We hope everyone’s summer is off to a good start!
Q2 2017 Economic / Market Recap
The “Trump Rally” that started in November has continued to advance in the second quarter. The year to date index returns for the first six months of 2017 have been:
U.S. Energy Sector: -17.13%
U.S Technology Sector: 18.89%
Barclay’s Aggregate Bond: 2.27%
International Developed Markets: MSCI EAFE Index: 13.81%
International Emerging Markets: Diversified Emerging Markets: 18.19%
The U.S. financial markets seem to be moving on a combination of three things —
1. Robust corporate earnings
2. Decent economic news
3. Optimism about a tax cut and substantial regulatory reform
After three years of flat earnings, Strategas Research Partners, LLC is estimating a 4.7% increase in earnings for the S&P500 companies in 2017ii. A positive earnings backdrop could continue to drive stock prices higher. One of our favorite investment books of all time is “One Up On Wall Street” written in 1989 by the great Peter Lynch. The title of chapter 10 tells the story of what Lynch thinks pushes stock prices higher—“Earnings, Earnings, Earnings.” He believes that much of what we tend to focus on is merely “noise” and what really causes financial markets to advance is corporate earnings. We tend to agree. Over the next year or so, look for the news here to stay mostly positive.
We continue to have decent economic news—not great, but not bad either. Kiplinger’siii recently reported these U.S. economic numbers:
GDP Growth 2.1% for 2017 (up from 1.6% in 2016)
Inflation 1.6% (down from 2.1% in 2016)
Unemployment currently at 4.3% (lowest in 16 years)
Interest Rates 10 yr. treasury notes up to 2.4% by year end (2.15% currently)
Globally, Europe and Japan have improved economic numbers over the past several years. We think caution is in order as the U.K. navigates the short-term implications of the “Brexit” vote. The broad outlook also remains increasingly positive for emerging markets.
The optimism that was so strong in the aftermath of the election is, in our opinion, beginning to fade. We haven’t been able to get a Republican Congress and White House to agree on tax, healthcare, immigration, or regulatory reform. They have nibbled around the edges of those issues, but no substantial legislation has been enacted. We think tax reform is the most critical in terms of its effect on the economy. We will not see 3%+ GDP growth without substantial tax reform. We think it’s possible to get GPD growth approaching 3% in 2018 if a tax bill passes soon. Unfortunately, we don’t see that happening until mid-fall at the earliest.
3Q 2017 Outlook
It’s the most frequent question we ask ourselves these days—is the U.S. stock market overvalued and headed for a substantial correction of 10% or more? For valuation, we often refer to the Morningstar “fair value” survey. They evaluate over 1000 stocks on the U.S. exchange and compare the current price to the “fair value”. They combine all the stocks into an index to estimate whether the market is undervalued or overvalued. Anything over 1 is overvalued, anything under 1 is undervalued. The current ratio is 1.02—the chartiv below illustrates what it’s been over the last year. It seems to confirm what we believe—the U.S. stock market is not grossly overvalued, but slightly ahead of itself.
The other short-term concern we have for U.S. stocks is what is referred to as the “seasonal effect” on stock prices. Simply said, U.S. stocks tend to go down from the period of mid-June to mid-October. Chris Verrone, technical analyst for Strategas Research Partners, released a report pointing out that stocks are approaching a more difficult stretch of the calendar.v Verrone pointed out that the average performance of the U.S. stock market for these months over the last 30 years is often negative.
Investors never seem to learn their lesson by chasing returns, ignoring risk, and not paying attention to value. The best example I have found recently comes from the government of Argentina. We’ve lost track of the number of times they have defaulted on their debt over the last 100 years and it’s only been a year since the country settled lawsuits on its most recent $95 billion default. That didn’t stop investors from gobbling up $2.75 billion in 100-year government bonds. Why would any investor in their right mind invest a penny in something issued by a country with a spotty payment record that matures in 100 years? It had to be the yield—these bonds pay 7.91% interest. We feel safe in arguing that investors chasing this return will be disappointed and will understand firsthand the concepts of value (or lack thereof) and risk (high indeed).
What’s An Investor To Do?
An investor’s best friend can be patience. Patience to wait, for example, on value to be restored—a 5% to 10% correction in U.S. stocks would restore value to a slightly overheated market. Patience to hold cash to wait for that correction—otherwise you have nothing to buy “bargains” with.
There are pockets of value and promise in the several sectors of the market—notably drugs, biotech, financials, and technology. We think a focus on certain sectors of the stock market is likely to lead to higher performance and less risk relative to the broad market average.
We also like to remind our clients that the financial markets are truly global. Investors have easy access to both the stock and bond markets in Europe, Japan, and even emerging markets by using some of the numerous exchange traded funds that specialize in these areas. We have had substantial results this year from increasing exposure to Europe and emerging market equities. Despite their nice run this year, these stocks remain substantially less expensive than their U.S. counterparts. We believe that additional overweighting to these markets may be both smart and prudent.
As always, we will continue to monitor the financial markets and the economy closely. Over the last few years, it has been hard to be a value investor. We are learning to be flexible in our search for value!
Industry / Office Update
We have been very busy over the last year dealing with changes related to the new so called “DOL Fiduciary Rule”. It is, in fact, the biggest regulatory change in our industry over the last 35 years. It has required that we “repaper” our service agreements, resulting in us generating a great deal of paperwork and asking clients for many signatures. We appreciate everyone’s patience as we adjust to this new environment!
Finally, we want to introduce our new Director of Marketing, Valarie Johnson. She recently served as a financial advisor with a national insurance and investment firm. She lives in Union County with her husband and three daughters. She is a welcome addition and vital member to our team!
We are thankful for our many clients and the trust and confidence they have placed in us. We appreciate the opportunity to serve them! We sincerely hope this is your best summer ever.
i “Morningstar’s Take on the Second Quarter”, July 7,2017
ii Martin Investment Management July 2017 newsletter
iii “The Kiplinger Letter”, volume 94, number 26, June 30, 2017
iv Morningstar.com, market fair value chart dated 6/28/17
v “The Sherman SITREP Report dated July 1, 2017