2017 was filled with worries about an impending nuclear showdown, the fragility of the Chinese economy, and the next tweet from President Trump. As it turned out, all that was beside the point. What really mattered in 2017 was a strong and increasingly synchronized global economy. Companies posted record profits and created jobs faster than they could find willing and able workers while the stock market set new records almost daily.
It was an unexpectedly bountiful year for the economy and the financial markets. The S&P 500, a broad measure for large U.S. stocks, gained 21.8% including dividends, more than doubling the 90-year historical compound annual return of 9.7%. Small U.S. stocks trailed with 14.7% returns for the Russell 2000 index. After trailing the U.S. for several years, foreign stocks played catch up last year, recording 25.6% gains for the MSCI EAFE index of large companies and 37.3% gains for emerging markets.
Bonds registered mediocre results as the US Federal Reserve followed through on its promise of three rate hikes, while central banks in Canada and England raised rates for the first time in years. The Barclays Aggregate U.S. Bond index gained 3.5% for the year, while the Intermediate Government/Credit index was up 2.1%, both short of historical averages.
Behind the big gains in stocks was a remarkably coordinated global expansion that alleviated the worst geopolitical fears. Economic activity signaled an upturn in growth in North America, Europe, Asia, and Latin America. Companies posted record profits and created jobs faster than many expected, driving the unemployment rate to 4.1%, a 17-year low.
The Fast Lane
Here are some of the other major investment themes from 2017:
- Last year was one of the calmest for stocks in decades. Investors thought the election of President Trump, along with other populist elections in Europe, would result in a volatile year for stocks. None of that happened and the VIX index, a measure of volatility approached record lows.
- Technology was the top performing sector in the S&P 500 for 2017, returning 38.8%. By the end of 2016, the FANGs (Facebook, Amazon, Netflix, Google plus usually Apple and Microsoft as well), had established their competitive dominance. In 2017, that power payed off with sharply increased profits and revenues. As a group, these six stocks accounted for nearly a quarter of the return of the entire 500 stocks in the S&P index.
- The growing influence of Amazon punished the retail sector in 2017, with the company’s purchase of Whole Foods Markets sending shock waves across the industry. The SPDR S&P Retail ETF (XRT) returned 4.2% for the year while Amazon’s stock gained 55.7%.
- Bitcoin easily wins the award for the most hyped “investment” of the year. The cryptocurrency started the year at $1018 and rose to a high of almost $20,000 before finishing the year at $13,407. To paraphrase Mark Twain: “you pays your money and you takes your chances.”
The Allure of Hindsight
Like everyone in our business, we make predictions about future investment returns. Unlike some, we don’t put much value in our crystal ball. No one really knows what happens next in the markets. In fact, it is that uncertainty that creates the opportunities for surprise years.
Since 1928, there have been 31 years the S&P 500 returned greater than 20%, including dividends. The average return in the following years was 9.9%, essentially the S&P’s long-run compound annual return of 9.7%. There is quite a bit of variation too, as the best following year returned 33.1% and the worst year saw a 35.3% decline.
Including dividends, the S&P 500 has gone up for 14 months in a row, the longest positive streak since 1928. There is a tendency to think the market is more likely to decline after a good run, but history indicates that stocks do not behave much differently after a big return year than after any other year.
Market bears, pointing to high stock valuations, suggest the market is due for a correction, but valuation levels are also not accurate predictors in the near term. If they were, then 2017 would have been a bust. In the short run, the momentum effect – the tendency for winners to keep on winning – is stronger than the valuation effect. Right now, there is no indication the economy and the resulting euphoria for stocks will suddenly end.
Higher than average stock market valuations are likely due to the economic environment. One reason stock valuations are elevated is that interest rates are below average, and interest rates are low because inflation is low. Stocks may not be expensive if inflation remains in the 1.5% to 2.5% range and long-term bond yields remain under 3.5%. For a mature economy with an aging population, these factors could lead to a prolonged period of higher stock valuations.
Inflation may hold the keys to the kingdom over the next several years. If inflation increases unexpectedly, the Fed could be forced to raise rates faster than the current pace, upsetting the markets. Right now, investors see little risk of an upswing in inflation, but the risks of a change in this sentiment warrants a close watch in 2018.
“It ain’t what you know”
Aside from the macro-economic backdrop, many geopolitical questions remain unanswered, and we suspect these themes will continue to be in the news.
- Despite the incendiary rhetoric, there is evidence the North Korean leader Kim Jong Un is acting rationally, stepping up to red lines but not crossing them.
- Will trade disruptions shock the economy? A drastic re-negotiation of NAFTA or attempts to close the trade gap with China are likely to be futile and only increase the chance of trade war – a fight that no one wins.
- What is Putin’s next move? Is Russia trying to reassert its nationalistic pride, looking to weaken the institution of western democracy, or eyeing the next Crimea?
- The political drama out of Washington has threatened to up-end confidence. If the economy is doing well, markets will likely continue to ignore the news flow.
Nearly every period in history is marked with a laundry list of that era’s worries. The natural inclination is to look to these problems to predict the next market decline. In reality, it’s rare for the risks we know about today to cause a pullback in stocks. Mark Twain also purportedly quipped that “It ain’t what you know that gets you in trouble. It’s what you know for sure that just ain’t so.”
What It All Means
A market characterized by historical rich valuations, but strong near-term momentum, poses a conundrum for investors. Should we stick to the long-term and ignore the short-run or vice versa? Neither approach works in isolation. One thing we have learned after 30 years is that investing is best approached with a heavy dose of humility. Acknowledging that the market is mostly right and avoiding the pitfalls of myopic conviction are keys to growing and protecting wealth over time.
Our advice is to stay invested in stocks, but with a focus on quality and broad global diversification. If the momentum holds, then foreign shares will likely continue to outperform. The biggest risk, we believe, continues to be in bonds. We are increasingly positioned in government over credit-backed bonds, and shorter duration bonds over longer term issues. Enhanced cash funds offer yields close to high quality bonds, making them a good place to ride out anticipated volatility in a rising interest rate market.
Portfolio structure is also critical, especially now. We believe a core-satellite strategy is a time-tested method for constructing a well-balanced portfolio. Another way to view core-satellite is by incorporating the idea of risk buckets. The first bucket is the personal risk bucket where the goal is protection from poverty or a significant change in lifestyle. The safest assets, such as your home and cash reserves, go in this bucket. A second market risk bucket holds stocks or bonds of average, or market driven risks. The goal here is to maintain an inflation-adjusted standard of living over time. The third bucket is the aspirational risk bucket, where the goal is to substantially increase wealth by taking higher risk. This bucket might hold concentrated stock positions or more actively managed portfolios of stocks and bonds. It could also include privately owned businesses or less liquid real estate investments. The key, obviously, is to correctly size the buckets.
Our annual investment report for clients will be mailed (or emailed, depending on your preference) over the next couple of weeks. Please reach out to us with any questions you may have and let us know if you want to schedule a time to meet and review your personal situation in more detail.
We wish you a happy and healthy 2018.
Contact us at 865-584-1850 or firstname.lastname@example.org
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.