ARQ Wealth Advisors 2Q 2017 Commentary
by Richard Siegel, CFP®
The second quarter of the year could simply be characterized as “more of the same.”
- The same positive returns in the equity markets – strong returns across global markets.
- The same positive returns in the bond market – strong bond returns as yields slowly dropped.
- The same monetary policy – measured interest rate increases. June was the 3rd increase since December 2016.
- The same modest economic growth – the unemployment rate dropped to 4.3%, the lowest level since 2001. Business confidence continues to improve and Q1’s initial GDP reading of 0.7% was revised upward to 1.4%.
- The same geopolitical risks – Middle East woes, terrorist threats, and North Korea’s acts of aggression.
- The same political uncertainty and partisan antics in D.C. – alleged collusion and conspiracy along with the refusal of either party to reach across the aisle. The Trump administration’s fiscal stimulus program struggles to get traction.
Well you know what they say, “If it ain’t broke, why fix it?” Point being that although there are many serious issues that need the attention of our public figures, corporate America and society in general, things have been pretty good lately. Consumers have more money in their accounts as their wages have started to increase, almost everyone that wants a job can find one, the economy has been chugging along at a respectable pace, and capital markets continue to log impressive returns.
We are primarily focused on the following issues that can significantly move the markets either higher or lower from current levels.
Fed policy – The path and speed of interest rate normalization.
Health of the economy – It is worth noting that the most recent stress test of our banking system finally marked the end of the financial crisis as all 34 large bank institutions passed the stringent capital requirements. GDP growth continues to deliver approximately 2% growth on a year over year basis.
Tax policy – Cutting the corporate tax rate would immediately increase earnings, making equity valuations more attractive.
Regulatory reform – regardless of your political leanings, less regulation can unleash a tremendous amount of economic growth. That said, lack of regulation can create market bubbles and can be detrimental in other ways.
We continue with our belief that U.S. equity prices are slightly elevated relative to historical valuations. As of the end of Q2, the forward PE ratio on the S&P 500 was 17.5 times earnings versus its 25-year average of 16.0. Although a typical correction can occur at any time, there are several reasons why we are not overly concerned at this time.
- Bull markets can end for different reasons, but when they have ended due to valuations, the valuations were significantly higher than where we are today. At the height of the tech bubble in March of 2000, forward PEs were 27.2, about 55% higher than current levels.
- Although stocks are a bit expensive, choices are limited. Historically, when stocks get expensive investors could allocate to cash or bonds and be handsomely compensated. This is not the case today.
- Corporate earnings have reaccelerated, and estimates for the next couple of years are rosy. Corporate earnings growth can put a floor under the market and justify higher prices.
- We have yet to see the “euphoria” of the bull market. This might be the most hated bull market in history as investors have been skeptical the entire way.
Foreign equity markets continue to impress, outpacing U.S. stocks. To reiterate, we increased our clients’ exposure to foreign stocks during Q1 of 2016 from 20% to 30% of their equity allocation. The rationale was based on 3 factors: more attractive valuations overseas, the strong dollar trend was getting a bit long in the tooth, and monetary policy overseas is looser than the U.S.’s shift into a tightening cycle. All three of these factors remain in place today. Below is a 10-year chart that illustrates the cumulative returns of U.S. stocks (S&P 500) versus MSCI EAFE (developed foreign markets) and MSCI Emerging Markets. On an annualized basis, the S&P has returned 7.15% per year over the past decade while the other two indices have returned 1.02% and 1.91% respectively. Foreign markets have a lot catching up to do.
Interestingly, here is a chart of the exact same indices for the preceding five years from June 30, 2002 to June 30, 2007. As you can see the under/over performance of U.S. and foreign equities is quite cyclical. On an annualized basis, the S&P returned an impressive 10.70% for this 5 year period while the other two indices returned a whopping 17.71% and 30.21% respectively.
Fixed Income Overview:
Bond prices tacked onto their gains from Q1 adding another 1.45% during the second quarter of 2017. This occurred as the 10-year benchmark Treasury yield gave back more of the gains it made at the end of 2016 when Trump won the election. The minor yield retracement was due to the new administration settling in and finding it difficult to pass agenda items along with muted economic growth during Q1.
As rates have once again come down and client portfolios have realized solid gains in fixed income during the first half of the year, we trimmed off a portion of our traditional bond holdings in favor of non-traditional holdings with higher yields and less interest rate exposure.
As we transition into the second half of the year, there is plenty to worry about. There is also plenty to be optimistic about. At the end of the day, the two primary influencers of the capital markets are monetary policy and corporate earnings growth. Corporate earnings have rebounded in 2017 and the outlook for 2018 is quite favorable, while monetary policy is tentative as the Fed attempts to normalize interest rates and unwind its balance sheet. Based on these underpinnings, any market pullbacks will be viewed as a buying opportunity.