During the second quarter of 2017, we witnessed a continuation of the strong stock trends from the first quarter, with international equity asset classes outperforming U.S equities. This does look and feel like the early innings of a new trend, which we first discussed in our LTWM Insider Q4 2016 blog, http://www.laketahoewealthmanagement.com/blog/ltwm-insider-market-and-economic-commentary-q4-2016. It is our core belief that globally diversified portfolios offer better long term risk adjusted returns than investing in only U.S. asset classes and we provided detailed research to support this belief in our last quarterly commentary, http://www.laketahoewealthmanagement.com/blog/lake-tahoe-wealth-management-insider-market-and-economic-commentary-q1-2017. We have seen very little downside volatility this year, which is unusual. The largest drawdown (percentage drop in the price of the S&P 500 index) has been -2.8% for 2017, which is the second lowest on record (1995 has a max drawdown of -2.5%). With asset class valuation levels so high, especially in the U.S, and the Federal Reserve raising short term interest rates, it is important to be cautious, since a negative economic or geo-political event could cause a correction in stocks, bonds and real estate. However, higher short term interest rates do not always equal poor stock performance. We will examine the historical relationship between the two at the end of this blog.
World Asset Class 2nd Quarter 2017 Index Returns
Second quarter index returns were strong for U.S and stronger for international stocks, while emerging market stocks led all major asset class returns for the second quarter in a row. For the broad U.S. stock market, the first quarter return of 3.02% was well above the average quarterly return of 1.9% (since January 2001). International stocks returned 5.63% for the first quarter, well above their average quarterly return of 1.5%, and Emerging Market stocks performed even better, up 6.27% vs. their average quarterly return of 3.1%. Global real estate stocks were positive but below their average quarterly return of 2.7%, due to increasing short term interest rates.
A larger sample of asset class returns shows the strength of emerging market and international developed stocks over U.S. stocks, while real estate and small cap stocks lagged behind. The value effect was negative for the second quarter in row (1st half of 2017), after a strong showing during the last quarter of 2016. The size effect was strong in developed international stocks but underperformed in the U.S. and emerging markets.
Bond market returns were positive due to a very slight shift down in the yield curve, except at the very short end, since the Federal Reserve increased the overnight lending rate another 25 basis points. The five-year Treasury yield was down 4 basis points for the quarter, ending at 1.89%, while the yield on the 10-year Treasury Bond decreased by 3 basis points to end at 2.37%; and the yield on the 30-year decreased 3 basis points to end the quarter at 2.99%.
The increase of interest rates at the short end of the yield curve does affect the prime rate and other variable rate debt, increasing costs for companies using variable rate debt to fund projects. The long end of the curve is not going to shift up until inflation expectations are stronger. Currently, inflation expectations are low. However, in her latest testimony on July 12, Federal Reserve Chairperson Janet Yellen has stated the Fed is ready to reduce the size of their balance sheet. This action will likely have the effect of increasing long term interest rates. Notice in the chart below that long term U.S. Government Bonds are the best performing bond sector so far this year, up 5.44%.
One cannot time markets and typically the short term is just noise. The strong start for equity returns in the first quarter, continued throughout the second quarter, in the U.S and internationally. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):
A DEEPER LOOK
The Russell 2000 Index (small-cap) is up 17.6% in the last year, while the S&P 500 (large-cap) is up 12.9%, over the same time period (price change only). The large cap index has closed the outperformance gap of small cap, but small cap stocks have outperformed large cap stocks since the Presidential election. Here is a one-year chart of the S&P 500 large cap index in blue and the Russell 2000 small cap index in green from July 14, 2016 through July 13, 2017. (Source: Yahoo Finance). Notice the spike up of the green line (small-cap) starting in November 2016:
Long-term research shows that U.S. stock market performance compared to international stocks is cyclical and at the end of 2016, the U.S. had outperformed international stocks for 110 months (over 9 years), which is one of the longest cycles of relative U.S. outperformance on record. As of June 30th, for the past six months, international stocks, as measured by the MSCI EAFE index, have outperformed U.S stocks, as measured by the S&P 500. The positive indicators for international stocks, including a strong U.S. dollar, lower valuations in Europe and emerging markets, economic expansion in Europe with higher inflation expectations, and positive money flows into international stock markets, have supported the continuation of this trend during the second quarter and will likely continue to support the trend through the second half of the year.
Shifting back to equity asset class valuations, the second quarter ended with the S&P 500 index near another high and pushed valuation measures to new highs. At the end of the second quarter of 2017, The P/E 10 ratio (price divided by 10 years of earnings) was 29.3, which is a new interim high, since the dot com bubble (it is now above levels during the great recession of 2008/9); and is also above two standard deviations away from its historical geometric mean. You can view the P/E 10 charts at https://www.advisorperspectives.com/dshort/updates/2017/07/03/is-the-stock-market-cheap
At the end of 2016, the S&P 500 P/E ratio was 20.5 for 2016 year-end EPS, and the current P/E ratio, as of July 5th, 2017 is 19 (based on 2017 year-end EPS), compared to the historical average of 17 for next year’s EPS. If we look at the S&P 500 price to sales ratio, which is the ratio that can’t be manipulated with accounting methods, it has moved up to 2.11, slightly above 2.08 at the end of the first quarter and a new high. With the increased valuation levels, the U.S. stock market has even higher expectations built in for the new “business friendly” administration, which is still caught up in delays of a new health care plan, tax reform and infrastructure spending to help boost our current late stage economic cycle.
With the Federal Reserve expected to continue to raise short term interest rates over the next year or two, let’s take a look at research from our friends at Dimensional, who took the time to look at similar periods in the past to see if a relationship exists between monthly changes in US stock returns and monthly changes in the Federal Funds Rate.
The Federal Reserve is on target to raise the overnight lending rate one more time this year and three times next year to bring interest rates to “lower” normalized levels, which does act like a brake on the global economy. However, knowing the Fed is going to raise short term interest rates does not provide any insight into expected stock returns. Valuation multiples expanded and will likely need to be supported by earnings growth during the second half of the year (2017 year-end EPS estimates for the S&P 500 are holding up well). Global GDP growth is still low, global debt levels are still very high. We are closely watching growing auto loans and declining auto sales; and student loan debt in the U.S., non-performing loans in Europe and China and other variable rate debt, which is now more expensive due to higher short term interest rates. The U.S. economy continues to have strong job growth without the inflationary pressure of wage growth. Economic activity is expected to be robust through the remainder of the year, however, due to very lofty valuations, we will remain cautious.