THE PRUDENT PALADIN THE PALADIN GROUP AT MORGAN STANLEY

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1 THE PRUDENT PALADIN THE PALADIN GROUP AT MORGAN STANLEY THE GAMBLER 3 rd quarter, 2017 A common refrain in our team meetings is that we live in interesting times. The state of the US stock market today leads us to feel much like a gambler at a poker, blackjack, or craps table, sitting on a mountain of winnings, but without the inevitable slump that befalls even the most disciplined bettors. As we have stated before and as any equity investor will tell you, the past years several have been easy for investors whose sole focus was on one large game: US stocks. Just as it is difficult to leave a casino after a great night, we find similar complacency in markets today. This complacency is not surprising to us, as the brain s reaction to investment gains has been shown by Harvard Medical School to be similar to heavy cocaine use i. Stated another way, making money in the stock market is addicting, and while nowhere near as difficult to walk away from as drug use, it is important for investors to realize that their physiology may be working against them precisely at the wrong time. Now, contrary to what you may be thinking, we are not suggesting investors abide by most of the lyrics quoted this quarter. It is not time to fold, nor to run away, but for YOU'VE GOT TO KNOW WHEN TO HOLD 'EM, KNOW WHEN TO FOLD 'EM, KNOW WHEN TO WALK AWAY, KNOW WHEN TO RUN. - THE GAMBLER, WRITTEN BY DON SCHLITZ select markets (particularly in the US), it may prudent be to sit on your cards, proverbially. in As stated prior newsletters, the valuation of the US stock market leads us to believe that while we have a couple more years of good times ahead before the business cycle slows, the next 5-10 year returns of US stocks could very well be below average. Other concerning things about the US stock market are declining earnings forecasts and low volatility. Since 1980, the market has had at least a 5% drop intra year every year except two: 1995 and this year, While we may be on the cusp of a quiet year from a market perspective, history says otherwise. Additionally, US earnings are projected to decline by 2% year over year by some analysts estimates, and as we ve stated before, as earnings fall, we ought to expect stock prices to reflect that. ii Where could we be wrong? As has been the case since 2009 when the Federal Reserve drove interest rates to zero, US stocks offer better potential returns than US bonds despite being slightly above historical valuations. Additionally, consumers and companies are flush with cash. Corporate cash as a percentage of current assets exceeds 30% (near the highs for the millennium), and consumers balance sheets are well above the prior peak in If optimism about the economy takes hold, there is no telling what investment by the corporate sector and individuals could do for the economy. All of that being said, we think that much like the baseball season, US growth is in its later stages. The US economy has

2 T H E P A L A D I N G R O U P A T M O R G A N S T A N L E Y been growing at a slow rate since coming out of the financial crisis; so many pundits will point to this fact as a reason why we can accelerate our growth rate to 3 or maybe even 4%. However, it is important for our clients to know the facts: without productivity growth, mathematically it is very difficult to grow an economy at full employment without some sort of stimulus from the government. Since the Federal Reserve is winding down its stimulus and Washington appears to be moving at a slow pace on new policies, we are not optimistic that this dynamic will change. However, as we ve also stated in prior newsletters, it is imperative for investors to embrace a global opportunity set. In other words, there are opportunities globally, and we are optimistic that investors such as the Paladin Group s clientele may be better rewarded for being globally diversified than in years past, where the best place to be was solely in a handful of US stocks. We will forego our usual mantra about the benefits of overseas investing as the merits of foreign asset exposure will become apparent when we when we review performance of the various sectors of the market. We want to briefly discuss something that frequently comes up in client reviews: risk. With markets at highs, interest rates at lows, and volatility still low, you may wonder what could be risky about this year s market. This complacency is exactly the reason we keep an eye on risk. To quote a former Secretary of Defense, there are 3 risks to worry about: known knowns, things we know we know, known unknowns, things we know we don t know, and unknown unknowns, things we don t know we don t know. In the first category, we have issues like valuation (stocks are above their long term average levels), and we know that historically this means lower than average returns, but this is intuitive. The last 8 years had higher than average returns, so it makes sense that the next period may have lower than average returns. So what is an investor to do? In the words of the gambler: hold em, but lower your expectations. What gets investors into trouble is belittling the known unknowns, pretending they carry no risk, and ignoring the presence of unknown unknowns. An example of a known unknown is potential war with North Korea. We know that this situation carries risk, but we don t have certainty around the potential implications of a conflict with this rogue nation. There are other known unknowns, like central bank policy. We think we know how this will play out: as the global economy improves, investors are okay with central bank tightening. Therefore, the price action as these policies recede should be minimal. However, this period is historically unprecedented, so there is no way for us to really know what is going to happen, and therefore we recognize that there are unknowable risks with this known event. The unknown unknowns present a conundrum. We know they are there, but because of their very nature, we don t know what or where they are. This inherent uncertainty in investing is what leads us to one of our core principles: controlling risk. If you recognize there are things in the world that are unknowable but nevertheless may affect your financial wellbeing, you can only protect against them by being diversified and ensuring what you own is of the highest quality. When those unknown unknowns rear their ugly heads, like in October 1987, you will be stuck with what you own so you had better be comfortable with your risk profile. Since Black Monday will have celebrated its 30 th birthday by the time this newsletter is published, it s worth mentioning that to hold em was a fine strategy even in the face of such a violent decline: the Dow & the S&P 500 finished 1987 up 2.26% & 5.81%, respectively. iii

3 T H E P A L A D I N G R O U P A T M O R G A N S T A N L E Y For the quarter, stocks continued their outperformance, with non-us countries leading the pack yet again. US Stocks (as measured by the S&P 500) finished up 14.2%, with mid and small cap up, but lagging large companies, up 11.17% & 10.9% respectively. The MSCI Europe finished up 23.2% and Japan s lead over the US narrowed, as it finished up 14.4%. Some surprising countries led the pack, with Italy, China, Denmark, Austria, and Holland all up over 28%, better than the US Tech sector! Bonds have continued to lag stocks, but their performance has accelerated from last quarter, with US bonds up 3.9% and non US bonds up 11.2%. Commodities have been a mixed bag, with gold up 11.1% but energy continuing to suffer: Natural Gas is down 19.3%, oil is up only 1.3%. The 10 year Treasury closed out the quarter yielding 2.33% iv. A FARCE OR THE FUTURE? A WORD ABOUT BITCOIN Along with politics, North Korea, and the Federal Reserve, one topic that has trickled into client meetings on a more frequent basis is the prevalence of bitcoin and other cryptocurrencies. A quick Google search will yield all sorts of results on what bitcoin is, how it works, what blockchain is, and much more. The short explanation is that bitcoin is a digital currency not tied to any sovereign nation that relies on the security of blockchain technology and the inherent scarcity of itself for value. Proponents of bitcoin argue that sovereign nations are going to be burdened by debt that will cause their currencies to devalue over time and that it is important for investors to be diversified on that front. Additionally, they argue that other forms of money (like gold & silver) have storage and logistic issues, making it difficult to be fungible, adding to the appeal of an all-digital currency. Finally, because only a certain amount of bitcoins can be mined, they have inherent scarcity (which adds value), unlike fiat currencies which can be printed ad infinitum by their issuing governments. Detractors will be quick to say that some of those potential positives are actually negatives. For example, while the United States has over $20 trillion in debt, we also have the largest GDP of any country in the world, rule of law, property rights, mostly free market capitalism, and a government with taxing authority. Detractors also point out that bitcoin has no underlying asset like gold to support its value nor any underlying claim on cash flows as stock & bond investors have. Our thinking can be summed up as somewhere in the middle but leaning towards the hold your horses camp. It is apparent to us that blockchain technology has tremendous growth potential especially in terms of private blockchains within organizations, decreasing costs and risks of centralized storage, and it is clear that deflationary pressures are an issue in the world s largest economies (otherwise, central banks would not be so active!). However, historically any investment which either has no asset to back it or a weak asset backing it (see Tulipmania in Holland, 17 th century) has not had a favorable long term existence. In short, bitcoin may not be the golden goose its followers view it to be, but by no means should we ignore the questions it raises. Sincerely yours, The Paladin Group at Morgan Stanley

4 THE PALADIN GROUP AT MORGAN STANLEY Randy Hartley, CFP Vann Russell Robert Randolph William Nave Financial Advisor Financial Advisor Financial Advisor Financial Advisor Glenwood Ave Suite 320 Raleigh NC toll free fax

5 THE PALADIN GROUP AT MORGAN STANLEY i Source: and ii Source: JPMorgan Guide to the Markets iii Source: NYU Stern School of Business & iv Sources: MSCI and Morgan Stanley Capital Markets The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Wealth Management recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Information contained herein has been obtained from sources considered to be reliable, but we do not guarantee their accuracy or completeness. An investment cannot be made directly in a market index. Dow Jones Industrial Average is a price-weighted index of the 30 blue-chip stocks and serves as a measure of the U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. As of May 30, 2011, the MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. An investment cannot be made directly in a market index. International investing may not be suitable for every investor and is subject to additional risks, including currency fluctuations, political factors, withholding, lack of liquidity, the absence of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be magnified in emerging markets. Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Morgan Stanley Smith Barney LLC. Member SIPC. CRC