Days of Wine and Roses
2017 was a beautifully sweet, heady year for global stock markets. Proof of this can be seen in the consistency of the performance of returns. For the first time in the history of the world (literally), global stocks had 12 straight months of gains (as measured by the MSCI All Country Equity Index). That means the last day of each month was higher than the first day of that month, for all 12 months -- the first time this has occurred since tracking began.* In addition, the S&P 500 set an all-time record for the number of days the index endured less than a 3% drawdown (over 300 days and counting).** (*MarketWatch.com 12/27/2017 “Global stocks just made history by rising in every month of 2017”) (**BusinessInsider.com 10/23/17 “The stock market just made history”)
We will discuss the individual asset classes later in the report, but it suffices to say that things couldn’t get much better. Just like the marriage of Jack Lemon and Lee Remick in the 1962 movie by this same title as above, our current financial bliss will not continue forever, and undoubtedly things will get ugly at some point in the future. But there are reasons to believe that disharmony is not immediately ahead.
It’s All About Taxes
Much has been said about the new tax plan lowering individual taxes for hard working Americans. There have been some changes to the code for the individual taxpayer, and some deleting of deductions that have been used by higher tax payers in the past. But make no mistake about it. This tax reform has little to do with the individual. It clearly has made filling out tax returns no easier. The major purpose of this tax reform was to make the US more competitive with international trading partners by bringing more American corporate assets and more jobs back to this country.
We are nearing the 9th full year of this bull market, and the most recent market surge has been attributable to the new tax legislation passed prior to yearend. Understanding this concept is relatively simple. Long term market direction follows earnings. If the stocks in the S&P 500, on average, increase their earnings, it stands to reason the market will increase along with those earnings. Yes, the market discounts news, and undoubtedly what is described below has been at least partially discounted already. But there is certainly reason not to throw in the towel on US Equities just yet.
As the corporate tax rate is reduced from 35% to 21% (the effective rate difference will be somewhat less), the savings can be used to enhance earnings in many ways. On top of many other positive economic trends, corporate tax savings only adds fuel to the earnings growth fire.
Many analysts are now assuming the S&P 500 will grow more in 2018 than they originally expected. How do they make that calculation? It’s fairly simple. They determine what they think the earnings will be on the S&P 500 stocks. Many are using a number like $145 or $150. Then they simply multiple that figure by a Price/Earnings (P/E) ratio. Assuming they use a P/E of 20, then they simple multiply the earnings by the ratio and get 3000 (150 X 20 = 3000). The S&P 500 Index closed 2017 around 2675. So that means many analysts are projecting the S&P 500 Index will grow from 2675 to approximately 3000 during 2018.
Although precise gains are impossible to predict this far in advance, it makes sense to believe that there are firm underlying fundamentals to the US economy and financial markets. So take it easy on the wine and roses, but don’t become overly concerned that the marriage of earnings and market direction is turning sour just yet.
The Best Vehicles For Long Term Investors
From the very beginning of our client relationships, our advisors have made it very clear that we manage portfolios with a long term investment horizon. We do that because we feel it is the best way to generate healthy long term returns without trying to become stock pickers or guess the next movement of the markets -- neither of which is possible according to financial academic research.
We have consistently used Dimensional Fund Advisors (DFA) mutual funds to represent the majority of our equity asset classes, because we feel they are best suited to give our clients the best chance at success without attempting the winless game of stock picking or market timing. Recent mutual fund research once again shows that DFA funds have indeed been a superior long term equity vehicle. The study shows how each individual DFA fund compared to all other funds in its category over the last 15 years. It is an enviable track record, and one we are proud to show our clients. See the data below.
This data includes all mutual funds in each category that were available for that 15 year period, including both actively managed funds and passive (index) funds. As you probably know, the long term asset class factors that have added additional return to a portfolio are Size (small outperforms large) and Style (value outperforms growth). When you review the performance of the DFA funds owning those factors over the last 15 years, you see very consistent superior performance in those categories. This clearly shows the reason we have chosen DFA as a key source of equity asset class vehicles for your portfolio.
Fourth Quarter 2017 Asset Class Returns
As mentioned earlier in the report, the last quarter of 2017 ended a consistently positive year. Equity returns for the quarter were fairly similar both domestically and in foreign markets. Over the entire year, international equity markets, in both developed and emerging market countries, generally outperformed their US counterparts. There are several reasons for this. First, International markets had underperformed domestic ones during 2015 and 2016, and their market valuations were cheaper than the US. They caught up a bit in this regard in 2017. In addition, European and Far East economies strengthened a bit during 2017. After dramatically underperforming in the previous two years and lagging the US, they bounced back a bit stronger last year.
Finally, there was a currency play taking place as well. The US dollar weakened against the British Pound and Euro during 2017. Americans holding foreign stocks got a boost in return because of this. Assuming those currencies strengthened 2-5% vs. the USD, US investors would get an additional return of 2-5% when measured in US dollars.
Expectations are for these same trends to continue into the first half of 2018. While the Federal Reserve seems intent on raising the discount rate further this year, there have not been any major signs of dangerous inflation, nor have intermediate or long term bond yields increased dramatically. The aforementioned economic growth continues to chug along both in the US and many other developed countries.
There are still plenty of areas of concern, including a portion of several European country’s shorter term sovereign debt still yielding less than 0%, as well as the mushrooming US deficit (calculated to increase another $1.5 trillion over the next 10 years due to Tax Reform), as well as a bevy of other wall-of-worry items. As the year continues, we will see just how the markets interpret these areas of concern.
In the meantime, stay warm, enjoy the Winter Olympic Games and get ready to find out just how long Punxsutawney Phil thinks this winter will last!
Frederick F. Kramer IV, JD
Co-Chief Investment Officer