This past summer the Cleveland Indians captured the attention of baseball fans winning 22 consecutive games. This wasn’t the longest streak in Major League Baseball history, but a grand feat in the modern era. Other great sports streaks include The University of Connecticut women’s basketball team’s 111 consecutive wins. Going back a few years, the University of Oklahoma football team won 47 in a row. For us Vandy fans, there is the streak of 1,013 games in which someone on the men’s basketball team has made a three-point basket. We recognize this streak doesn’t involve victories, but we have learned to take what we can get.
In 2017, the S&P 500 was positive on a total return basis every single month, going 12 for 12. It was the first time ever for this calendar year feat! Up 22% in 2017, the Index’s winning streak stands at 14 months, nine consecutive quarters, and now nine years. The markets’ march higher has been rather astounding, especially considering all that has transpired globally over this period.
U.S. economic growth accelerated to 3% by mid-year helping to fuel market gains, after slowing to 2% or less for much of 2015 and 2016. Stuck in no-growth mode for longer than the U.S. post the “Great Recession,” 2017 was the year other major global economies joined the recovery. In a rare showing of global sychronization, all 35 member nations of the Organization of Economic Co-Operation and Development (OECD) are expected to post economic growth in 2017. International investors took note with the MSCI All-World ex-US index up 28%. A weaker U.S. dollar also helped U.S.-based exporters and investors who used appreciated U.S. dollars in recent years to gain exposure to emerging markets ahead of this strong rebound abroad. The MSCI Emerging Markets index gained 38% in 2017, aided by a healthy dosing of technology stocks.
Widespread economic growth provided additional tailwinds for corporate earnings growth and optimism. Then, just prior to the Christmas holiday, U.S. investors received the gift of corporate tax reform. The topic had occupied major investor mind share in 2017. So much so that when coupled with improving economic growth and corporate earnings, any fears of unwinding the Federal Reserve’s Quantitative Easing program, trade wars, or military unrest took a back seat.
Put simply, 2017 was a remarkable year for global investors. On the following pages, we’ll discuss many of the factors that could support or derail the markets’ winning ways, implications of accelerating economic growth for fixed-income investors, and how these factors have influenced our investment decisions. For a brief moment as we transition into a new year, however, we’ll step back to appreciate the unprecedented 12 for 12 climb and remain grateful our job is not to play Wall Street oddsmakers betting on a big up turn or downturn in any given year.
Today’s Stock Valuations We Can Comprehend. Understanding the Lack of Market Volatility is a Little Perplexing.
The S&P 500 trades at 17X 2018 estimates, including the anticipated earnings boost from corporate tax reform. International stocks are a couple of multiple points cheaper, which is historically the case. While equity valuations are at the upper end of historical ranges, the potential for upside continues to be supported by global economic growth acceleration, public companies benefitting from widespread consolidation and cheap credit, and few attractive investment alternatives. As one market strategist observed, until interest rates move meaningfully higher it seems we are in a “TINA” market (i.e., There Is No Alternative). We understand these dynamics and have consistently advocated for maintaining meaningful public equity exposure in Market Commentaries for several years now. It is also why we remain sensitive to the outlook for interest rates and the impact rising rates could have on both bonds and stocks.
What has proven more difficult to reconcile, however, is the absence of any stock market volatility. Markets rarely go straight up and generally react to company-specific and geopolitical news that clouds corporate earnings visibility. In assessing the markets’ eerily steady climb, we recognize large swaths of investors (endowment, retail, and pension) are either underinvested or are having to take greater equity risk in an effort to achieve high single-digit portfolio return targets when the global fixed-income portion of their portfolios yield just 2%. In effect, this crowd has contributed to the “BTFD” market (i.e., Buy The Freakin Dip). Also, the massive move to passive investing has undoubtedly influenced market volatility - depressing it recently as many otherwise active investors have for the time being chosen to allocate it and forget it. Whatever the reasons, this shift is reflected in the following chart, which highlights the historically low levels of market volatility.
Even still, we were surprised in 2017 that the stock market didn’t react more when a ruthless dictator fired a ballistic missile over our allies’ homeland to prove he could strike U.S. shores, the politics controlling the fate of tax reform were re-shuffled (albeit temporarily), or negotiations with some of our largest trade partners got tense. Markets instead yawned at these developments having now gone 289 trading days without a 3% peak to trough retreat. That is the longest streak in history (another first in 2017) and much better than the 16% average intra-year decline over the last 100 years. Moreover, the average daily price change for the S&P 500 was just 0.3% in 2017. This was the lowest since 1965. A big 2% or more daily drop or gain? There were 55 in 2009, 35 in 2011, but zero in 2017. (Sources: Bespoke Investments and A Wealth of Common Sense).
Perhaps the muted volatility is just one more example in a long list of why unexpected market influences make trying to predict the market pointless? Or, as some argue vehemently, there are an unprecedented confluence of factors pushing stocks to historically high prices, in effect coiling a spring such that when it finally gives, the unwinding will prove particularly painful?
Given the reality of a very wide range of outcomes, we continue to keep some cash on hand and look to maintain equity exposure at prudent levels given clients’ overall investment objectives. If stocks grind higher for years to come, which is what those who insist that we are in the middle innings of a secular bull market are forecasting, our clients will benefit from a seat at the stock market table. If, on the other hand, stocks correct due to higher rates, geopolitical turmoil, or any number of events that could cloud earnings visibility, we stand ready to increase exposure to stocks at cheaper prices.
The Tax Bill Is Across the Goal Line
Investors spent much of 2017 focused on Congress’ efforts to pass tax reform legislation. While unclear how “huge” corporate tax cuts would be, or the changes the markets were anticipating, we remained confident the year-long slog down the field would end up in the end zone. Republicans’ need to score only increased with the multiple healthcare fumbles earlier in the year, which meant even the party’s more rebellious members recognized time was running out to put points on the legislative scoreboard. And while certainly not pretty and with considerable details yet to be unpacked, the 21% corporate tax rate proved lower than the 25% to 27% rate most observers had originally anticipated.
In our January 2017 Market Commentary, we noted that “after the tax reform dust settles, we can think more about whether companies focus on ‘pre-tax’ or ‘post-tax’ rates of return when pricing goods and services.” The perspective will impact how much of the lower tax rates lead to improved corporate earnings. This discussion, which directly impacts how much shareholders, customers, and employees will share in the gains, moves front and center with the bill’s passage. Already, high-profile companies such as Comcast, Wells Fargo, Southwest, and AT&T have made moves to increase employee wages or promised accelerating capital investments that will improve consumer options. Never mind that some of these early movers looking to share their tax savings have had issues with government regulators as of late.
How Many Points the Bill Represents Remains to be Seen
Regardless, this tax bill is a big deal for U.S.-centric companies in terms of global competitiveness and earnings. In the last twelve years, 4,700 previously U.S.-based companies had taken steps to change their tax domicile given the often 15 to 20 percentage point savings involved. Current estimates are for an approximate $10 boost to S&P 500 earnings on the $145 consensus estimate for 2018. The impact varies greatly by company and sector. Normalized earnings per share for many domestically focused and capital intensive companies with modest levels of debt could increase as much as one-third in 2018 on tax-reform alone.
Markets are forward looking and the big gains of 2017 have clearly anticipated some level of this boost. Although in a bit of a surprise, the performance of some of the biggest sector winners from tax reform such as financials and industrials, which were up 22% and 21% in 2017, considerably lagged tech shares up 39%. Yet for the most part tech companies’ gains under the bill are relatively modest beyond the ability to repatriate at a reduced tax rate cash otherwise held overseas to defer taxes.
A Lower Corporate Tax Rate Is One Thing. Less Red Tape Is Another.
Anyone who pays taxes can identify with the magnitude of lowering the corporate statutory rate from 35% to 21%. What is more difficult to appreciate is the economic impact of fewer Federal rules and regulations, at least as defined by the number of new regulations published in the Federal Register.
The regulatory burden is particularly onerous for small businesses, which often have limited resources to invest in non-revenue producing compliance functions. Arguably, this mounting burden had advantaged large industry players, further weighing on small business sentiment and on new business formations. As a result, many small business owners had long deferred capital and operational investments. In a fairly dramatic reversal, however, the National Federation of Independent Businesses’ (NFIB) optimism index has spiked to record levels in recent months. In fact, the NFIB CEO recently commented “we haven’t seen this kind of optimism in 34 years, and we’ve seen it only once in the 44 years that NFIB has been conducting this research.”
Business activity cycles and small business owners are not immune to the positive “wealth effect” of a rising and resilient stock market. Nevertheless, the correlation between reduced regulations and increasing small business optimism is noteworthy. And whether due to less red-tape or a natural cycle, this shift among the economically crucial small business segment is a welcome development that is no doubt contributing to economic growth.
Yield Curve: Flat as a Pancake But Not Yet Inverted
The yield on the Ten-Year U.S. Treasury stands at 2.4%, which is where it was this time last year. Unlike stocks, however, bond prices were modestly volatile in 2017. In September, the yield on the Ten-Year was 2.1% before shooting up in recent weeks as investors began to factor in the inflationary risk of improved economic data, the potential economic boost from tax-reform, and additional Federal Reserve rate hikes.
As anyone shopping for bank CDs or with variable rate loan obligations can appreciate, recent rate increases have been material. Spurred on by the three Fed-rate hikes in 2017, the yield on the 2-Year Treasury is now 1.9% versus 1.2% at this time last year. Even government money markets are offering 1% plus versus the 0% with which investors had grown accustomed. We’ve made adjustments in our cash equivalent holdings so that clients may benefit from the rate rise. Considering the Federal Reserve has communicated expectations for three more hikes in 2018, long suffering cash savers may soon have reason to smile given the relative improvement.
Long-term interest rates, however, have barely budged. The 30-Year Treasury yields just 2.8%. The spread between Ten and Thirty-year Treasuries is as meager as it has been in years at just 0.3%. Given percolating inflation risks and a U.S. debt balance that now exceeds $20 trillion (excluding unfunded entitlement obligations), one has to ask why investors are willing to loan Uncle Sam money for thirty years at such low rates. After all, a 1% increase in rates, which would leave rates well below historical norms, could negatively impact a 30-year Treasury bond’s price by 20%.
Clearly, some investors do not fear inflation, despite a number of high-profile strategists calling it the biggest hidden risk to stock and bond investors entering 2018. Instead, these investors see owning long-dated Treasuries as an attractive hedge against slowing economic growth and geopolitical risk. And U.S. rates still look appealing relative to much of what is available in Europe and Japan. Their central bankers’ efforts have even exceeded US historical measures, resulting in negative rates for shorter dated government issues. Investors in German bonds must look to eight-year or longer bonds to receive positive rates.
“You can read Adam Smith, you can read [John Maynard] Keynes, you can read anybody and you can’t find a word to my knowledge on prolonged zero interest rates—that is a phenomenon nobody dreamed would ever happen.” –Warren Buffett, April 2016
The potential warning signs regarding out-year economic growth that a flat yield curve, let alone one that inverts, portends is not lost on us. As for our view as we evaluate investment options in a bond market that will sell off aggressively if inflation fears take hold? We’ll continue to resist reaching for yield on longer-dated bonds and opportunistically accumulate short and intermediate term bonds when prices come in and spreads between Treasuries and either corporate or municipal bonds widen. We also continue to identify other less correlated but relatively attractive yielding investments outside of traditional fixed-income. This allows us to respond to client income needs without outsized interest rate risk. We are also fortunate that the relative size of our fixed-income portfolio and independence to shop outside of many of our competitors’ often marked-up firm inventory affords us great flexibility when these investment windows open.
A Tech-Filled World
Technology continues to rapidly change how we share information, produce, and consume goods and services. Following 2017’s big gains among large-capitalization tech companies The Wall Street Journal recently highlighted how these companies are changing the investment landscape too. With the S&P 500 tech index’s 39% appreciation, the sector (which excludes other tech-based firms like Amazon and Netflix) now represents 24% of the S&P 500 compared to 21% at the beginning of the year. Similarly, the rapid growth of Asian companies like Alibaba and Tencent have contributed to the technology sector’s 28% weighting in the MSCI Emerging Market index versus a 17% ten-year average.
These big tech companies’ market leadership positions and potential for further innovation given significant research and development investments in exciting areas such as artificial intelligence, healthcare (clinical and administrative), and transportation, are why investors should have exposure to the sector. Also, for the most part, these are not the tech companies of the 1990s that contributed to the NASDAQ ultimately losing nearly 80% of its value from March 2000 to October 2002. The nearly $700 billion total market cap for all of the publicly traded cryptocurrencies (including Bitcoin’s fourteen-fold 2017 return) seems more akin to the investor feeding frenzy and risk appetites representative of the 2000 tech bubble. Nevertheless, the emerging tech concentration within domestic and international stock indices is influencing our portfolio construction, particularly with regards to certain passive investments. While in many cases valuations are defensible, much of the the sector remains high-risk high-reward given regulatory risk, potential overnight tech obsolescence, and the advertising dependency of many business models.
“Twenty years from now you will be more disappointed by the things that you didn’t do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.” –Mark Twain
The new year is an opportune time to revisit your financial plan and investment goals. A new tax law in 2018 and 2017’s significant stock market gains only increase the timeliness of taking a fresh look. We recognize many of our clients work with other professionals to determine spending patterns, college savings, charitable gifts, and estate plans, relying solely on us for investment management. But, for those who look to us for a financial plan as well, we welcome the opportunity for the review. It is included in how we serve clients and a valuable exercise for determining investment risk tolerance and tax-efficient investment strategies.
Finally, in 2017 Woodmont has continued to invest in technology in an effort to improve our administrative functions and investment management research and execution capabilities. In addition to our quarterly market commentary and periodic deeper dive investment and planning reports, we will also provide clients and friends a weekly email newsletter called “Fifteen on Friday.” The goal is to curate a thoughtful list of interesting pieces of the week, across a wide range of subjects from arts, culture, business, and technology. Some of you are already receiving it. Beginning in early 2018 we’ll distribute this email to all clients on Friday afternoon. Feel free to opt out if your reading list is already too long, or certainly send us some of your favorite pieces for potential inclusion.
Thank you for your continued confidence. Best wishes for a healthy and prosperous 2018, and please know we look forward to discussing your investments and answering any questions you may have.
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