2017 Q2 Market Update

State of the Markets

The second quarter of 2017 saw significant gains in stock markets around the world. In the U.S., rising consumer sentiment, consistent job creation, and resurgence in corporate profits propelled the stock market higher despite the lack of significant improvement in other economic indicators. After years of relative underperformance, international and emerging markets have advanced significantly, driven by a combination of accelerating economic growth and rising corporate earnings.

The U.S. stock market had a total return of 3.1 percent for the quarter, resulting in gains of 9.3 percent for the first half of 2017. International markets achieved even better results. Non-U.S. developed countries rose 6.1 percent for the quarter and 13.8 percent through the end of June. Emerging markets advanced 6.3 percent for the quarter and 18.4 percent for the first half of 2017. The U.S bond market had a relatively strong quarter as well, with a year-to-date return of 2.7 percent.

The total returns for major asset classes are below.

We would like to share our views on several key themes emerging in the current investment landscape:

Value vs. Growth: The Tug of War Continues

Equity portfolios sometimes have a value orientation which means they have significant exposure to smaller companies and cheaper companies (“cheaper” is often referred to as “value”). This can result in meaningful advantage when the market is favoring smaller and cheaper companies, which was the case in 2016 when value and small-cap stocks significantly outperformed large-cap benchmarks like the S&P 500.

So far in 2017, small-cap and value tilts have been working well internationally, but this approach has lagged in the U.S., where large, growth-oriented companies have been outperforming their smaller, value-oriented counterparts. 

FAANG (Facebook, Apple, Amazon, Netflix, Google)

Speaking of large-cap growth stocks, much of the year-to-date gain in the U.S. stock market can be attributed to a handful of mega-cap technology stocks. This trend is often referred to in the news as FAANG, an acronym representing Facebook, Apple, Amazon, Netflix, and Google. (Some media references to FAANG may include or exclude Apple, Microsoft, and or Netflix, which makes the whole concept somewhat random.)

The performance of these five companies accounts for a significant portion of market gains in 2017, which leads to the question: If these companies are driving growth in the U.S. stock market, should you own them? 

The answer is: Yes. Picking individual winners and losers in advance is tough. Consider owning the entire market so you have exposure to virtually every publicly traded company. 

Follow-up question: OK, but shouldn’t you own more?

Follow-up answer: Even though market performance is sometimes driven by a small group of large companies (which is not unusual based on research by AQR Capital Management ), there is significant risk in over-allocating to big, expensive, momentum-driven companies. After all, sometime companies are expensive for the wrong reasons. 

A company’s stock price often rises and becomes expensive relative to current fundamentals when investors have extremely high expectations for the future. If that future doesn’t materialize, then the stock price will come back to reality. Market history is full of examples of companies with significantly high growth potential whose stock price got ahead of fundamentals. Many of these situations resulted in steep declines or long periods of price stagnation. Cisco, Enron, Wal-Mart, Pfizer, and Microsoft are prime examples.

The FAANG companies may be significant winners going forward, which is why we wouldn’t recommend betting against them. Instead, we would encourage investors to own them in rational proportion – along with many other publicly traded companies. We believe owning the market as a whole will give investors the best outcome with the highest probability of success. Historical evidence is on our side in this belief, as depicted in the chart below, which compares the Russell 3000 (and index representing the entire U.S. stock market) to the Russell Top 50 (an index representing the largest 50 companies in the U.S.). In the period from 2002 through June 2017 (the longest overlapping time period) the Russell 3000 compounded at 7.5 percent per year while the Russell Top 50 earned 5.8 percent. You don’t have to concentrate on the biggest winners to get the best returns.

Bubble, Bubble, Toil, and Trouble

Another common theme in the media is around bubbles. “Is the U.S. stock market in bubble territory?” is a common question asked of pundits on financial news shows.

First, let’s define a bubble as occurring when an asset sells at a price that no reasonable future outcome can justify.

We are eight years into the current bull market, which started in March 2009 and has resulted in a gain of 258 percent (price only) for the S&P 500. More than half of the returns are attributed to changes in valuation as the market went from a very low valuation in 2009 to a relatively high current valuation. The rest of the gains can be attributed to fundamental growth in corporate earnings and dividends.

While valuations for U.S. equities may be high, we are confident that they are at the upper end of a justifiable valuation based on current interest rates, inflation, and corporate profits. We put the emphasis on justifiable and don’t believe we are anywhere close to the levels seen in other true valuation bubbles. 

That said, we recognize that high valuations often result in subsequent periods of lower returns. This is why we emphasize: (a) seeking global diversification, (b) balancing the risk of equity exposure with bonds and alternative strategies, and (c) making sure your financial plan is likely to achieve success in a wide range of potential scenarios. 

Conclusion

The media likes to focus their stories and headlines on themes that prompt strong reactions. We prefer to focus our efforts on historical evidence, economic reality, and portfolio strategies designed to get results required to meet our client’s financial goals. 

As always, thank you for your trust and confidence.
 

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