Roof Advisory Group MarketView – Closing Out a Strong 2017
Fourth quarter market returns closely resembled the trend that was in place for all of 2017. Stocks moved higher driven by firming global economic data, solid corporate earnings results, and expectations for tax reform. In a change of course from the previous three quarters, U.S. stocks led the charge outpacing international and global equities. Interest rates were little changed during the quarter resulting in marginally positive returns from bonds.
Full-year 2017 equity market returns were impressive and well in excess of even the most optimistic beginning of year forecast. Equally impressive was the ultra-low volatility environment that persisted throughout the year. The largest decline for the S&P 500 index in 2017 was a very modest 3%, we experienced zero trading days where the S&P moved by more than 2% and the year ended with a streak of 540 trading days without a 5% correction. Expectations for this placid volatility environment to continue are probably too hopeful.
To put it simply, the economy is strong. Estimates for fourth quarter GDP are hovering around the 3% mark. If estimates match up with reality, it will be the third straight quarter of 3%+ GDP growth. This would translate into the longest such stretch in almost 13 years. Outside of the U.S. global growth looks healthy and synchronized with all 45 developed economies growing and roughly two-thirds experiencing accelerating rates of growth. This represents the most broad-based upturn since 2010.
The current economic expansion has lasted roughly nine years so far which equates to the third longest expansion in history. Given the duration, it’s natural for investors, economists, and pundits to focus on when the expansion will end, and the next recession will begin. We don’t know the answer. But at this point we do not see the excess leverage, irrational exuberance, or the widespread mispricing of risk that typically precedes a significant downturn.
We ended the third quarter reexamining our mid-point equity stance given the backdrop of strong economic momentum, impressive corporate earnings growth and the increasing likelihood of tax reform. Given these favorable variables we increased equity exposure to the “one step above mid-point” level across client portfolios in early October. Our focus was adding domestic stocks with lower valuations than the broad market and increasing our international equity exposure. Our positive view on developed international stocks remains intact as the economic recovery in Europe continues to gain traction.
No major changes were implemented within the fixed income segments of portfolios. We remain comfortable with avoiding long maturity bonds where we are not adequately compensated for the associated interest rate risk. Conversely, we remain comfortable with our exposure to more economically sensitive fixed income strategies that in our view do provide the type of yield and total return prospects that compensate us for our risk exposure.
2017 Performance Attribution
Full-year 2017 portfolio returns were impressive, and we feel as though we captured more than our fair share of the equity market upside within our balanced and diversified portfolio strategies. Our performance results were driven by three main factors which we have summarized below.
- “Growth” stocks and more specifically the technology sector – Growth oriented equities dramatically outpaced the broad stock market with technology stocks outperforming the S&P 500 Index by roughly 15 percentage points. We tilted portfolios towards these segments of the market early in 2017 and were well positioned for this outcome.
- International stocks – Foreign stocks topped U.S. equities in 2017. We increased our allocation to international equities (primarily Europe) several times throughout the year. And while our equity exposure remains firmly tilted towards domestic markets, our international allocation was certainly significant enough to result in positive performance attribution.
- Fixed income – The broad bond market (represented by the U.S. Aggregate Bond Index) posted a return of 3.5% in 2017. Not a terrible result in our view given the historically low-interest rate environment. However, results within our fixed income allocations were considerably better than the broad bond market. Our active management decisions and exposure to areas such as Preferred Stocks and multi-sector strategies added a significant amount of value.
As we close the books on 2017 and look forward to 2018, we are encouraged by solid global economic momentum, estimates for double-digit corporate earnings growth, the potential benefits from tax reform, and by a lack of any meaningful indicators that would signal a near-term economic decline.
With all that said, we think it is overly optimistic to expect a replay of 2017. Stocks moving aggressively higher at an uninterrupted pace, without any measurable declines is a very aggressive baseline assumption. Many challenges and potential drivers of volatility remain – including – geopolitical risks, central banks shifting to tightening mode, and economic data or corporate earnings results not measuring up to lofty expectations.
Navigating the fixed income markets will be another challenge in 2018. The Federal Reserve has raised interest rates multiple times. However, interest rates or yields on “core” bonds are still not close to the levels we would classify as attractive. We have been pleased with the results from our active and opportunistic approach within our fixed income allocations. Given the continuation of the low-interest rate environment, we think that approach is going to be just as important in 2018.
We have included some commentary and a few charts on topics that we view as relevant, interesting, and important discussion points for our upcoming MarketView webcast.
Low Volatility Environment
We mentioned above that the largest decline for the S&P 500 index in 2017 was only 3%. The chart below shows the intra-year declines (red dots at the bottom) for the S&P for every year since 1980. Comparing the 2017 maximum decline with the average intra-year decline of 14.1% over this 37-year period reinforces the point that this truly was an extraordinarily low volatility environment and viewed in the context of historical outcomes, is an outlier and not the norm.
We increased our international equity allocation several times in 2017 and think those moves are justified for several reasons. The European economy (where our international exposure is primarily tilted) continues to improve. We’ll dive deeper into this topic on our upcoming MarketView webcast. However, we also like International stocks for the simple reason that they haven’t experienced the same parabolic move higher that U.S. stocks have since the rebound from the financial crisis. While the S&P has almost tripled since early 2009, international stocks have only captured about 40% of that advance. We think this leaves a significant amount of room for international stocks to “catch-up” to domestic stocks.
The details and implications of the recently passed Tax Cuts and Jobs Act are broad and far-reaching and better suited to be covered in detail on our upcoming MarketView webcast. Here are some abbreviated thoughts in the meantime.
We view the near-term impacts of tax reform to be firmly tilted towards the positive side. Expectations are for corporate tax cuts to provide a measurable boost to already very positive earnings forecasts for 2018. U.S. corporations will finally have a tax rate that is comparable to other developed economies resulting in a more even playing field going forward.
Our hope is that corporations don’t direct the bulk of their tax savings to “financial engineering” activities such as stock buybacks and dividends to shareholders and instead make the type of long-term capital investments in plants, property, and equipment that can improve productivity, drive expansion and enhance real economic growth. Also on our wish list is that individuals are confident enough in their prospects to increase consumer spending which as we all know is the backbone of the U.S. economy.
Our concerns center around the longer-term implications of the increased debt and deficits that will most likely be associated with tax reform. The U.S. has never enacted meaningful tax reform initiatives when our debt levels have been as high as they are presently. Most analysts and economists don’t believe that the increase in growth due to tax reform will be great enough to pay for itself. We are skeptical here as well.
Are Stocks Too Expensive?
After an almost 20% advance on the S&P 500 Index and with multiple stock market indices hitting new all-time highs in 2017, many of our clients have been asking the same or very similar questions. When is it going to end? Is this rally justified? Is the stock market too high?
As always, we think it is important to focus on the fundamentals. And in this situation, that means focusing on the market valuation and not just the market level. Despite the very impressive stock market rally in 2017, many investors are very surprised that from a valuation perspective, stocks aren’t more expensive now than they were at the beginning of 2017. Let’s take a quick look at the math using the Price-to-Earnings (or “P/E”) valuation ratio. The P/E ratio is a simple and commonly used valuation method that measures an index or stock’s price relative to its per-share earnings.
As illustrated above, the S&P was trading at a forward P/E multiple of 16.9 to start 2017. Using estimates for 2018 earnings and some reasonable assumptions for how tax reform will benefit earnings, we ended the year at the same valuation level.
Apologies for the math and granted the equation above does incorporate several estimates. However, we think the exercise illustrates several key takeaways. Corporate earnings growth has been the catalyst to the stock market advance. Also, if investors are just looking at the market level and not the market valuation, they may be missing a very important piece of the puzzle.
Adding Value in Fixed Income
We have maintained a healthy allocation to Preferred Stocks within client portfolios for several years. We view Preferred Stocks as a component of our fixed income allocation and portfolio weightings to this asset class range from roughly 6%-9% depending on each client’s specific investment policy. We have a favorable view on Preferred Stocks due to their attractive interest rates as well the floating-rate component associated with the vast majority of our exposure. The floating-rate component will help to increase our income stream as short-term market interest rates increase and also dramatically reduces the risk of declines in principal value associated with rising interest rates.
The investment vehicles we use to gain exposure to Preferred Stocks varies across portfolios and includes individual securities, mutual funds, and exchange-traded-funds. For simplicity purposes, we have shown the 2017 performance of a Preferred Stock index that closely represents the exposure of our various strategies within this asset class. The chart below also reflects the performance of the broad bond market (Aggregate Bonds) as well as several other specific segments of the fixed income market.
The results were impressive in absolute terms and especially notable compared with the broad bond market. Preferred stocks were a significant contributor to returns in 2017.