State of the Markets
The third quarter of 2017 saw significant positive performance in most equity asset classes, leading to significant gains for the year.
The U.S. stock market (represented by the S&P 500) had a total return of 4.5 percent for the quarter, resulting in gains of 14.2 percent year to date. International markets achieved even better results with emerging market equities up almost 8 percent for the quarter and 27.8 percent year to date. U.S. small capitalization stocks (which led the pack in 2013 and 2016) and other diversifying assets like real estate holdings (the best performing asset class in 2014) have lagged so far in 2017. Despite these disparities, overall returns for a globally diversified portfolio are quite good.
The total returns for major asset classes are below.
The Driver of Stock Market Returns
What is driving the returns we are seeing from domestic and international equity markets this year? Is it the hope of tax reform? Is it central banks propping up the markets? Are we in the blow-off stage of the “bubble” we keep hearing about?We would propose none of the above. In the long-term equity performance is driven by corporate earnings.
Looking at actual and anticipated corporate earnings can give some meaningful insight into the performance markets have experienced over time. The chart below represents a combination of actual and estimated corporate earning per share for U.S., developed international, and emerging market indices as defined by MSCI. If you focus on the trends highlighted in the green circle, you will see that for the first time since 2011, all markets are experiencing an upward trend in earnings per share. From our perspective, this is the most reasonable justification for the significant gains we’ve seen over the last twelve months.
The chart also provides some insight into the eighteen month period beginning in 2015 in which all equity markets struggled. Earnings were declining in emerging market countries and stagnating in the rest of the world. While international markets took it on the chin during this period, the U.S. market was relatively resilient and hung on like a boxer who rope-a-doped for a few rounds before coming back to win the match.
After a significant period of international earnings slack, this is the first time in many years that the world as a whole is prospering. Combine this upward trend in earnings with relatively low valuations of international markets and this may be the beginning of a run, not the end.