First Quarter 2018 - Market ReviewSubmitted by Karstens Investments on February 6th, 2018
By Michael D. Karstens, CFP®, AIFA®
Wow, what a perfect year for investors. Stocks rose around the world with many markets reaching record levels; couple that with very low volatility and you end up with a very robust 2017. For the year, the S&P 500 Index rose 19%. The Dow Jones Industrial Average was up an even larger 25%. One of the best performing U.S. indexes was the NASDAQ. Driven by heavy weightings in the tech giants, Apple, Alphabet (Google), Microsoft, Amazon and Facebook, the NASDAQ gained 28.2% for the year. These ve companies accounted for nearly 1/3 of the index gains. Perhaps even more surprising is how smooth the ride was.
There wasn’t as much as a single 3% pullback in all of 2017 and we are currently in the longest period ever without such a minor correction, over 420 days and counting. Chart 5 shows the intra year peak-trough declines since 1980. You can see how uncommon the lack of a 3% decline is. Obviously declines of at least 8-12% are expected and 15%+ declines aren’t all that uncommon. On a global basis, almost every major yardstick for global stock prices ended the year with double digit gains. Driven by improving economic growth, sturdy corporate earnings and ongoing government stimulus, i.e. government money printing, stocks rose on almost every market. The S&P Global Broad Market Index which includes stocks from 48 countries, gained 22.7% in 2017. It was also a banner year for emerging market stocks, with the S&P Emerging Broad Market Index climbing nearly 32% in dollar terms, the best gain since 2009.
Commodities were a mixed bag in 2017. Copper at +31%, gold +13%, oil +12%, and cotton +11% all posted nice gains. For the farm economy returns weren’t so good; corn was at for the year, soybeans fell 4%, and sugar and orange juice were down 22% and 31%. Natural gas prices fell over 20% for the year.
Interest rates really started to move up in 2017 which slightly depressed some bond prices. All in all, there wasn’t much to be gained from cash or bonds in 2017. With that being said, interest rates continue to be a very important story. There is little doubt that ultra low interest rates have been a major driver in higher stock and real estate prices.
So what drove the markets in 2017 and will they continue? Very low and in some cases, continuing negative interest rates certainly helped. With that said, rates have been moving lower for some time so there were certainly some other variables that probably played a major part. Improving global economic conditions clearly played an important role and most economists see continued growth in 2018. Corporate pro ts were probably one of the biggest factors as they continue to grow. As you can see in Charts 2-4 on page two, both auto sales and housing starts have really recovered back to pre- crisis levels. Mortgage payments as a percentage of household income remain at very low levels, supporting house prices. Couple that with the new tax bill and much lower corporate taxes, and most will see even higher pro ts in 2018. How much of this is factored into today’s market is the big question.
So what could go wrong? Some areas of concern:
1. Extreme valuations of financial markets. U.S. stocks currently trade at over 18.5 times next year’s projected earnings, the highest in the last 15 years. As you can see on Chart 6, P/E ratios are currently 110%-133% of their long-term average and many other market metrics are at record levels.
2. Worsening U.S. fiscal financial position. The fiscal budget deficit for 2017 was approximately $700 billion and for the rst time total public debt surpassed $20 trillion, only 9 years after it hit $10 trillion, a level not exceeded in 200 years. Up until very recently, the U.S. Federal Government interest expense was the same as it was ten years earlier, even though debts have doubled. We can thank record low interest rates for that! Most believe that the new tax law, even with higher projected GDP growth, will add to our annual de cit. In addition, for each 1% increase in interest rates, the de cit would rise by $140 billion. Since 50% of the debt matures in less than 3 years, the impact of higher interest rates would hit fairly quickly.
3. Rising inflation. There are already important signs that inflation is on the rise, signs that are not being measured by the CPI. The little know ECEC (Employer Costs for Employee Compensation) rose 4.4% in Q3 2017, up sharply from 1.3% at the beginning of 2016. This is telling us that labor costs are rising sharply.
4. Slowing government money printing. Some would call this quantitative tightening (QT) as opposed to quantitative easing (QE). The European Central Bank (ECB) has been buying 60 bil- lion euros ($70.6 billion) of bonds per month. The Bank of Japan, meanwhile is acquiring Japanese government bonds in sufficient quantity to keep its 10-year yield pegged near zero percent. Peter Boockvar, chief market analyst at the Lindsey Group, estimates the Fed’s shrinkage of its balance sheet and the ECB’s tapered buying will mean $1 trillion less owing into capital markets next year. “I am completely amazed at the nonchalance with mon- etary policy, and some do not even mention it as a risk factor,” he writes in a client note, after listening to sell-side prognosticators’ 2018 market predictions. “Let me know if you’ve seen one fore- cast that includes a lower P/E multiple due to $1 trillion of liquidity that is being removed by the Fed and the ECB alone in 2018 on top of more Fed rate hikes. I haven’t seen many.” We’ve said for some time that government money printing was helping stocks and bonds. Will monetary tightening hurt them? As you can see in Chart 7, global government printing (balance sheet expansion) peaked in 2017 and is set to decline substantially.
5. High investor sentiment. A year ago investor sentiment was fairly restrained as investors worried about Brexit, global political concerns, terrorism, and a seemingly dysfunctional government. Today much of the concern has swung to optimism and bull- ish prognostications. Investors intelligence recently stated that “Nearly 2/3 of investor newsletter writings were bullish on stocks in mid-December, nearly a three-decade high. Such high readings are not usually conducive to high intermediate term returns.” Also, information provided by Charles Schwab shows client cash percentage is at record lows and well below levels at previous peaks. (See Chart 8).
So as investors, what can we expect moving forward? Probably the most important question in determining the long-term returns investors can earn is how much risk they are prepared to take. Those prepared to take more risk should generally expect higher returns in the long run. But taking too much risk can also lead to disaster for investors.
An investor holding a 60/40 S&P 500/Treasury bond portfolio in September 1929 would have had 39% of his money remaining by June of 1932. An investor holding 100% S&P Composite would have retained 18% of his money. Losing 61% of your money is no fun, losing 82% is an awful lot worse. The 100% S&P strategy outperformed the 60/40 strategy by about 1.5% annually since 1920, so there was, in fact, a higher return for the additional risk. Whether an investor would have been able to take that additional risk, however, is another matter.
As you can see on our rst chart back on the rst page, using the same measures but a shorter time frame, once again the S&P 500 outperformed a 60/40 portfolio since 2007, however, an investor 100% in the S&P suffered a loss over 50% to start the period and didn’t recover for four years.
What if the market didn’t recover so quickly? What if the inves- tor needed to pull out cash during the downturn? Determining how much risk you take as an investor is a crucial exercise. A 25-year-old who is 40 years away from retirement probably has more risk capacity in his retirement savings than a 65-year-old who relies on those savings for a large portion of his neces- sities. There are also two additional risks that we probably shouldn’t rule out, the risk of depression and the risk of unanticipated inflation. It has been quite some time since we have seen an extended period of these events. Hopefully we won’t see either soon.