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First Quarter 2017 Newsletter

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Old, Bloated, Slow and Scary

No, we’re not talking about some of your in-laws.  Rather, we are discussing the US economy and its stock markets.  Let’s take them one at a time.


The current bull market started in March of 2009.  After the worst bear market in most people’s lifetimes, the bull started its upturn and hasn’t stopped since.  The older this bull market gets, the closer it moves to its eventual top, right?  Well, all things must end, but just when the ending occurs is really tough to determine.  See Chart 1 below:

Chart 1

As you can see, this is the second longest bull market in the last 60 years.  But what does that mean?  There is no reason why it cannot continue, and to make matters more difficult, often the last year or two of a bull market offers excellent returns.  Bailing out early might insure a lower average annual return for a long-term investor.  Clearly, time alone is not a meaningful determinant in forecasting a major market turn.


Many believe that today’s US stock market is at least fairly valued if not overvalued, especially considering the “Trump Rally” that started immediately after the Presidential election.  See Chart 2:

Chart 2

The P/E ratio is one of dozens of popular market valuation formulas that investors and academics use in trying to determine when the next major market turn will take place.  This chart shows the trailing 12 months of S&P 500 earnings divided into the average monthly price of the S&P 500 stocks.  Unfortunately, if you compare that P/E ratio with the price of the market (blue line vs. gray mountain), you will see virtually nothing that allows one to consistently time when to be in and out of the market.  There are times when the P/E ratio is very high, and the market is not, and times when the opposite is true.  You can also substitute future estimates of earnings to this formula, yet that still doesn’t meaningfully help determine future price movements.

Lastly, there are lots of behind-the-scene variables that can further confuse this process.  What happens if interest rates are low vs. high?  Should they matter in market valuation?  Or what about the growth rate of an economy?  Should it matter if we’re having a 4% GDP (Gross Domestic Product) vs a 1% GDP?  The variables involved in any valuation formula will always demand some type of assumptions that will affect that formula’s usefulness.  Driving while only using a rearview mirror is tough, and predicting future variables can be even more difficult.  Think back to April 2016.  Who could have guessed with any degree of certainty the numerous variables that have changed over the last 12 months? The only thing we can be certain about is that change will take place.  This makes future economic estimates questionable at best, and dangerous at their worst. 


The rate of US economic growth has been tepid for a few years in a row. Many investors believe that the rate of economic activity is directly related to stock market returns. They think a slow or stagnant economy foretells low returns, and a strongly growing economy points to higher returns.  Unfortunately, it is not that simple.  It would seem logical that faster equals more and slower equals less.   But that is not the case.  Chart 3 shows the returns of higher growth developed countries vs. lower growth developed countries: 

Chart 3

The top half of the chart shows average annual returns for developed countries that had both high and low growth in the previous year.  Some investors may be surprised to find that countries that had slower growth the previous year outperformed countries that had higher growth the previous year.  The bottom half of the chart shows developed countries that have higher growth in the current year again underperformed those with lower growth in the current year.  In both past and present time periods, the lower growth developed countries outperformed the higher growth developed countries. 

How could this be?  It has to do with the market valuation at the time of analysis.  It is not only the growth rate of a country that determines its companies’ earnings growth, but the valuations already placed on those earnings.  Often, the stock prices (valuations) of higher growth countries have already discounted that growth, and the stock prices of lower growth countries may be undervalued due to that low growth.  That allows that market to reevaluate those valuation during the course of the year, and the data shows that low growth is usually the winner, probably due to this discounting valuations process.


Volatility is a double edged sword.  Investors don’t seem to mind when their portfolio takes off to the upside.  They seldom worry that their account value is growing too quickly.  But when the reverse happens, they lament over the risk and volatility occurring to their net worth.  Sometimes, for various reasons, market movements can become very tepid, which may place investors into a false sense of calm, with expectations for continued low volatility.  Many of us may tend to quickly forget past periods of much greater average up and down daily market movement. In Chart 4 below, we see how many up and down days of 1% or greater occurred during each year since 1970.

Chart 4

Notice the meaningful difference in volatility over the years.  There have been multi-year cycles of very high amounts of 1%+ daily volatility, as well as the opposite.  Now check out 2017, through the first quarter.  If we annualize the amounts for 1%+ days for 2017, we come up with a total of 4 up days and 4 down days, which would be the lowest volatility since 1970, and most likely ever. 

Why do we point this out?  Because current investor expectations for volatility could be very unrealistic.  Any reversion to even moderate volatility could be jarring to them, when in reality it is the very low volatility we have been experiencing that has been abnormal.  We can guarantee that sometime in the future, possibly sooner than later, we will go back to a normal level of up and down daily market movements.  When this happens, it is important to remember that we are long term investors, and a higher amount of price fluctuation is very normal, and actually should be expected.  It is part of the price one pays for receiving the higher long term returns of equities.   

All Together Now

The four characteristics discussed point to very important reasons why it is so difficult to time the market, as well as why active management has such a difficult time in beating a benchmark.  Length of market cycles, valuation levels, economic growth levels and market volatility act like landmines to someone trying to pick and choose only the “best” times to be in or out of the market.  In addition, attempting to estimate future variables for an old, bloated, slow and scary stock market and economic landscape is truly a formula for underperformance. 

Of course, the answer is to not use these factors when managing a portfolio.  Proper diversification, and the use of academically proven asset class factors improve the odds of outperforming both active management and indexing. In addition, diligent rebalancing of the portfolio during periods of feast or famine will insure that you buy low and sell high. Then, hopefully, you will find that your outlook, quality of life and long term investment experience will make you feel young, lean, active and fearless.  Unlike some of your in-laws.

First Quarter 2017 Asset Class Returns

Many of the first quarter 2017 asset class returns regressed from some of the meaningful extremes of the 4th quarter of 2016.  International asset classes beat their Domestic counterparts, and Emerging Markets went from being the weakest performing asset class last quarter to the strongest this quarter.  Domestically, Large Cap beat Small Cap and Growth/Core beat Value.  After having negative returns across all durations last quarter, bonds of all maturities had modest positive returns due to yields dropping back from their ramp up after Donald Trump won the Presidential election. 

During the quarter, one of the three interest rate increases that the Federal Reserve Board promised last December came to fruition.  The two remaining increases over the course of the next 9 months appear to be very possible as well.  The markets took these increases in stride, and it appears the modest economic growth, as seen in corporate earnings announcements and employment figures, is not being adversely affected by the rising rates. 

There seems to be more market reaction to political events than economic ones.  The only down day of 1% or more during the quarter took place after Trump pulled the Republican Healthcare Bill prior to Congress voting.   Bears looked at the possibility of this failure bleeding into a potential Trump tax reform bill on the horizon.   In actuality, the bullish marketreaction after the Trump victory was based on expected legislation coming out of the new administration, including deregulation, new tax legislation, increased spending on US infrastructure and others.  There is some concern that these other legislative efforts may have problems similar to the initial fail of the new healthcare bill.  If that would be the case, one can only expect the market to take back some of the gains that have occurred since the election. 

Obviously, only time will tell with many of these issues.  The connections between economic growth proposals and political ideology seem as interwoven today as anytime in the past few decades.  It should be quite interesting to see how this Washington-Wall Street dance proceeds.  But clearly, it would seem logical that the very low volatility the markets have experienced so far in 2017 will not be able to continue for the long term.  We will continue to monitor asset class performance and make the necessary changes to the portfolio in order to stay within the desired risk/reward levels you have chosen.

Try to get outside and pay more attention to the new heads of flowers popping up during springtime rather than focusing on the talking heads on TV.  You’ll undoubtedly enjoy the former much more than the latter.


Frederick F. Kramer IV, JD
Co-Chief Investment Office