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Large-Cap Report 3Q18

The stock market reached all-time highs during the third quarter as we marked the 10-year anniversary of the Lehman Brothers bankruptcy (the largest bankruptcy in U.S. history). During the third-quarter the S&P 500® advanced 7.7%, and the Russell Midcap® gained 5.0%. Bond returns were relatively flat as interest rates rose resulting in the Bloomberg Barclays Intermediate Gov./Credit Index returning 0.21% and the Bloomberg Barclays Aggregate Index advancing 0.02% during the quarter. While U.S. equity markets were the clear winner, international stocks also gained as the MSCI EAFE® gained 1.4% (2.4% excluding currency effect).

September 15, 2018, marked the 10-year anniversary of the Lehman Brothers failure and the near-melt down of the global financial system. Although that was a decade ago, the memory is still raw in many investors’ minds and that bad memory may be partially responsible for this long-tenured bull market. As Sir John Templeton said “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” There was certainly much pessimism in 2008 as people lost jobs, housing foreclosures reached record numbers and retirement accounts dropped sharply. Perhaps more important than lost money was the loss of confidence - not only in financial institutions but in capitalism itself. Fortunately, resilient and well-advised investors not only recovered, but prospered as U.S. stocks have advanced over 330% since their low point in 2009. So where do we stand? Clearly, pessimism is gone, skepticism has waned, and optimism and glimpses of euphoria are appearing. In fact, the Consumer Confidence Index in September reached levels not seen since 2000 and the NFIB Small Business Optimism Index has been at record levels since the beginning of 2018.

The third-quarter set a number of records – not only as stock indices reached record levels, but also as two U.S. companies reached the eye-popping $1 trillion market valuation level. While Apple remains the only company valued at over $1 trillion, Amazon also briefly reached the $1 trillion mark in September before settling at just under that level. Overall, Technology stocks have been the biggest driver of market gains – up over 20% on a year-to-date basis, and reaching a 26% weighting in the S&P 500 Index. This importance was noted by Standard & Poors as they reshuffled the companies within the Technology Sector (reducing the Technology Sector weight by 6% to 20% at quarter end). The biggest change affects the newly labeled Communication Services Sector (formerly Telecom) which now includes Twitter, Facebook and Alphabet (formerly Google), which were previously in the Technology Sector.

Although the market has largely shrugged off trade tensions, they remain a key source of uncertainty. In September, the administration announced a new 10% tariff on another $200 billion of Chinese imports which was countered by Beijing’s announcement of 5-10% tariffs on $60 billion of U.S. goods. Meanwhile, the Federal Reserve (Fed) again voted to raise its short-term interest rate by 0.25% (to a range of 2.00% to 2.25%) and continued to shrink its balance sheet. Despite these headwinds, the current economic fundamentals are strong -- perhaps the strongest since the recovery began. U.S. economic growth was reported at 4.2% (real GDP) for the second quarter. Additionally, earnings growth has been tremendous in 2018, driven not only by tax cuts, but by strong revenue growth and expanding operating margins. All of which has powered the record-high business and consumer confidence levels and, perhaps surprisingly, a modest drop in valuation levels (as earning growth exceeded the price gains).

Madison’s Large Cap strategy modestly underperformed the S&P 500® Index during the third quarter. The portfolio’s focus on high quality stocks was beneficial, but performance was held back by the market’s rewarding of aggressive growth stocks at the expense of those stocks with more attractive valuations. In fact, the Russell 1000 Growth Index gained 9.2% vs. the Russell 1000 Value Index gaining 5.7% during the last three months.

TJX Companies (TJX) benefitted from accelerating sales, while Jacobs Engineering (JEC) is showing the fruits of a management led operational turnaround that is also producing accelerating sales. Henry Schein, Berkshire Hathaway and Novartis round out our top contributors to third quarter performance. Our Information Technology (IT) allocation has had difficulty, however, keeping up with the big, headline IT issues (FAANG stocks in particular). Soft performance from other IT names with exposure to automobiles was detrimental. Advertising company Omnicom (OMC) had a weak performance quarter, and we reduced the position size of OMC in the portfolio by about half during the period. Cognizant Technology, Analog Devices, J.M. Smucker and TE Connectivity were also among our five weakest performing holdings.
We continue to trim our high valuation multiple growth stocks after their strong run so far in 2018. In their place, we’re finding opportunity in underappreciated bargains such as PACCAR (PCAR) and Dollar Tree, Inc. (DLTR).

As we enter the final quarter of the year, continued volatility should be expected as the market weighs accelerating U.S. economic growth, robust earnings and strong employment figures against tighter monetary policy, higher interest rates and escalating trade tensions. The near-record length economic expansion will come to an end at some point and markets will likely sell off in advance, but accurately predicting that point is nearly impossible, making market timing a futile endeavor. With this in mind, we continue to believe investors are best served by choosing risk assets based upon investment time horizon and risk tolerance. This approach, along with investing in stocks of lower-risk, higher-quality companies will allow investors to participate in the market while providing some shelter as we experience more typical market volatility.

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  • “Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC, and Madison Investment Advisors, LLC, which also includes the Madison Scottsdale office. Madison Funds are distributed by MFD Distributor, LLC. Madison is registered as an investment adviser with the U.S.

    Securities and Exchange Commission. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer, and is a member firm of the Financial Industry Regulatory Authority.

    Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. 

  • S&P 500® INDEX: Widely regarded as the best single gauge of the U.S. equities market, this world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 focuses on the large-cap segment of the market, with over 80% coverage of U.S. equities, it is also an ideal proxy for the total market.

    Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000® Index, which represent approximately 35% of the total market capitalization of the Russell 1000® Index. As of the latest reconstitution, the average market capitalization was approximately $3.7 billion; the median market capitalization was approximately $2.9 billion. The largest company in the index had an approximate market capitalization of $10.3 billion.

    Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. 

    The MSCI EAFE (Europe, Australasia & Far East) Index is a free-float adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. These indices are unmanaged. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. 

    Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. fixed income securities. The U.S. Aggregate Index covers the USD-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS,and CMBS sectors. 

    Bloomberg Barclays U.S. Government/Credit Bond Index includes securities in the Government and Corporate Indices. Specifically, the Government Index includes treasuries (i.e., public obligations of the U.S. Treasury that have remaining maturities of more than one year) and agencies (i.e., publicly issued debt of U.S. Government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. Government).

    All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.

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