Wow! It has been a nice run for the market thus far in 2017. Returns have been higher than historical averages, and volatility has been muted. There have been only eight trading days where the S&P 500 has moved 1% or more in either direction. One year ago, many strategists predicted a major selloff if Donald Trump was elected president. Stocks have instead rallied steadily. Market pundits will no doubt continue to dominate the headlines with their less than weatherman-like accuracy to keep investors on edge.
We are proud of our portfolio performance in 2017, as our diversified portfolios have generated attractive returns, with less risk (beta) than the overall market. Portfolio returns benefited from meaningful exposure to emerging-markets and international stocks, both of which outperformed the already strong U.S. stocks. We have been able to reduce risk in portfolios by a meaningful allocation to real estate investments and broad diversification.
The U.S. market delivered strong returns in the third quarter, extending its winning streak to eight consecutive quarters and a remarkable 18 out of the last 19 quarters. The S&P 500 Index closed at an all-time high. Within the U.S. market, larger-cap growth stocks—technology stocks in particular—continued their year-to-date dominance over smaller-cap and value stocks, a sharp reversal from what we saw last year.
Moving to the fixed-income markets, core investment-grade bonds inched up for the quarter. Bonds have aided in portfolio diversification, but we continue to be leary of their ability to produce meaning income in an environment with rising interest rates.
In this quarter’s commentary, we highlight a few of the positive economic indicators in support of a synchronized global growth recovery. But, as always, there are significant uncertainties and “unknowables” when it comes to economic forecasting. Humility and intellectual honesty—knowing what you don’t know and what you can’t know and can’t accurately predict—are crucial. Stock market corrections can happen any time despite the global economy’s current health, and investors should prepare themselves for market dips and drops along the way.
We look to strong years like 2017 to rebuild and strengthen portfolios rather than an opportunity to spend excessively. We often talk about taking a long-term view during difficult markets (2008-2009), because we understand losses won’t last forever and positive years will average out with negative years. Not to be a wet blanket, but when we get a great year like 2017 it can make your eyes glint with possibilities. However, it’s pragmatic to remember the same long-term view still matters. We need these good years to help average out the difficult years. It is always our first objective is to protect your irreplacable retirement and legacy nest egg.
Third Quarter 2017 Investment Commentary
Late summer, early fall has a reputation as the worst seasonal period for stocks, yet global stock markets rallied again. The old adage of “sell in May and go away” (until November) would have left money on the table this year. Emerging-market stocks were strongest, surging 8% in the third quarter followed by European stocks, which gained 6.2%. More broadly, developed international stocks rose 5.5%.
Our portfolios have benefited over the past year from the very strong performance of international and emerging-market stocks. Despite the strong gains, foreign stocks continue to look very attractive relative to U.S. stocks.
Update on the Macro Backdrop
The synchronized global economic recovery that we wrote about in the first quarter continues, providing a solid foundation for corporate earnings and financial assets in general. Below we highlight a few of the positive global economic indicators: For the year, our diversified portfolios generated attractive returns as all the major asset classes registered gains.
- The OECD Composite Leading Indicator recently hit its highest level since October 2014, and growth is broadly distributed across OECD (Organization for Economic Cooperation and Development) countries, reflecting a healthy global expansion.
- In August, the Global Manufacturing Purchasing Managers Index (PMI) hit its highest level in over six years. Eurozone and Emerging Market PMIs also rose to multiyear highs.
- Easing inflationary pressures in emerging markets have allowed numerous emerging-market central banks to lower interest rates this year, which is typically positive for local stock markets.
- Real GDP growth in the United States remains subpar by historical standards but continues to grind along at around a 2% annual rate.
- Financial conditions have eased over the past year, despite the Federal Reserve’s three rate hikes. This could bode well for economic growth over the next few quarters at least.
- Finally, global central bank policy remains accommodative and simulative.
Still, there is disagreement and debate among economists and strategists as to whether inflationary or deflationary risks should be paramount for investors at this point in the cycle, and related to that, whether Fed policy is too dovish or hawkish. As always, there are significant uncertainties and “unknowables” when it comes to economic forecasting. Humility and intellectual honesty—knowing what you don’t know and what you can’t know and can’t accurately predict—are crucial. As such, we always consider a range of potential scenarios in our investment decisions and portfolio management rather than betting heavily on any single macro forecast. “It’s difficult to make predictions, especially about the future” (Yogi Berra).
Asset Class Performance & Investment Outlook
U.S. Stocks: The near-term macroeconomic (fundamentals) backdrop for U.S. stocks still looks pretty solid, but U.S. stocks have high valuation risk. Across almost every absolute valuation metric, U.S. stocks look expensive to very expensive. The S&P500 return through September 30th was 14%.
In our assessment we are cautious when it comes to U.S. stocks, looking out over the next five-plus years. We will always have a meaningful allocation to U.S. stocks, but we have underweighted this class (vs. foreign stocks and real estate) in comparison to historical weightings.
Foreign Stocks: International and emerging-market stocks have generated strong performance over the past year. Part of this performance can be explained by the euro’s sharp 12% appreciation against the U.S. dollar in 2017. This will not add a meaningful contribution to foreign stock gains much longer.
However, foreign stocks still look very attractive relative to U.S. stocks, and are projected to offer solid – perhaps double digit – returns. This compares to low single-digit returns we expect from U.S. stocks.
In Europe and the emerging markets, we are seeing the corporate earnings (and stock market) recovery we have been expecting. Yet, earnings remain far below their pre-crisis highs and below what we view as their long-term trend growth level.
The relative strength chart to the right shows that U.S. stocks’ large return advantage since the financial crisis has only begun to reverse. As we’ve written before, and financial market history demonstrates, asset classes go through cycles of relative performance—driven not just by their underlying economic fundamentals but by human herd behavior and market sentiment that swing to excess. We may be in the early stages of the pendulum swinging back in favor of foreign stocks. We wish we could predict short-term swings in sentiment, but we feel confident that over the long-term the indicators suggest this will be the case.
Fixed-Income: Fixed-income allocations in our balanced portfolios added value this year. This sector plays an important role in portfolio diversification and providing needed liquidity. However; we remain cautious and prefer to use private or non-traded real estate instead to generate income and protection.
Despite the U.S. economy’s rather healthy economic indicators, it’s worth noting that a typical 5% to 10%-plus stock market correction can happen at any time, triggered by any number of unpredictable and/or unexpected events. Historically, the U.S. market has dropped at least 5% roughly three times a year and declined 10% or more about once a year. We are at 330 days and counting since the last 5% drop, which is the longest such streak in 26 years. Given that historical reference, the U.S. market seems long overdue for a correction. However, we are not in normal times and the correction in 2008-2009 was deeper and more severe than normal, and our recovery has been slower than expected.
A true bear market in U.S. stocks (a sustained 20%-plus decline) is almost always associated with an economic recession. Absent a recession, a bear market is unlikely. Recessions, in turn, are typically caused by excessive Fed tightening, usually in response to inflationary pressures, an overheating economy, or financial market excesses, none of which seem imminent in the U.S. or global economy. So although this is now the third-longest economic expansion and second-longest bull market in U.S. history, neither appears ready to die of old age just yet.
If that’s the case, then we expect to continue to benefit from our exposure and overweight to international and emerging-market stocks as their performance “catches up” to U.S. stocks. We anticipate the economy to grind along with low growth and modest increases in interest rates, both of which bodes well for real estate as a diversifier.
But as the cycle turns, the likelihood of a recession increases. We’d say one is very likely within the next five years, and a bear market as well. Our long-term outlook assumes that will happen. Our portfolios will have exposure to risky assets that will be hit hard by a recessionary bear market—although the degree of exposure depends on the individual portfolio’s risk objective. Investors must be prepared—psychologically and financially—for market dips and drops along the way. They are inevitable and may be unsettling, but they are also temporary.
In the meantime, we have built balanced portfolios that are resilient across a range of scenarios. They are diversified across investment strategies, asset classes, and risk exposures; and tilted to the areas our analysis indicates currently have the most attractive risk/return profiles.
We are continuing to work hard to watch your retirement nest egg and incorporate your financial planning objectives. Please feel free to call our office with any questons you may have.
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.]