“Let the Good Times Roll!” Yes, the 1979 song by Ric Ocasek and the Cars may describe the market’s attitude in the first half of 2017. “You Might Think” the markets are “Magic” or “All Mixed Up” – other classic Cars songs – but, nonetheless, investors should be pleased to see their mid-term results.
With the trading year half-way complete now, “It’s All I Can Do” to give you the major market stories in 2017:
1. All three major non-cash asset classes (equities, fixed income, and alternatives) are positive to start the year.
2. Large-cap equities have significantly outperformed small-cap equities, the largest outperformance to start the year in almost 20 years. Large caps, as represented by the S&P500, were up 3.1% for 2Q17 and up 9.3% Year-to-date (“YTD”) through June 30th. Small caps, as represented by the Russell 2000, were up 2.5% and 5.0%,
3. Growth is significantly outperforming value. In fact, it’s the biggest outperformance to start a year ever besides 2009. The S&P500 Growth Index was up 4.4% 2Q17 & 13.3% 1H17 vs the S&P500 Value Index, up 1.5% and 4.9%, respectively!
4. International stocks are outperforming domestic stocks. The last several years have seen the opposite, but now international is outperforming domestic in what may be a tidal change. The MSCI EAFE Index was up 6.4% for the second quarter and now 13.8% YTD!
5. Minimal volatility – Despite political noise and other headlines around the world, the equity market continues to move forward with little whipsaw. The CBOE Volatility Index, Wall Street’s so-called “fear gauge”, saw its lowest level in over two decades!
Let’s drill down into the various asset classes.
Equities: Obviously, we can see from above that returns in ‘equity land’ were quite decent. In general, stocks rallied on strengthening corporate earnings, improving economies both here and abroad, and continued support from central banks. Earnings from S&P500 companies increased 14%, the best growth since 2011.
Fixed Income: The Barclays US Aggregate Bond Index gained 1.5% in the second quarter and is now up 2.3% for the year. The Barclays Global Aggregate Bond Index produced even better returns, +2.6% 2Q17 and +4.4% YTD, thanks to stronger results overseas. Many bond investors, including DWM, have been surprised at the falling US government bond yields. The 10-year Treasury Note started the year at 2.45, peaked in March at 2.61, only to close the quarter at 2.30. Why aren’t rates going up? Much of it has to do with skepticism about the passage of Trump’s fiscal agenda. Amongst other things, there has not been the promised major tax reduction nor a flood of fiscal spending yet. As such, inflation expectations weakened in June. However, hawkish comments in the last several days from major central banks, including our US Fed indicating a strong chance that they will announce in September a decision to start shrinking its balance sheet, has caused a reversal in bond yields to start the third quarter. We see the Fed continuing to unwind the past years of stimulus via rate hikes or balance sheet reductions in a well-announced, controlled fashion.
Alternatives: The Credit Suisse Liquid Alternative Beta Index, our chosen proxy for alternatives, was up 0.4% for the second quarter and 1.1% YTD. This benchmark gives one a good feel for what alternatives did in general. Of course, there are many flavors of alternatives so drilling down into the category can reveal very different results. Furthermore, alternatives can take the form of either alternative assets and/or alternative strategies. “Traditional” alternative assets like gold* and real estate** fared well through the first half, up 7.8% and 3.2%, respectively. However, another “traditional” alternative in oil (a commodity) suffered, falling back into bear territory. US fracking companies continue to pump at lower prices frustrating OPEC’s goal of price stability via OPEC member supply cuts. A couple of alternative strategies fared differently: managed futures*** have shown losses in the first half, down -5.6%; whereas merger arbitrage**** has had a decent gain of 2.2%. These examples show how alternatives behave independently, thereby providing the ability to reduce the volatility of one’s overall portfolio.
It has been a solid first half for most balanced investors. Looking forward, it’s hard to say what path the markets will take. They could continue this nice trajectory upward - did you know that US stocks were up in January, February, March, April, and May? This is significant because, historically, when US stocks are up in the first 5 months of the calendar year, the average return for US stocks for the full calendar year was +28.8%! This first-five-months-up event has only happened 12 times and in all 12 times, the year ended up in double digits!
However, domestic stocks are getting expensive. The S&P500 now trades at 18x projected earnings over the next 12 months, its highest level in 13 years. Overseas stocks are still a relative bargain compared to the US and one of the reasons for their recent and expected-to-continue outperformance. Furthermore, where the US has raised short-term interest rates four times since the end of 2015, international central banks have been and will remain relatively more accommodative for the near future.
The other scary thing is that the equity and bond markets are sending mixed signals. If bond yields stay down, that would tell us that the bond market sees tepid economic growth, which could be true if all of the pro-growth Trump agenda plans do not come to fruition. For now, the equity markets are signaling otherwise – that this bull market has legs based upon strong corporate results and improving fundamentals. No, Mr. Ocasek, the signals from the bond market and equity market are not “Moving In Stereo.” Only time will tell to see what market is signaling correctly. In the meantime, the goal is to have a portfolio in place that can weather any storm. At DWM, we think our clients’ portfolios are well-positioned for what the markets will throw at us. We look forward to the journey. In fact, and finishing with one last Cars’ classic, “Let’s Go!”
Brett M. Detterbeck, CFA, CFP®
DETTERBECK WEALTH MANAGEMENT
*represented by the iShares Gold Trust
**represented by the SPDR Dow Jones Global Real Estate ETF
***represented by the AQR Managed Futures Strategy Fund
****represented by the Vivaldi Merger Arbitrage Fund