital, we serve clients across the US with a tailored team approach based on the principles expressed by Todd in this article. We’re a boutique wealth management firm focused on serving successful individuals, families, foundations, and endowments with a low client-to-advisor ratio and fee-based advisory services. What new financial goals do you have in mind? Contact us to learn how we can help.

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Your financial health is essential to all the things you want to do in life. Now is the perfect time to reflect, reset, and plan. This guide outlines four financial resolutions that can improve your lifestyle in the new year.

Discover:

  • Aspects of your financial health you need to examine
  • What you need to know about the new tax law. Will you be rid of the alternative minimum tax in 2018?
  • Common money drains that can quickly zap wealth

Resolve to make 2018 a prosperous year. Click here to immediately access your guide.

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With retirement on the horizon, it’s imperative to consider several key financial factors before entering what may be the most enjoyable and relaxing time of your life. If you bypass these considerations, there is a significant chance you’ll end up with less money saved.

Therefore, to boost your retirement savings, ask yourself these seven key questions:

#1 – Does my ability to afford retirement depend on Social Security benefits?

According to Kevin Woods, CFP® and Director of Financial Planning at Gratus Capital, the answer to this question will ultimately determine when to begin collecting Social Security. It’s important to know that if you postpone collecting Social Security benefits by four years, from age 66 to age 70, you’ll receive additional Social Security income. However, many investors neglect to run a breakeven analysis regarding this income postponement.

Keep in mind that it takes about 11 years to reach the breakeven associated with delaying your benefits until age 70. Specifically, it isn’t until every year past age 81 that you’ll begin to receive more overall from Social Security than if you started collecting at age 66.

Beyond pressing financial needs, another key determination of when to begin collecting Social Security benefits is your health. Waiting 11 years may be a long time for some individuals, but not others. Ask yourself how healthy you are and if your parents lived well into their nineties? If so, then it may make sense for you to postpone taking Social Security.

Overall, without running a breakeven analysis, you won’t have a complete financial picture.

Helpful Resource: The Social Security Administration offers a simplified document explaining when to start receiving retirement benefits.[i]

#2 – When should I enroll in Medicare medical insurance?

“Every 65-year-old should enroll in Medicare Part B, whether retired or not,” said Woods. “If you don’t enroll during the enrollment period for Medicare Part B or prescription drug coverage, you run the risk of being charged higher premiums for the rest of your life. There is a seven-month window for enrolling in Medicare Part B, beginning three months before you turn age 65. Also, you’ll want to research supplemental insurance coverage, which could ultimately save you thousands of dollars in retirement.”

Helpful Resource: Detailed instructions for applying for Medicare.[ii]

#3 – What is the tax impact on my retirement savings?

Your Individual Retirement Account (IRA) savings are not all yours,” said Woods. “Expect to pay roughly 25 to 30 percent of your Traditional IRA or 401(k) savings toward taxes. For example, if you believe you have $80,000 to live off each year, yet haven’t accounted for taxes, then in reality your income is closer to $55,000 after taxes.

Also, keep in mind that you may need to pay taxes on your Social Security benefits.[iii]

#4 – Should I hold onto my life insurance policy?

There are a couple key reasons to maintain life insurance policies throughout retirement.

First, it’s important to conduct a liability risk review. Specifically, if you’re sued during retirement, ask yourself how much of your nest egg is exposed? Keep in mind that an IRA is only protected up to the first one million dollars. This becomes particularly important if you’ve rolled other financial funds into this one vehicle, surpassing the protection threshold.

In many instances, and depending on the structure of your policy, life insurance assets are protected from creditors and other judgments. However, without a comprehensive risk analysis, it’s difficult to determine whether continuing to pay life insurance premiums makes sense or not.

Second, some investors have single-life pension benefits that end upon the insured person’s death. This loss of income could negatively impact your spouse or another loved one.

#5 – Can I afford to continue my charitable giving in retirement?

Having a fixed income in retirement doesn’t mean that there isn’t room for charitable giving in your financial plan. Consider giving a percentage of either your total net worth or of your annual net income.

Let’s say you’ve been earning $300,000 annually for the past many years and donating five percent of your annual income meaning $15,000 each year. Then, consider the same approach in retirement.

For example, if your retirement income is now $150,000 per year, you could continue to contribute five percent ($7,500) in annual giving. “This way you can continue to make a positive impact within your community, yet realign your approach with your revised retirement income,” said Woods.

Helpful Resource: Comprehensive Charitable Giving: 7 Steps to Create Positive Impact & Change

#6 – What am I retiring to?

Have you considered what your retirement days will look like 365 days a year, year after year? Many pre-retirees neglect this important process. Will you volunteer, golf, travel, watch your grandchildren or something different altogether? If so, how often, and what will you do with your remaining time beyond these activities?

According to Woods, picturing the life you’ll pursue while retired is a critical planning step towards experience a fulfilling retirement.

#7 – Should I pay off my mortgage?

“If at all possible, retire debt free,” said Woods. “At the very least, own what you can afford since you’ll be using your retirement savings to pay off your mortgage. The years just before retiring are an excellent time to reset your mindset regarding spending. For example, if the new Lexus you want today at $50,000 equals five percent of your future retirement savings, are you still okay with this purchase? Only you can decide. However, the closer you are to retiring, the more aware you should become about large purchases as well as other long-term financial commitments and their respective impact on your retirement savings.”

In Closing

The questions to ask yourself in preparation for retirement can sometimes seem daunting. The sooner you start tackling these questions, the better. We can help.  If you have questions pertaining to any element of your financial life, including retirement, estate, insurance, tax and philanthropic planning or asset management, please contact us.

Authored By:

The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.

__________________________________________

[i] https://www.ssa.gov/pubs/EN-05-10147.pdf

[ii] https://www.ssa.gov/medicare/

[iii] https://www.fool.com/retirement/general/2016/04/30/is-social-security-taxable.aspx

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AdvisoryHQ recently released their 2018 ranking of the “Top 10 Best Financial Advisors in Atlanta, GA,” and we are proud to announce our inclusion on the list!

AdvisoryHQ developed a breakthrough “Top-Down Advisor Selection Methodology” that is based on a wide range of filters including fiduciary duty, independence, transparency, level of customized service, history of innovation, fee structure, quality of services provided, team excellence, and wealth of experience.

We are extremely honored to be recognized by AdvisoryHQ this year.

What makes this recognition even more special is the element of surprise.  Since AdvisoryHQ reviews and ranking articles are always 100% independently researched and written, firms do not even realize that they are being reviewed by AdvisoryHQ until after reviews have been completed and published to the public.

Read more at AdvisoryHQ: https://www.advisoryhq.com/articles/advisoryhqs-methodology-for-selecting-top-advisors/

Rankings and recognitions by unaffiliated publications should not be construed by a client or prospective client as a guarantee that Gratus Capital will provide a certain level of results in client accounts, nor should they be construed as current or past endorsements of Gratus Capital by clients. AdvisoryHQ based its selection on publicly available information. Gratus Capital is not responsible for any content prepared by AdvisoryHQ regarding the services offered by Gratus Capital. Additional details regarding the criteria and process utilized in formulating these rankings can be found by clicking here.
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Forest fires are terrifying to witness. Having lived in California for a couple of years in the mid 2000’s, I didn’t have to go far to find traces of nature’s fury given the dry climate. Once started, forest fires have little hope of being extinguished by human efforts – only contained. The goal of the heroic fire crews that battle the inferno is to “control burn” as much fuel in advance of the actual blaze so that there is nothing left to burn once the fire arrives. There is no doubt, on seeing an actual forest fire from a distance or its aftermath, that the intensity is high, the path is indiscriminate, and the damage is quick but severe.

Activity in global equities over the past three trading sessions (February 2nd, 5th, and 6th) is allegorical to forest fires, seeing steep daily declines in stocks for seemingly no reason. Yet, was there really no reason for the recent declines? As we’ve indicated since Q4 of 2017, the fuel for the recent forest fire was created through the combination of (1) excessively high investor sentiment, (2) exceedingly low volatility (e.g., VIX), and (3) large money flows into stocks. Each one of these, alone, was not problematic, but all combined made a different situation entirely. Incidentally, observation of the conditions above led our Investment Committee to recommend a portfolio rebalance prior to the recent drop.

What sparked the sell-off?

While pinpointing the exact reason is almost impossible, the most likely source of the recent selling pressure has been the upward movement in US interest rates. As can be seen in the chart below, recent moves in the 10yr US Treasury bond have brought rates to near 3%, a level not seen since 2013 during the so-called “taper tantrum.” Higher rates become an issue because, at some point, bonds become competitive with stocks for portfolio allocations.

In our opinion, the other root cause of the sell-off has to do with the unwinding of the short volatility trade that has been very popular with both hedge funds and pension funds. Essentially, since the “flash crash” (which occurred in late 2015), volatility in the options markets (as measured by the VIX index, seen below) has moved to extremely low levels. This low reading in the VIX index signals that portfolio hedging with options has not been occurring to any significant degree. Further, this expectation of low future volatility was being speculated on by many (to include pension funds) as a way to enhance return in a portfolio. The problem with this strategy, however, is that once investors begin to unwind these speculative VIX positions, this process creates a positive feedback loop sending volatility higher. Many taking these speculative positions may have only fully realized the risks inherent in such a strategy once the sell-off began.

Where do we go from here?

Just like in a forest fire, while the intensity is high and the moves are erratic, we don’t see the selling pressure lasting for much longer once the fuel of interest rate movements and VIX position unwinding dissipates. That is not to say that equity markets could not move lower from here over the near term. But given the tinder of suppressed volatility, low interest rates, and excessive investor sentiment, a garden variety correction in the 5-10% range makes sense. On the other side of this current corrective phase for equity markets, the excesses will have been cleared out, allowing investors to focus on some of the positive factors present in the markets. In our view, global equity markets can move higher over the remainder of the year based on a combination of the following positive dynamics:

(1) Global earnings and revenue growth are strong
(2) All major economic regions around the globe are in a synchronized expansion
(3) US Interest rates aren’t rising in a disorderly manner
(4) High Yield bonds aren’t signaling duress
(5) Global inflation remains modest (between 2-3%)

In summary, as we await the culmination of the current corrective phase in equity markets, we would like to highlight that periods like this underscore the need for diversified investment portfolios. This diversification includes allocations to cash, fixed income and, where appropriate, alternative assets. Specific to cash holdings, most portfolios have been positioned with elevated cash levels due to our recent rebalancing activity. This cash will give us optionality in the case that equity prices decide to move markedly further from current levels. We’ll look to redeploy this cash as opportunities arise.

As we approach the final stages of the current bull market, episodes like the one we currently find ourselves in should be considered the norm as opposed to the exception. This heightened level of equity volatility will test resolve and challenge investor convictions, which is why we’ve been revisiting client risk profiles and cash flow goals in recent months. Rest assured, we are mindful of many of the risks being discussed in the equity markets. If the fundamentals of this aging economic recovery change then we will take appropriate action. For now, we need to let the fire burn the accumulated tinder on the forest floor so that we can move higher from here.

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Gratus Capital is an SEC-registered investment advisor. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of February 2018 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

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Gratus Capital, LLC
3350 Riverwood Pkwy, Suite 1550
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Phone: (404) 961-6000
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