Key Takeaways From 2017
Think back to Monday, November 7, 2016, the day before the Presidential election. What was your outlook if Hilary Clinton would be elected? What was your outlook if Donald Trump would be elected? This is not a political newsletter, but I would like to suggest that personal emotions (which are often governed by the news, your political affiliation, or how you were raised) are often a poor indicator of future returns. Investors governed by their emotions may have missed two to three full years of returns. At the very least, the performance of the market since election day is a stark reminder of the unpredictable nature of investing.
This past year was a stellar year for large U.S. stocks. Large-cap U.S. stocks gained 21.7% for the year. This was the ninth consecutive year of positive returns for the index, tying the historic 1990s bull market and capping a truly remarkable run from the depths of the 2008 financial crisis. Investors in higher risk portfolios comprised mostly of stocks might feel like they just won the national championship in their chosen sport – a feat that is very difficult to repeat. This is not to say the year ahead cannot be positive, but we caution against over-optimism.
Smaller stocks had an impressive year but paled in comparison at 14.6%. Small-cap stocks carry a higher risk than large-cap stocks and will often outperform them.
The broad driver of the market’s rise for the year was rebounding corporate earnings growth, which was supported by solid economic data, synchronized global growth, low inflation, and accommodative monetary policy. U.S. stocks got an additional boost in the fourth quarter with the passage of the Republican tax bill, presumably reflecting investors’ optimism about its potential to further enhance corporate after-tax profits, at least over the shorter term.
Volatility has been extremely low. By year-end, the S&P 500 Index had rallied for more than 400 days without registering as little as a 3% decline. This is the longest such streak in 90 years of market history, according to Ned Davis Research.
Foreign stock returns were even stronger, with developed international markets gaining 26.4% and emerging markets up 31.5% for the year.
Real estate funds: We primarily use private real estate funds (not trading on the daily markets), and these returns ranged from 6% to 11% depending on how conservative and liquid the fund is. These funds have a volatility range that is extremely low, thus assisting in keeping our portfolio risk (beta) low versus the overall stock markets.
Moving on to bonds, the core bond index fund gained 3.5% in 2017. This return was close to the index’s yield at the start of the year, as intermediate-term interest rates changed little during the year. Although the Federal Reserve raised short-term rates three times, yields at the long end of the Treasury curve declined and the yield curve flattened. Often this is a negative signal as long-term investors are cautious.
Corporate bonds across all credit qualities and maturities had positive returns. High-yield bonds gained 7.5% and floating-rate loans rose 4.1% for the year.
Overall, the year 2017 was a very good one for most financial markets. While the overall outlook remains positive, significant central bank policy shifts could trigger increased volatility or a stock market correction. The start of a recession is possible during the year, but we don’t foresee this until perhaps 2019. As asset prices increase, so does uncertainty. It is more important to stay disciplined and patient. We remain confident in our diversified portfolio positioning looking ahead over our long-term investment horizon.
Investment Commentary About 2017
Looking Back: Key Drivers of Our 2017 Portfolio Performance
Our diversified balanced portfolios generated strong returns for the year, consistent with the positive overall environment for most financial markets. Foreign stocks turned in impressive returns that outpaced U.S. stocks, especially in the more aggressive emerging markets.
We feel that our clients should be impressed with their overall performance, especially when they factor in the total lower risk of their portfolio (measured by the beta reported on your statements).
Growth stocks (such as Apple, Google, Amazon, etc.) outpaced more conservative stocks by up to a factor of 2.5 to 1.
After a strong rebound in 2016, value stocks (such as Union Pacific) and many valuation-sensitive managers struggled to keep up with the surging growth market. The comparison between value versus growth stocks is an annual race with each style trading positions from one year to the next, but never in predictable sequence. Overall value stocks and growth stocks have won an equal amount of times, but value stocks obviously bring a lot less risk to investor accounts. Thus, in the past we have balanced our portfolios in favor of value stocks. Fortunately for our higher risk clients, we changed our positions to hold more growth stocks in 2017 than we had the year before.
At the beginning of the year we purposely underweighted small stocks versus large stocks. This proved to be the correct adjustment. However with the recently adopted tax plan, we feel that smaller companies may benefit more from the stimulus it provides; thus in 2018 we are considering a slightly higher allocation to small stocks.
In summary, our portfolio returns were enhanced by strong performances in growth stocks and international stocks.
Looking Ahead: Updates about Our Asset Class Views
U.S. Stocks: As noted above, U.S. stocks were up 21.7% for the year, driven in part by impressive earnings and expectations of a historic corporate tax cut, which the Republican-led Congress duly delivered after intense internal struggles. However, we are suspicious that a lot of the stock gains may have already been achieved as investors extrapolate the potential earnings (thus the theory to “buy the rumor”); when the actual benefits are delivered disappointment may set in (“sell the news”). Only time will tell if the actual benefits live up to the hype.
One risk to U.S. stocks is the potential for wages to increase at a higher pace, thus cutting into corporate profits. Wage growth has been stagnant for many years, and the unemployment rate is at historical lows. If companies plan to grow they need to attract workers, a task that is getting more difficult to pull off without paying more in wages.
U.S. stocks should produce a positive return but likely well shy of their performance in 2017. We hold a neutral outlook on U.S. stocks.
Foreign Stocks: Political uncertainties notwithstanding, Europe continues its economic recovery within what appears to be a benign fiscal and monetary environment. Europe is matching the United States in terms of economic growth and, according to Capital Economics, is on track to generate its strongest growth since 2007. Earnings have rebounded strongly, with Ned Davis Research analysis showing continental Europe and U.K. local-currency earnings growing over 25% and 35%, respectively, over the past 12 months. (The United States has seen earnings growth of 14% over the same period, according to NDR.) While earnings were up strongly, investor sentiment was relatively depressed (especially during the fourth quarter), leading valuation to be subdued.
Like European stocks, emerging-market stocks posted strong earnings growth of nearly 20%. Yet after the recent run-up, we still expect emerging-market stocks to generate solid annualized returns. These returns are anticipated to be better than what we expect from U.S. stocks.
Fixed Income: Our return expectations for core bonds remain muted looking out over the next five years, in the range of 2.5% to 3.2%. Today we’re faced with taking on elevated levels of risk and a low yield. [We are are testing to see how many of our clients are actually reading this entire report. The first person to call Julie or Amy will win a $50 Starbucks gift card.] Remember that bonds lose value when rates increase. It is projected that only a half percent increase in rates could wipe out the total return from bonds.
This outlook explains our meaningful positioning away from core bonds. We have moved substantial exposure away from bonds into real estate funds, which we find to produce higher income with lower interest rate risk. For the remaining portion of our fixed-income exposure, we have used a barbell strategy placing one-half of our bond allocation in high-yielding bonds and preferred stocks, and one-half in Treasury inflation-protected government bonds in our higher risk and medium risk portfolios. In lower risk and defensive portfolios, we feel we have no choice but to use traditional bonds. If you consider yourself to be a conservative investor, please visit with us as to what your options might be.
Looking Ahead: A Quick Word about the Macro Outlook
In terms of the near-term macro outlook, the consensus view is that there is little risk of a U.S. or global economic recession in 2018. The market expects the in-sync global growth that we saw in 2017 to continue. Most of the investors and strategists we respect seem to share this view. However, when an outlook becomes the strong consensus view, one should assume it is already included to a meaningful degree in current market prices. This is where our investment discipline comes in, because we think we have an edge in assessing fundamentals, valuations, expected returns, and risks across different asset classes and over longer-term periods.
We believe a bear market (20% or more decrease) is likely sometime in the next five years. Again, we can’t confidently predict exactly when, but one reasonable scenario would be triggered by ongoing monetary policy tightening, which is already underway in the United States, and could be followed by other central banks. Given the boost to asset prices from unprecedented monetary stimulus, it is reasonable to expect some negative impact as central banks stop and then reverse course. On the other hand, should U.S. stocks continue their very strong upward trajectory, we will further reduce our exposure to them.
Putting it All Together: Our Portfolio Positioning for Early 2018
Currently, we anticipate lower expected returns for U.S. stocks. As such, we will be adjusting our portfolios to underweight U.S. stocks versus our normal position. We will overweight international stocks in which our return expectations are materially higher. We also remain comfortable slightly overweighting emerging-market stocks relative to U.S. stocks, although valuations are less compelling than they were a year ago.
Our fixed-income positioning also remains unchanged. We continue to favor a strong real estate allocation to help offset the risk of bonds in a rising interest rate environment.
The year 2017 was a very good one for most financial markets and particularly global stocks. Yet we know the path to long-term investment success is simple to describe but not easy to achieve. Acknowledging this, we focus on the more realistic goal of having a “high batting average” – maintained by following our investment discipline and only taking on risk when we believe it raises our clients’ potential for portfolio return without materially impacting the potential downside.
Thank you for your continued confidence and trust in our team.
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.]