Investment Commentaries: First Quarter 2017
|Index Returns||1st Quarter 2017||Trailing Twelve Months|
|S&P 500 US Large Cap Index||5.92%||17.07%|
|MSCI All Country World Stock Index||6.91%||15.39%|
|Barclays Capital Aggregate Bond Index||0.80%||0.20%|
|US Core Consumer Price Index-(Inflation)||0.39%||2.06%|
The first quarter was by most measures a continuation of the trends that took hold after the presidential election in November of last year. Stocks, both domestic and international, increased at a healthy clip, while bonds have lagged substantially. But it is still the case that, as we first noted in our interim first quarter commentary on February 27th, market expectations of regulatory and tax reform that boosted performance of stocks into the new year have not yet materialized. As a result, stocks as measured by the S&P 500 have not reached a new high since March 1st.
Measures of both institutional and retail investor sentiment have declined since the beginning of the year, but are still elevated relative to pre-election levels. Investors are not alone in their recent optimism regarding economic conditions. Consumers, small businesses, and executives at large companies have all indicated significantly more optimistic sentiment following the presidential election. The chart below indicates that so far it looks like those groups have been putting the cart before the horse. As far as the positive impact of improved sentiment on markets is concerned, the saying “don’t look a gift horse in the mouth” may be somewhat applicable. That said, it behooves us to take a closer look at portfolios and the current environment from a longer-term perspective.
The sentiment of hope for a stronger economy that has carried markets upward since November is under threat on a daily basis by political issues that have been derailing the President’s agenda. That is what is important to markets right now, but market prices continuously adjust to reflect investors’ aggregate response to new information, and new information is never-ending. Markets usually find reasons to over-react to information in the short-term, without a reasonable understanding of the impact that the information could have on value in the intermediate or long-term, and without appreciating the possibility that tomorrow’s information could make today’s information obsolete. This is why we believe it is so important to have a long-term view, and acknowledge just how much emotions can drive market behavior. Given that view, we thought it would be informative to point out a few observations pertinent to our management of client portfolios.
1. Economies and markets are cyclical, and this expansion is at the longer-end of the range for both.
2. Market valuations - while above average - are not grossly inflated by historical standards. Valuation is rarely the reason that market downturns start, but can be additional fuel to the fire when a downturn begins. Higher prices relative to measures of profitability mean that future returns rely more heavily on expectations of continued low cost of capital and above-average growth. Reliance on either of those factors should be highly scrutinized, given the current outlook on interest rates, and the expectation of growth based on uncertain regulatory and tax reform
3. Downturns in the stock market are not unusual, but markets recover. Downturns are uncomfortable to live through, but there is yet to be a time when markets have not recovered from one and moved on. The chart below illustrates the depth and duration of bear markets (declines of greater than -20%) from 1962 to date. During that period of over 54 years there were eight bear markets, yet stocks returned 10% (including dividends) annually on average, and 17,366% in total when compounded.
4. Attempting to time the market is counterproductive. Because markets are cyclical and people are wired to find patterns and extrapolate, individually and in aggregate they tend to over-estimate their ability to predict the future, and under-estimate the impact that emotions have on their decision-making. In attempting to buy what has been performing well, and sell what has been performing poorly, the average investor buys high and sells low, when their intention is to buy low and sell high.
There are several ways to demonstrate the impact that emotional decision-making can have on investment returns, including the chart below which shows how the average investor’s returns have compared to returns on several asset classes over the 20 years from 1996 – 2015.
The study, performed annually by the Dalbar Company, determined that the average investor achieved annualized returns of 2.1% over the 20-year period. That return is below the rate of inflation, which means that most investors did not maintain purchasing power over those 20 years, let alone grow portfolios in value. Dalbar attributes most of the underperformance to panicked selling during market downturns, and exuberant buying at market highs.
We firmly believe that our views must come back to answering one question: How does this impact client portfolios? We discussed some of the actions we took late last year and early this year in our last commentary; specifically, how our actions reflect the importance we place on diversification, portfolio rebalancing, cash management, and disciplined security selection. Since then, the actions we have taken fall into two major categories:
- As a result of portfolio rebalancing, we have been reducing exposure to equities that had become overweighted relative to our target allocations, and reinvesting the proceeds into sectors of the bond market; primarily bonds of shorter maturities that are less sensitive to changes in interest rates.
- We increased allocations to emerging markets stocks for balanced portfolios in late January. Doing so contributed to portfolio returns during the quarter, as returns for emerging market stocks meaningfully outpaced domestic stocks: Since January 24th, the MSCI Emerging Markets Index is up by 5.47%, while the S&P 500 Index of US stocks is up by 3.62%.
Going forward, we will be paying close attention to market developments and how they could impact longer term outlooks for client portfolios. We will also be dedicating time in upcoming client meetings to discuss the ideas we introduced above in more depth, and update your investment action plans via our risk tolerance assessment and a review of your investment objectives. As always, it is a privilege to have you all as clients, and we look forward to meeting with you soon.
Matt A. Morley, CVA, CEPA
Chief Investment Officer