Second Quarter 2017 Key Takeaways
The first half of 2017 proved to be a very strong period for global stock markets.
Large-cap U.S. stocks were impressive with a surge of 9.3%. However, international stocks were the stars and continue to lead the way with returns in the mid-teens. Our portfolios benefited from a solid weighting in foreign stocks, specifically European and emerging-market stocks. Since the Great Recession of 2008-2009, U.S. stocks have been so strong that any attempt to diversify into international stocks, bonds and real estate seem to drag down the returns of portfolios in comparison. We have been positioning portfolios with a strong international stock allocation for several years because we believed this sector provided a better value and higher growth outlook than U.S. stocks. Finding a good opportunity doesn’t mean it pays off immediately, so it has been nice to see the reward from our analysis has come through.
Core bonds also delivered reasonable returns (vs. their risk) of 2 ½% in six months.
The overall markets have been remarkably calm which is a bit surprising considering political and international geopolitical tensions. This steady environment was briefly interrupted during the last few days of June. Global stock and bond investors were rattled by comments from the heads of the European Central Bank and the Bank of England suggesting they are considering less accommodative policies. In response, bond yields quickly spiked higher (and consequently lowered bond prices), while currency markets saw large swings. Nevertheless, at quarter-end, the S&P 500 was only about 1% below its all-time high.
We seem to be in an environment where investors are still willing to buy on the dips, which adds a degree of confidence to investing.
Economic and corporate fundamentals largely still look solid, and investors expect the second quarter earnings season to demonstrate a continuation of the strong growth trends exhibited so far in 2017. From a big picture perspective, we think the odds favor a continuation of the ongoing mild global economic recovery we’ve witnessed so far, this year. That should be broadly supportive of riskier assets, such as stocks. We believe there is still more room to run for foreign stocks versus the U.S. market, given their more attractive valuations and earnings growth potential, even after their strong performance in the first half of the year. However, we are challenged to suggest that the second half portfolio gains in 2017 will be as strong as the first half.
New data on this quarter’s report: We would like to introduce a new portfolio measurement tool this quarter. Beta is a measure of your overall portfolio risk. In simple terms, if we assign a score of 1.0 to the S&P 500 overall stock market, a Beta score will tell you how risky your portfolio is in relation to the market. For example, if the stock market returned 9.3% this year (and is assigned a score of 1.00), and your portfolio returned 7% and had a Beta score of .60 you should be very happy.
Your performance is only slightly short of the overall market return, but the risk you took to achieve this return was substantially less or around 2/3’s the risk of the market. Your Beta score will help guide you on how conservative or aggressive your portfolio is, and give you a comparison of your actual return vs. the market return. You can then assess if you are comfortable with the risk you are undertaking with your investments to achieve your goals.
Second Quarter 2017 Investment Commentary
As we look back over the past quarter and first half of the year, a few things stand out. Overall stock market volatility remained extremely low, despite significant domestic political uncertainty and unsettling global and geopolitical events. Both risky assets (stocks) and defensive assets (core bonds) performed very well. And the period was marked by some significant market trend reversals from the previous year.
The S&P 500’s actual realized volatility recently fell to near its lowest level in the past fifty years, according to a recent Goldman Sachs report, while the S&P 500 Index continued to hit all-time highs. The U.S. stock market’s calm ascendance seems to fly in the face of ongoing political uncertainty and geopolitical tumult. Each day seems to bring a new headline concerning something else to worry about.
That said, maintaining a degree of mental calmness and composure is a valuable attribute of successful long-term investors. Global risks always exist and unexpected events inevitably happen, causing markets to fall no matter their valuation. The world and financial markets have faced numerous negative shocks over the decades, but the broad economic impacts have ultimately proved transitory. Over the long term, financial assets are priced and valued based on their underlying economic fundamentals—yields, earnings, growth—not on transitory macro events or who occupies the White House. Therefore, we believe it is beneficial for investors not to react to every domestic political development or geopolitical event with the urge to sell their stocks nor get overly excited and jump into the market on some piece of news they view positively. Having a disciplined investment process and a focus on the long term are essential to best achieve your financial objectives.
It may seem somewhat surprising or contradictory that both global stocks and defensive core bonds have performed well. Treasury bond prices typically rise when people are worried about the economy or other macro risks, but that doesn’t seem to be what is driving core bond prices this year given the low volatility and strong performance of riskier assets. Rather than fears of an impending macro shock, it seems the bond market is responding largely to the recent declines in inflation and inflation expectations (inflation is the enemy of bondholders).
The equity market, on the other hand, likes neither too little inflation nor too much. So, stock investors have had plenty of reasons to propel prices higher: Inflation is lower but still in the ballpark of the Federal Reserve’s 2% target. The global economic recovery is ongoing. S&P 500 company earnings are rebounding. And global central banks, including the Fed, are not expected to aggressively tighten monetary policy any time soon.
In the short term, both markets may be “right”. (often referred to as a Goldilocks environment). But the current state is not sustainable for very long—something has to give. The Fed holds a big key as to how things might play out: will it tighten too much, too little, or manage it just right? Nobody knows, but based on history, we wouldn’t put all our chips on any single scenario. Potential changes to fiscal, tax, and regulatory policies are also big unknowns.
A final observation: Several of the market trends and consensus market views we highlighted at the start of the year have reversed (again):
• European stocks are beating U.S. stocks by a wide margin.
• The U.S. dollar is down (about 6%).
• Treasury yields are down.
• Oil prices have plunged 20% from their recent highs.
• Growth stock indexes are crushing value indexes. We have preferred value stocks in the past as we build conservative portfolios, but this past year we reevaluated our aggressive portfolios with a concern that we may be holding them back. Consequently, we reduced the real estate exposure and increased the growth stock exposure at just the right time.
• Larger caps are beating smaller caps.
• Emerging-market stocks are outperforming U.S. stocks.
The recent market shifts only reinforce the point we made then. We don’t think anyone can consistently and accurately time short-term swings in markets or inflection points in market cycles. It is when “the experts” are overwhelmingly aligned on one side of a trade and the consensus is strongest that a trend will continue, that it has the most potential to reverse.
Most of the market reversals we’ve seen this year are consistent with, if not driven by, an unwinding of the so-called Trump trade. This is shorthand for the markets’ almost knee-jerk reaction (which soon became consensus) that Trump’s election and the Republican sweep of Congress would herald a period of inflationary, pro-growth fiscal, tax, and regulatory policies, unleashing the U.S. economy’s animal spirits. Instead, as the Trump administration has gotten bogged down in a myriad of other issues, with little progress on the economic front, confidence in that scenario has diminished.
In general, we agree with Warren Buffett who recently said, “If you mix your politics with your investment decisions, you’re making a big mistake.” We made no changes to our portfolio positioning when Trump was elected even though we received multiple calls from concerned investors. Therefore, the unwinding of that narrative this year hasn’t hurt our performance nor led us to make any portfolio changes.
We think it is prudent to construct portfolios that are prepared for, and are resilient to, a range of potential outcomes. As a result, in our more balanced and low risk portfolios, we maintain some exposure to core bonds, despite very low current yields, because of their risk-mitigating properties in the event of a recession or other shock. But given core bonds’ paltry yields and unattractive longer-term return prospects, we maintain meaningful exposure to real estate as a more stable and higher earning asset. Real estate should also provide some protection against rising interest rates and inflation.
Based on our analysis of valuations and longer-term earnings fundamentals—even putting aside any near-term political or geopolitical risks—U.S. stocks present a less attractive expected returns. Even if we think there is still room for them to perform positively, valuation risk is high and offers no margin of safety in the event the of a negative shock. Having said that, we don’t see any near-term trigger for a sharp market decline.
Outside of the United States, we see strong potential for both improving earnings growth and higher valuations—leading to relatively attractive longer-term expected returns.
We believe the outperformance of foreign stocks still has room to run given their superior valuations and earnings growth potential versus the U.S market. Even with their strong performance so far this year, our longer-term return expectations continue to favor Europe and emerging markets compared to the United States.
Foreign stock markets are also seeing increasingly positive investor sentiment and strong cash inflows. More than $12 billion has flooded into U.S.-domiciled European stock funds and ETFs this year, reversing 13 consecutive months of net outflows prior to that. Year-to-date inflows into emerging-market stock funds are close to $30 billion.
Momentum seems to be shifting in favor of foreign stocks. We are seeing more and more Wall Street strategists recommend an overweight to European and emerging-market stocks: a position we have held for a while. This can feed on itself in a virtuous cycle—as more money flows into these asset classes, it can boost prices and returns, attracting yet more inflows and driving prices higher.
Real Estate continue to look attractive from a low volatility (vs. stocks) and a high yield (vs. bonds) perspective. We continue with our position to underweight bonds and overweight real estate in our Tailored Portfolios. High Yield Preferred Securities and Business Development Corporations are adding attractive yields of 5-8% with low volatility.
Putting It All Together
We don’t expect a recession in the near term, but we remain alert to and positioned to meet the high level of uncertainty that characterizes both global financial markets and the current geopolitical environment. We maintain exposure to assets—core bonds and real estate, that should generate positive returns in the event of a recession and a bear market in stocks.
We continue to focus on portfolios that have lower risk (Beta of less than 1.00) than the general stock market. The days are gone when you could simply invest 60% of your portfolio in stocks and 40% in bonds. More diversification and creative ideas are needed to achieve a modern-day retiree’s goals and survive in a volatile world.
We enjoy getting to know our clients personally so we can design an investment approach that will help them reach their retirement goals.
Committed to your successful retirement,
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]