Markets in Rare TerritorySubmitted by Integras Partners on October 24th, 2017
U.S. markets have been surprising this year, both for the magnitude of gains and the near absence of volatility. Through Sept 30th, the S&P 500 Index® gained 14%, compared to 20% for foreign stocks (as measured by the EAFE Index) and 28% for Emerging Markets. We have been outsized beneficiaries of several themes we mostly expect to continue into next year.
The major surprise has been the absence of normal volatility. Should these conditions persist, this will be the least volatile year for U.S. stocks since 1964. Only three days this year has the S&P 500 risen or declined by 1%. In normal markets we experience about 30 such days per year.
For eight years we’ve experienced slow economic growth partially, tepid inflation and central bank intervention, all leading to reluctance by investors to embrace market risk. While much of this still holds true, things are changing for the better; even in the face some of real concerns.
We see six major themes supporting global markets as likely to persist well into 2018:
US economic growth is expected to improve slightly through year-end to roughly 2.5%-3% GDP growth. It is expected to rise further to 3% for the first half of 2018. For it to remain at 3% or above however, we must have some structural and/or policy reforms (i.e., tax reform/cuts, immigration reform, infrastructure).
Inflation is expected to creep up next year with higher oil prices due to stabilized inventories and our dollar slipping 9% YTD vs. foreign currencies, increasing import prices. Moderate inflation provides an incentive for consumers to buy goods earlier, providing pricing power to companies and resulting in higher corporate earnings.
The global economy is accelerating at the most synchronized pace in a decade. Every developed nation’s economy is currently in economic expansion providing support to future earnings growth.
Interest rates should rise over the next year as the U. S. Federal Reserve both raises interest rates and begins reducing its $4.5 Trillion balance sheet. With the Fed Chair position up for renewal, continued skillful communication is necessary for markets to absorb these events. Higher rates will benefit certain assets (financial stocks) and be detrimental to others (bonds, utilities). We will be watching these events closely.
Stock valuations do currently appear high on the surface. However, with the underlying fundamentals of earnings growth, interest rates and equity risk premium the US market is fairly valued as a whole. Stocks are priced roughly at 22 times 2017 earnings and 19 times 2018 expected earnings. Rising interest rates will impact this math so corporate earnings growth of roughly 10% is needed to support these valuations. We’ll be watching this even closer.
Most known risks today are low probability “tail risks”. War, market panics, Chinese credit implosion and our President’s Tweets are all possibilities we know exist. It’s the ones we don’t see that cause concern; but by no means do we anticipate exiting current positioning to guard against them now.
We’re certain that this elongated period of exceedingly soft downturns coupled with outsized gains in equities will end. Investors have been rewarded the past two years with the unprecedented pairing of almost triple normal returns with half the volatility. We have written about what “normal” looks like and are concerned our clients and the investing public may have forgotten what it is - or more importantly, what it feels like.
Normal markets experience broad rallies and declines throughout the year. Average annual gains are in the 5%-12% annual range with an average drawdown of 14% at some point during the year. A drawdown of that magnitude today would likely cause considerable angst given the fear most investors still harbor from the 2008 Financial Crisis.
With our time-horizon layered portfolios, our clients’ investments are structured to weather far larger moves before some change in positioning would be required. So when it happens, please recognize that if most of the themes above remain in place it is a normal correction that will run its course and the market will then return to…..normal. It will not derail your plan. If you’re not an Integras Partners client, call us sooner rather than later!
We are now entering the historically strongest period for equity market returns. The months of October thru April have accounted for the vast majority of upside moves throughout history. There is reason to believe this seasonality should persist this year as well. In light of such outsized gains already received, do not expect similar returns this time. Given current valuations and rising interest rates we expect stock returns over the next 5 years to be subpar with bonds returning near zero or below. One more reason we incorporate Real Assets in many of our clients’ portfolios to complement market assets.
In closing, we want to thank you for the trust you place in us to keep your best interests front and center in everything we do. Our objective is to help you achieve goals, not chase benchmarks. Success in that endeavor requires knowledge, effort and discipline. Our aim is to deliver those attributes to you every day.
Select a few people like yourself who would appreciate having such a relationship as well. The easiest way to introduce us may be to forward this email.
Have a terrific rest of the year and a wonderful Holidays if we don’t see you beforehand!