Investment Commentaries: Third Quarter 2017
|Index Returns||3rd Quarter||Year to Date||Trailing 12 Months|
|S&P 500 US Large Cap Index||4.5%||14.2%||18.6%|
|MSCI All Country World Stock Index||5.3%||17.8%||-19.3%|
|Barclays Capital Aggregate Bond Index||0.8%||3.1%||0.1%|
|US Core Consumer Price Index - (Inflation)||0.5%||1.2%||1.7%|
During the third quarter of 2017, many events with the potential to disrupt financial markets occurred, but prices continued to trek higher. Along with one of the worst hurricane seasons in recent memory, terror attacks in the UK and Spain, and a devastating earthquake in Mexico; pressure along political fault lines both globally and domestically continued to build without much progress on the underlying issues. Despite many opportunities for investors to become more risk-averse in behavior during the third quarter, the S&P 500 index of large cap US stocks reached 19 new highs, and the index never declined more than -2.2% from its previous high. As we head into the fourth quarter, we evaluate what is driving returns and investor complacency, and we identify risks to continued returns.
As mentioned above, markets not only added to positive returns for the year during the 3rd quarter, but they remained uncharacteristically calm through events that had the potential for significant disruption. The primary measure of risk and uncertainty in markets is volatility, and the most widely-used indicator of volatility is the CBOE S&P 500 VIX index, which indicates how widely returns on the S&P 500 Index are expected to range over the next 12 months. Interestingly, VIX was at all-time lows at the end of the 3rd quarter, suggesting that markets are expected to remain calm going forward.
Markets are calm in large part due to the continuation of economic growth and stability, and neutral policy by the Federal Reserve.
The economy is growing at around 2% on an annualized basis, the Unemployment Rate at 4.2% is historically low, and inflation of between 1.3% and 1.7% is mild but not sluggish. A few more-frequently released indicators are slightly down based on their most recent release: Real Personal Consumption Expenditures declined by -0.9% month over month, and Initial Jobless Claims were most recently reported to be 8.5% higher than they were at the same time last year. We are watching these indicators for signs of continuing deterioration, but we think they will likely recover as economic impacts of hurricanes Harvey and Irma flow through the data. Despite the recent weather-related hiccups, we believe a recession is unlikely over the next 6-12 months.
Moderate growth and the expectation for continuing calm are also contributing to more optimistic behavior by businesses, which are building Inventories (up 8.7% on an annualized basis over last month), and investing in productivity (Durable Goods orders up 4% vs last year). The confidence exhibited by US businesses influences the willingness of investors to continue shifting investments away from the perceived safety of cash and bonds, and towards more volatile stocks, despite historically elevated prices relative to underlying values.
So far this year, equity markets have significantly outperformed cash, bonds, and real assets such as commodities and real estate. Globally, international stocks have significantly outperformed domestic stocks. Within domestic equity markets, large cap stocks have outperformed small and mid-cap stocks. When we look beyond the return numbers alone, a few themes emerge that help to shed light on relative performance across asset classes.
Outperformance of International Stocks: Global economic stability and signs of healthy growth have attracted investors to international stocks after years spent out of favor due to seemingly non-stop sovereign debt and political crises. Because they have been out of favor, Non-US stocks also exhibit lower valuations relative to domestic stocks (see the chart to the left). Lower prices relative to underlying earnings indicate the perception of more uncertainty for those economies, but also imply the potential for higher returns than US stocks going forward.
While increasing economic stability explains some of the exceptional outperformance of non-US stocks this year, the weakening US dollar has also played a significant role for US investors who measure returns in Dollars. As the chart to the right demonstrates, nearly half of the 20% return on developed market stocks this year is attributable to the declining value of the Dollar relative to other currencies. The Dollar’s value has declined by -8.5% this year against a basket of other major currencies.
The currency impact is much less significant for emerging market stocks, suggesting that performance in those markets is attributable primarily to strengthening fundamentals.
Outperformance of Large Cap US Stocks: The trend of outperformance in stocks relative to bonds is ongoing as a result of the neutral/positive economic growth outlook in the US, as well as attractive potential returns relative to low-yielding government and corporate bonds. That said, investors have continued to favor the stocks of larger companies, as they are seen to be less risky than smaller counterparts. This preference for stocks over bonds, and large companies over smaller ones, has entered a self-reinforcing cycle that is most clearly visible in the performance of high-momentum stocks.
A stock is considered high-momentum if it has outperformed the overall market over the previous 3-12 months. So far this year, a widely-used Exchange Traded Fund (ETF) of high momentum stocks has returned a little over 28%, compared to 14% for the S&P 500 in aggregate (see chart below). Historically, high-momentum stocks as a group have outperformed the market by around 2% on an annual basis, suggesting that the 14% outperformance this year is excessive, and is certainly well-above what investors should expect over the long-term.
The thought behind momentum strategies is that stocks that have performed well in the recent past will continue to do so, and that investors can use outperformance over previous periods as an indicator of future outperformance. This means that momentum investors buy stocks whose prices and overall market value have increased, which in turn causes another round of increase in price and overall market value, regardless of the underlying fundamental health of the company.
The popularity of Momentum as a stand-alone investment strategy exemplifies the current state of investor sentiment: “Just keep doing what has worked, and expect it to continue.”
Investing in a stock or group of stocks under the assumption that past is prologue and that higher prices beget higher prices without regard for the health and growth of the underlying companies, is equivalent to placing a bet that a dog can chase its tail at ever-increasing speeds forever. Eventually, the dog will get tired or bored, or both. At this point in the market cycle, investors would do well to remember the familiar disclaimer required for all investment products: “Past performance does not guarantee future results.”
A significant aspect of our role as portfolio managers is to continuously survey how portfolios are positioned in relation to the objectives of our clients, and within the context of market conditions. Client portfolios benefited from continued participation in strong equity market returns during the quarter, but we remain selective in the quality of individual holdings, and careful not to lose sight of the possibility of increased market volatility in the near term. In fully-diversified client portfolios, we took advantage of the markets’ calm during the quarter to realize a portion of outsized gains in international stock positions, and redeployed those gains into underappreciated areas of the bond market and other income-generating securities. Going forward, we will be looking for opportunities to make similar changes across portfolios. We do not take lightly the trust you place in us as advisors, and look forward to speaking with you soon.
Matt A. Morley, CVA, CEPA
Chief Investment Officer