“We’ve been growing at 1.5% to 2% in spite of stupidity and political gridlock because the American business sector is powerful and strong and is going to grow regardless.” & Jamie Dimon, 1956 – present, Chief Executive Officer of J.P. Morgan Chase & Co.

IT’S A PUZZLEMENT Set in the early 1860’s Bangkok, the musical masterpiece ‘The King and I’ by composer Richard Rodgers and dramatist Oscar Hammerstein tells the story of Anna Leonowens, a widowed British schoolteacher, who arrives at the Royal Palace to tutor the many wives and children of modernist King Mongkut of Siam (now known as Thailand) in the ways of the West.

In this classic tale of East meets West, Anna and the King inevitably struggle to find common ground. The King’s struggle between maintaining tradition and adapting to the modern world leads to frequent tensions and their relationship is marked by conflicts and disagreements during much of the play.

It is after one of those disagreements that the monarch wonders why the world has become so complicated and proclaims in song: “When I was a boy, world was a better spot. What was so was so, what was not was not... It’s a puzzlement”.

Over the years, numerous other public figures expressed puzzlement when they encountered something that made little sense.

Consider for example former Federal Reserve Chair Alan Greenspan, who in February 2005 remarked that he found it puzzling that long-term bond yields were declining in a period during which the FOMC had just raised short-term interest rates by 150 basis points (1 basis point equals one hundredth of one percent, or 0.01%). Notorious for practicing the art of constructive ambiguity (also known as ‘Greenspeak’), the Maestro termed his puzzlement a ‘conundrum’.

More recently, current Federal Reserve Chair Janet Yellen candidly conceded that eight years into a global expansion with unemployment very low, the persistence of stubbornly low inflation was puzzling.

The central bank’s preferred inflation measure, the BEA’s Core Personal Consumption Expenditures (PCE)

price index for August increased by just 1.3%, undershooting their target of 2% annual inflation for the sixthconsecutive year (see top chart on next page). In other words, inflation isn’t following their formulas. The Fed chair freely admitted that the committee may have ‘misjudged the degree to which longer-run inflation expectations are

consistent with their inflation objective’ and ‘that their inflation models could be off in some fundamental way.’ To quote the King of Siam: “There are times I almost think, I am not sure of what I absolutely know… It’s a puzzlement”.

Such candor emanating from the nation’s top banker is refreshing and disturbing at the same time, notably because the Fed is about to do something it has never done before: starting to gradually reduce or ‘roll off’ its enormous $4.5 trillion balance sheet, which primarily consists of government and mortgage-backed bonds.

After the 2008 financial crisis, the Fed embarked on a monetary experiment now widely known as ‘quantitative easing’ (QE) by buying Treasury bonds and mortgage-backed securities to help pull the economy from the brink of disaster. As a result, it’s balance sheet

ballooned from $900 billion to an unprecedented $4.5 trillion (see bottom graph on next page).

In the latest quarter, the domestic economy grew at a 3.1% annual rate and seems to be strong enough now for the central bank to gradually unwind the massive stimulus program that started nearly a decade ago. By no longer reinvesting interest and principal payments from maturing securities, it will pare down its holdings by $10 billion in October and increase that amount steadily in the months to come.

The process of shedding trillions of dollars in bonds (known as ‘balance sheet reduction’) is devised to be very slow and thoughtful without causing disruption to the economy or markets. But remember that there is no guidebook and virtually no historical precedent on how to actively reduce a central bank’s balance sheet.

Not only is the Fed preparing to shrink its balance sheet, it is simultaneously in the process of raising short-term interest rates back to more sustainable levels, which adds an additional level of complexity to the monetary tightening procedures.

Investors have taken the news in stride so far, but the turmoil that engulfed bond markets after comments by then-Fed Chair Bernanke sparked the ‘taper tantrum’ in 2013 shows the potential for these delicateoperations to unsettle markets if they are not handled carefully.

If they get it wrong, the fallout could be dramatic, such as unsettled financial markets and a sharp rise in interest rates, which could spill over into the broader economy. Expansionary monetary policy has been credited with being a major driving force behind the powerful stock market rally that began in 2009. While shrinking the balance sheet is not necessarily a negative for the stock market, it will at least remove a pillar of support.

King Mongkut might have been onto something when he uttered: “And it puzzle me to learn, that tho’ a man may be in doubt of what he know, very quickly he will fight;

he’ll fight to prove that what he does not know is so”. Let’s hope the Fed gets it right!

A question now puzzling the minds of many investors is undoubtedly the booming stock market’s ability to keep rising with historically low volatility despite an unpredictable political climate, geopolitical tensions, natural disasters, a weakening U.S. dollar, rising interest rates and stretched valuations.

Wall Street’s reaction to the launch of intercontinental ballistic missiles by the rogue North Korean regime? - yawns; to political turmoil in Washington DC? - yawns; to the Fed’s four interest rate hikes and its shift to

quantitative tightening? – moreyawns.

Although AAIISentiment Surveys show unusually low optimism about the short-term direction of the stock market among individual investors (33.3%), their equity and equity fund allocations (66.8%) stood above their historical average of 60.5% for the 53rd consecutive month in August.

It’s also worth noting that despite trepidation about lofty stock valuations, U.S. households collectively now have 39.2% of their total financial assets, which includes houses and other tangible properties, invested in equities.

According to Ned Davis research, who tracks these percentages using Federal Reserve data, that level is well above the 28% long-term average and close to levels seen near previous market peaks.

If investors are concerned about the stock market, it certainly seems inconsistent with their behavior. Fund flows show that investors are continuing to pour money into fast-growing technology companies and foreign equities. Rare dips in the market have been seen as buying opportunities.

This behavior is evident in the near record-low level of the CBOE Volatility Index (VIX), which measures

investors’ expectations of market volatility. Known as Wall Street’s ‘fear index’, the VIX is trading at a multi-decade low and recently slipped to a reading of under 10, half the average level over the past 25 years (see graph on this page). A low VIX signals that investors are feeling confident - the lower the level, the less fear there is. On the other hand, extreme lows in this indicator often suggest that the market could be vulnerable to declines.

Are investors increasingly blind to risk? As the King of Siam cautioned: “Am I right when I believe I may be wrong? Is a danger to be trusting one another.” Even so, the path of least resistance for stocks seems to be higher for now, with the fourth quarter historically being a strong period for the stock market.

In what is statistically the worst month for stocks, equity markets turned in an unseasonably strong performance in September. Wall Street celebrated the end of the third quarter by pushing the S&P 500, Nasdaq Composite and Russell 2000 index to all-time highs. It was the first positive September for both, the S&P 500 and the Dow Jones Industrial since 2013. The tech-heavy Nasdaq Composite posted its 50th record close for this year and gained almost 5.8% for the quarter while the S&P 500 climbed more than 3%.

It was also the least volatile September on record, with the S&P 500 index’s average daily percentage change measuring a meager 0.39%. The benchmark index has now gone 318 trading days without a drop of 5% -the fourth longest streak since 1928– and 41 consecutive weeks without a weekly move of 2% or more in either direction, according to BAML and LPL Financial Research.

From Europe to Asia to Latin America, economic indicators are improving, and so are their stock markets. European shares closed out the best month of the year after a string of upbeat data underscored the region’s economic recovery. The Stoxx Europe 600 index ended the quarter with a return of 2.1%.

An improving outlook for economic growth in most emerging countries boosted the MSCI EM index by nearly 7% for the quarter. They are this year’s top-performing asset class, returning almost 25% year-to-date.

After falling in July and August on anxiety about tensions with North Korea, Treasury bond yields edged sharply higher in September as a much-anticipated tax plan was unveiled and the Fed re-emphasized plans to hike interest rates. Treasuries

recorded a slim return of 0.06% for the quarter, bringing their year-to-date gain to 2.31%, according to an index compiled by Barclays.

At 8½ years, this second-longest bull market in history is aging gracefully and nothing says that it must end soon, despite stock valuations that look rather rich by most fundamental measures. No question, this bullish utopia will not last forever, but old age and high valuations alone don’t cause bear markets. They do leave markets highly vulnerable to negative surprises and sudden shocks however, as current valuations offer no margin of safety in the event the optimistic scenario currently priced into the market doesn’t play out.

Low volatility tends to lull investors into complacency, which can create market imbalances. The longer these imbalances persist, the greater the risk of a rapid and disorderly correction.

As we head into the fourth quarter, October has historically been the most volatile month of the year

with more 1% daily changes than any other time. Moreover, the Stock Trader’s Almanac warns that in the last three years ending in ’7’, the stock market plunged in October: 2007, 1997 and 1987. The upcoming 30th anniversary of the

‘Black Monday’ crash of ‘87 when the market dropped over 20% in a single day should serve as a reminder that large declines are an inherent feature of securities markets.

With the potential for volatility to reappear at any time, investors should not wait for a bear market before they attempt to assess their risk tolerance and decide on an asset allocation strategy that can withstand downside risks and meet long-term return objectives. The time to prepare is now!

If that sounds complex or overwhelming, it might be wise to engage the help of one of our experienced financial professionals who can design a diversified asset allocation strategy based on your unique financial goals, needs and risk tolerance.

Whether you are a novice investor or a seasoned stock picker, we all have different financial needs and objectives, yet we all share the same ultimate goal for our investments: allowing us to achieve our lifelong financial goals. “Everyday I do my best for one more day”, the King of Siam concluded. We couldn’t agree more! At Telos, our talented and dedicated team is giving their best every day to provide the highest level of wealth management services to our clients, so they can spend their time and efforts on the things they value most. OCTOBER 2017