During the fourth quarter stock markets were strong, resulting in excellent full year returns. The U.S. government passed a tax reform package that dropped the corporate tax rate to 21% that enabled the stock market to rally to new highs. Broad U.S. stock indices set over 60 record highs during 2017. The Dow hit 20,000 for the first time on January 25, 2017 and hit 25,000 on January 4th, 2018, setting 71 new record highs during the year. Valuation levels have also increased to near record highs, especially the P/E 10, Tobin’s Q and P/S ratio; all of which are not heavily influenced by a changing corporate tax rate. The tax reform package has increased business confidence and investor confidence may now have reached irrational levels.
Compare the chart above with a chart of the past 20 years for the NASDAQ Composite index, which has a clear bear trap at the early stages of the rally (mid 1998) and a tough bull trap after the collapse of the rally (mid 2000). It took the NASDAQ almost 15 years to regain the peak it reached in 2000 (Chart is from Yahoo Finance, end of day 1/8/18).
Of course, no one can time market corrections. However, if history is a guide, then when valuations reach these lofty levels caution is warranted. Caveat emptor, buyer beware; or as Warren Buffett famously said as a reason for his long-term investing success, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
For those who want to dive deeper into our market and economic commentary:
World Asset Class 4th Quarter and Full Year 2017 Index Returns
Fourth quarter index returns were very strong for U.S., international and emerging market stocks, and above average for global real estate stocks. Emerging market stocks were up 7.44%, significantly above its average quarterly return of 3.2% (since January 2001). For the broad U.S. stock market, the fourth quarter return of 6.34% was well above the average quarterly return of 2.0% (since January 2001). International stocks gained 4.23% and were also well above its average quarterly return of 1.6%.
A larger sample of asset class returns shows the strength of emerging markets (EM), with small cap emerging stocks on top, followed by the broad EM index and EM value stocks in third. For the quarter, growth was stronger than value in the U.S. and internationally. Small cap stocks outperformed large cap stocks internationally, but underperformed in the U.S.
Full year, 2017 results were very strong for most asset classes:
Emerging market stocks were the best performing broad asset class and International Developed Stocks performed better than U.S. stocks. Global Real Estate results were not as good as its historical average return, but returned more than bonds during 2017. For the full year, the value effect was negative in the U.S., international developed, and emerging markets; and small cap stocks performed better than large cap stocks in non-U.S. developed markets, but underperformed in the U.S. and emerging markets. The Russell 2000 Value Index was up 7.84%, well behind the broad Russell 2000 Index return of 14.65% during 2017. It is worth pointing out that in the previous year, 2016, the Russell 2000 Value Index was up 31.74%, well ahead of the broad Russell 2000 small cap index (up 21.31%). Large cap stocks were similar to small cap stocks. The Russell 1000 Value Index was up 13.66% in 2017, while the broad Russell 1000 Index was up 21.69%. However, during 2016, the Russell 1000 Value Index was up 17.34%, well ahead of the broad Russell 1000 large cap index (up 12.05%). Growth was much stronger than value during 2017, after value was much stronger than growth in 2016.
Bond markets around the world were positive due to a shift down in the yield curve at the long end. The downward shift at the long end, combined with the large shift up in the short end of the yield curve, caused a significant flattening of the curve. As a reminder, a steep curve is associated with strong economic expectations and a flat or inverted curve signals future economic weakness. Here is the large shift up in rates for the short end (maturities of 5 years and less) and notice the 10-year maturity stayed the same and maturities greater than 10 years had a shift down:
Most bond analysts were expecting the long end of the curve to shift up with the rest of the curve, since the Federal Reserve was raising short term rates and reducing bond purchases. However, the long end of curve shifted down and the lower rates provided extra return for the longest maturity bonds The Citi World Government Bond Index (1-5 years) finished well behind long term government bonds for 2017.
One cannot time markets and typically the short term is just noise. At the start of every year, major financial news outlets discuss the January effect and how the trend in January sets the tone for the year. There is no empirical evidence to support this theory and we had a great counter example two years ago, in 2016, when January 2016 was the worst U.S. stock market start in history; and we ended the year with strong stock returns. In 2017, January started well for stocks, both in the U.S and internationally and stocks returned well over 20% for the year. History does show that after a year of stock returns above 20%, there is a high probability the following year is positive for stocks. The first week in January for 2018 was the best start to a year since 2003 for the DOW and since 2006 for the S&P 500 and NASDAQ. 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):
The fourth quarter was a continuation of the 2017 trend of stock prices increasing faster than corporate profits, faster than cash flows, faster than book value, and certainly faster than revenue; which means valuation multiples expand and they were already elevated in most risky asset classes. The present environment is similar to past stock market peaks, when proponents of the rally provide a reason for why valuation doesn’t matter. At the end of 2017, The P/E 10 ratio (price divided by 10 years of earnings) was 32.1, up from 27.9 at the end of 2016. A P/E 10 value of 32.1 is 106% above the geometric mean valuation, well above 2 standard deviations, which is 86% above the mean. More P/E details are available at https://www.advisorperspectives.com/dshort/updates/2018/01/02/is-the-stock-market-cheap. At the end of the fourth quarter, the S&P 500 P/E ratio was 21.4 for 2017 year-end EPS, and 18.34 for 2018 year-end EPS, compared to the historical average of 17. However, the S&P 500 price to sales ratio is currently 2.35 vs. 2.01 one year ago. The P/S ratio is the highest since the dot.com bubble. Global growth is still low, but beginning to rise. Global debt levels are still very high. NYSE margin debt is at all-time highs. We are closely watching bond markets for any increase in credit spreads or spike in interest rates that could cause a stock correction. It is wise to be prudent and we will continue to be prudent in our investment committee meetings in the coming weeks as more companies provide earnings guidance for 2018; and stock analysts adjust their earnings expectations. We will also be watching for any catalyst that could cause a significant re-pricing of risky asset classes, since a correction could be meaningful as asset valuations are at extremely high levels.