In an attempt to convince Parliament to find compromise with the American Colonists, the British Statesman, William Pitt, declared “you cannot conquer America.” Pitt was one of a small faction to appreciate the resilience of Americans at the time. Of course, while he recognized the uniqueness of America, even Sir William probably would have stopped short of forecasting the 241 years of independence we celebrated this week. Similarly, few stock market observers have appreciated the resilience of the now nine-year old U.S. bull market, which just registered its seventh consecutive quarterly gain and is up three-fold from the 2009 bottom.
For the first half of 2017, the S&P 500, MSCI All-World Index, and the small-capitalization Russell 2000 gained 9%, 11%, and 5%, respectively. The FANG trade, or now FAAMG (Facebook, Amazon, Apple, Microsoft and Google), returned with a vengeance. The average stock in the group was up 22% fueling the NASDAQ’s 16% year-to-date gain even after the index’s June decline. Bonds benefitted from a flattening of the yield curve. Rates firmed a little at the end of June, but the Barclays Aggregate Bond index still returned 2.5% for the six month period.
Even more surprising than 2017’s continuation of the market’s historic climb has been an unprecedented lack of volatility. According to Barron’s, the VIX Volatility Index had closed below 10 just 11 days in the past 20 years. A remarkable seven of those 11 days were in the second quarter of 2017. Likewise, Bespoke Investment Group points out that the S&P 500 failed to register a drawdown greater than 2.8% in the first half of 2017. This was the second smallest drawdown for January to June in 89 years and only a fraction of the 11.2% average.
Strong Gains Despite the News Flow
The market’s resilience has been despite mixed economic indicators, international terrorist attacks, an evolving Middle East stand-off, North Korean missile launches, and a stalled legislative agenda the market pegged as pro-growth heading into the year. Muted volatility has been tough to reconcile in light of the news flow. In this Market Commentary, we’ll discuss some of today’s more pertinent market dynamics influencing returns, volatility, valuations, and investor sentiment.
As for the bottom line, these past few months are a reminder that trying to jump in and out of the stock market is never a good idea. Complacency, of course, isn’t the right approach either. This is why we continue to periodically re-balance client portfolios keeping equity exposures consistent with one’s long-term objectives and risk tolerance. We are confident there will be a time to get more aggressive and increase target equity exposure and one day maybe even buy longer duration bonds. In the meantime, Buffet reminds us “the investor of today does not profit from yesterday’s growth.” Put another way, while we aren’t tempted to call a market top we will stay focused on making a lucid assessment of the risk versus reward of today’s investment decisions.
Up 50% or Down 50% from Here?
Almost 85% of market strategists surveyed by CNBC last week expect the market to be up in the second half of 2017. Sixty-four percent of these strategists surveyed are expecting a second half gain of 5% or greater. Market prognosticator Professor Robert Shiller and longtime growth stock investor Ron Barron each recently made a case for potentially big (50% plus) market gains. Even Jeremy Grantham, a high-profile bear, seemed to capitulate recently stating “I’ve dedicated my life to financial bubbles, and I don’t think it is a bubble.” There are still a few bears left, many of whom offer predictions even gloomier than these are rosy. Much of the thesis for the bulls and the bears is anchored around the impact of interest rates on stocks. The bulls insist the implied 5% earnings yield on 2017 S&P 500 earnings is still attractive relative to the current 2.3% yield for a Ten-Year Treasury. The bears worry about the threat that potential higher interest rates pose to price to earnings multiples and economic activity, producing a potential double whammy for stocks of lower P/E ratios on reduced earnings.
Needless to say, we welcome the idea of markets rerating 50% higher as Shiller outlines or doubling in the next decade per Ron Baron. We also recognize that there is no opportunity to financially re-boot for many of our soon-to-be retired, retired, and institutional clients. At 18X 2017 estimated non-GAAP earnings, U.S. equities are trading in the upper bounds of historic market valuations. While in his “capitulation” Grantham correctly noted we’ve been at higher than historical average P/E levels for twenty years now, markets have also been subject to an unprecedented level of central bank intervention at home and abroad. As for the takeaway, U.S. stocks look neither cheap nor like an asset class to abandon. Also, we still like the relative valuation attractiveness of international and emerging markets, which currently trade at lower valuations and offer investors higher dividend yields even after outperforming in the first half of 2017.
Source: Capital Group Mid-Year Outlook
While this international tilt is not predicated on policy reforms, it is worth noting France’s new President recently initiated policy discussions aimed at reforming the country’s labor laws. Imagine that, when just a few short months ago the markets’ worry for France and the European Union was the opposite - fears of a strengthening labor position amidst a growing nationalistic fervor. That market threat may resurface. Yet for now some in France think they’ve found their much younger version of President Reagan.
No Sausage Yet
Speaking of political debates, there’s been a considerable amount inside the Beltway (and at a few town halls). Markets were keenly focused on Washington completing corporate and possibly individual tax reform entering the year. The Republicans took up healthcare reform instead for practical legislative and political reasons. With the healthcare industry representing 18% of Gross Domestic Product and 14% of the S&P 500, the markets are certainly attune to the debate. Before last week’s “repeal and delay” suggestion, healthcare legislation viewed as having a chance to pass both Houses of Congress represents more of a policy tweak than a transformation. Thus, outside of a few healthcare subgroups, and the 3.8% Obamacare tax on investment income, the market has been focused on the debate as much for what it foretells for upcoming tax reform efforts as anything.
Corporate tax reform remains the most widely-accepted source for a second-half boost for the market. Republicans desperately need a win, and most all agree the system needs reforming. So, we still think at least a more modest version of tax reform will get passed, which under most all scenarios would be accretive to 2018 corporate earnings and stimulate the economy. Otherwise, the 2018 mid-term Congressional elections may be more of a transformation than a tweak for the party in charge.
First-Half Stock Sector Winners and Laggards Were Tied to the Sausage Making
Last year’s “Trump Trade” winners such as financials, energy, and infrastructure stocks, were 2017 first-half laggards. Technology and Healthcare have been the top sectors this year after not participating in last year’s fourth quarter rally. The shift emerged as investors begun to worry about the pro-growth legislative agenda stalling. The yield curve started to flatten, and investors saw opportunity in the less cyclical healthcare sector and the secular growth story imbedded in the tech giants. The first half’s enthusiasm for tech giants peaked in early June, at which time the FAAMG stocks represented a significant 42% of the NASDAQ 100’s (QQQ) market capitalization. These large-capitalization tech stocks continue to be a very disruptive force in many sectors of the economy. Amazon’s intent to buy Whole Foods is the latest indication of the scope of the company’s appetite.
The Passive Phenomena and Its Implications
Woodmont first utilized passive investment strategies via low-cost exchange traded funds (ETFs) and index mutual funds in the mid-2000s. An early adopter, we used to spend considerable time educating clients on the advantages of this Wall Street innovation. Fast forward ten plus years and the industry’s shift to passive has been dramatic. The education requirement now leans more towards explaining why we don’t exclusively use these passive instruments. Instead, we seek to optimize a portfolio’s mix of passive, active managers, and direct investments.
While we’ve made mention of the impact passive and other non-fundamental based investment strategies can have on individual securities, their impact has more recently begun to affect the market as a whole. In fact, recent estimates are that as much as 60% of U.S. market assets are invested in ETFs, index mutual funds, and high speed trading or other computer driven trading strategies. Given the higher trading levels of some of these strategies, J.P. Morgan estimates that just 10% of trading activity is in the hands of fundamental discretionary traders.
Couple this shift in the way assets are managed with the declines in the universe of investable U.S. stocks from over 7,000 in 1997 to 3,600 today, and much has been made regarding the demise of stock picking. The irony is we believe fewer active investors and increased influence from non-fundamental computer-based trading strategies ultimately leads to less market efficiency - not more. As a result, we continue to augment our portfolio of direct investments with a few proven active managers we believe are well-positioned to take advantage of these trends. The potential disruption looks greatest, and thus the opportunity for active managers attractive, in asset classes where the implied liquidity of a passive instrument is overstated relative to the underlying assets actual liquidity.
Looking for Active in All the Wrong Places?
While many institutions and individuals have fled “active” management in the public equity realm, they’ve flocked to active private equity. Just last week, Apollo raised the largest ever buyout fund at $23.5 billion. The WSJ estimates $1.5 trillion of private equity capital has accumulated waiting to be invested. Considering this private equity capital is generally leveraged several fold, the total amount of new capital looking for a home is significant. As assets have ballooned in recent years, these private equity firms have become the new titans of Wall Street.
We appreciate the large opportunity set of the private realm, especially when considering the trend of investing in global infrastructure such as roads, terminals, and airports. We’ve identified a number of ways our clients can gain exposure to this asset class in reasonable slices and with lower fees. Our enthusiasm for large and broad-based portfolio allocations remains tempered, however, given what is certain to be the industry’s struggle to deploy such large amounts of capital at prices that will net attractive returns after the “titans” fees and expenses. Not to mention the lost investment optionality when committing multi-year capital, particularly if we are at the front end of a rising interest rate cycle.
July 4th: A Time to Reflect, Celebrate, and Remember
The first half of the year highlighted some of the deep divisions within our nation, particularly with regard to domestic policies and opinions of our elected officials’ and even each other’s motives and veracity. Watching the news channel of your choice, and certainly following the Tweets of any one of hundreds of high-profile government and media news figures, it is easy to forget we have much to celebrate as a nation.
On the remembrance front, it was one hundred years ago last month that American troops first stepped onto European soil to fight alongside our allies in World War I. The U.S. ultimately committed 2 million soldiers to the effort losing the lives of over 116,000. In total, over 5 million allied troops lost their lives in what historians have called “The Great War.” As for celebration, the uplifting bi-partisan response to the horrible June 14th attack on Republican Congress members and staff practicing for the annual Congressional Baseball Game for Charity was worthy of the institution these members serve. The fact the members played the game as scheduled and raised record amounts speaks to the “can’t conquer” that Sir William recognized over two centuries ago.
If anything, our remembrances and celebrations are proof that our nation has risen to the challenge repeatedly in times of crisis. Broadly speaking, are we in a crisis now? In terms of a consensus for solving a number of domestic policy issues, the public’s faith in media and the institutions governing us, and the threat of terrorism at home and abroad, arguably yes. Yet, given what our nation has confronted in the most arduous of times since declaring our independence 241 years ago, we think we will once again rise to the challenge.
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