Despite the perennial naysayers and financial journalists whose job is to create sensationalism when none exists, the second quarter of 2017 witnessed robust returns from common stocks. This was despite strong political headwinds pushing against the President’s most important agenda items – reforming health care, taxes and regulations.
The market’s impressive ascent since last November’s election was attributed to the belief that the aforementioned initiatives would be swiftly enacted, creating a second-stage economic lift-off. After the Trump-bump gains were “baked in the cake” so to speak, any delays enacting the President’s agenda were expected to cause the market to drop like a thrill-seeker in a barrel going over Niagara Falls. In typical Washington tradition, everyone wants progress, but no one wants change. How is it possible that stocks continue to climb in the midst of this uncertainty, and does it mean that we are on the verge of a correction or worse, a bear market? Possibly, but not necessarily.
This bull market’s duration is getting long in the tooth, but there have been two other post WW-II expansions that were longer. What about valuations? At current levels, the P/E ratio (price divided by earnings) of the S&P 500 is 18.5 times estimated earnings for 2017 and 16.5 times 2018 estimated earnings. While not under-valued, current price levels must be viewed in the context of earnings, inflation and interest rates. Earnings have been strong, inflation is running under 2% and interest rates are still very low from a historical perspective. For example, the 10-year U.S. Treasury note is yielding a paltry 2.3% as of 06/30/17. Investors with a ten-year (or longer) time horizon are comparing the total return potential (price gains and dividends) from a collection of the greatest companies the world has ever known to the return from a “risk-free” investment like U.S. Treasury securities and many are concluding that safety is a relative term.
Large companies (S&P 500) have grown at a 6.8% compound annual growth rate (excluding dividends) since 1957 and endured numerous crises during that time. Once dividends are included, the rate is over 9%. That sure looks like a compelling reason to participate in this wonderful experiment called capitalism which has created more wealth and pulled more people out of poverty than any other economic system in history. Are we saying the market will not experience a pull back at some point soon? Not at all. We have no idea when the next pull back will come, but we are 100% certain that another correction will come, and another one after that as history has repeatedly demonstrated. The S&P 500 has experienced an average intra-year decline of 14% annually since 1980. So far in 2017 it hasn’t dropped more than 3% and all three major indexes (S&P 500, DJIA, NASDAQ) are at, or near, all-time highs. Suffice it to say, it has been a profitable recovery from the lows of the 2008-2009 recession and periodic market declines, while unsettling, can temper unhealthy speculation.
Economy
U.S. growth, as measured by GDP (gross domestic product), is below past recoveries, and some economists now believe 2% may be the new normal. This is partly due to slowing population growth and declining labor force participation. Our economy is creatively evolving (as evidenced by Amazon’s announced purchase of Whole Foods and the impact on traditional grocers) and global growth rates are accelerating.
Pardon the pun, but it pays to pay attention to the American consumer who makes up about 70% of GDP. As the consumer goes, so goes the economy and the U.S. consumer is enjoying solid growth in personal income and spending, contributing to the rebound in housing and automobile sales - two of the largest contributors to the economy. Household balance sheets have been restored and with unemployment at 4.3%, we are now believed to be at “full employment”. The Chicago Purchasing Managers Index just posted a reading of 65.7%, its highest number in 16 years. The stock market is defying the skeptics because it is a mirror of our economy, not politics.
Markets
The second quarter of 2017 continued the upward momentum witnessed during the first quarter as stocks posted gains across the board. International markets led the way with impressive returns of 6.27% and 6.12% respectively from emerging (MSCI EM) and developed markets (MSCI EAFE). For the year’s first half, those same markets posted incredible gains of 18.43% and 13.81% respectively. Large U.S. companies (S&P 500) fared very well in the second quarter and first half of 2017 with gains of 3.09% and 9.34% respectively. After leading all comers in 2016, small U.S. companies (S&P 600) posted minimal returns of 1.71% and 2.79% for the second quarter and first half of 2017. This goes to show how valuable broad diversification and discipline can be. Investors who abandoned international markets at the start of 2017 and put those dollars into last year’s big winner (small stocks) made a tactical mistake.
So far, this year, longer-term bond yields have not moved up in lock-step with recent increases in short-term rates by the Fed. The FOMC (Federal Open Market Committee) has raised rates four times this economic cycle starting in December of 2015, and most recently on June 14th when it lifted its target rate to a range of 1.00% - 1.25%. Over the past six months, the yield on the 90-day U.S. T-bill has more than doubled from 0.46% to 1.02%. However, the yield on the 10-Year U.S. T-Note has dropped from 2.45% to 2.30% during the same time period, resulting in a flatter yield- curve. This is due to investor concerns about a slowing economy as the Fed tries to raise rates. Our bond benchmark (Bloomberg Barclays 1-5 Year Government/Credit Index) returned 0.56% in 2Q-17 and 1.14% for the year’s first six months. The chart below shows the increase in U.S. Treasury yields of varying maturities over the past 12 months.
What’s Next?
The main drivers of the Trump bump may be losing momentum, yet the market continues to move forward support- ed by strong fundamentals. Speaker of the House, Paul Ryan has said that tax reform must be revenue neutral which makes significant tax cuts less certain. The ACA repeal and replacement has become a political football and regulatory reform appears to have taken a back seat for the time being. Trump tweets, Russian collusion, border walls and worries of protectionism, China downgraded, EU dissolution concerns during French and UK elections, Syrian air strikes and North Korean missile launches; will Brad and Angelina get back together, will Tony Romo ever play in the NFL again – what does it all mean?
Noise! And paying too much attention to it will scare you right out of a prudently developed plan that was designed to increase the likelihood you will be able to achieve your life’s most meaningful goals. Ignore the noise and forget trying to time the market since it is almost impossible to do so successfully on a consistent basis. Instead, focus on your goals and the resources needed to fund those goals, not on this deafening and never-ending noise that is being regurgitated ad nauseam 24/7 by the news media vying for increased ratings so they can sell more advertising. Better yet, call the professionals at Wealthview and talk about your concerns. We’ve been advising investors for over three decades and can bring a much-needed detached objectivity to an otherwise subjective and emotional perspective.
Best wishes for a safe and relaxing summer!