Third Quarter 2017 Market Review

Equities around the world had a strong quarter with non- US stocks outperforming those in the US.

 US stocks were up 4.5%. Among” smart beta” factor ETFs momentum had a very strong outperformance while minimum volatility underperformed.an outcome to be expected in strong up markets (details in table below).

Once again led by the FAANG stocks Facebook, Apple, Amazon, Netflx and Google which together make up not only 10% of the S+P 500 but a very high weighting in many actively managed mutual funds (Netflix has a small weighting in the S+P 500.

Except for Apple, the above noted stocks that dominate the market weighting trade at high valuations. Amazon trades at a price earnings ratio of 195 –the company plows all its cash flow from businesses back into business development. Therefore showing high revenues can capital investment but low profits.  Facebook with a  p/e of 38 and Google trades at p/e of 34.5 are well above the market p/e..which itself is historically high (see below)

Depending how one looks at these stocks : Amazon on its way to dominance in just about everything and Facebook and Google now replacing broadcast television and other media as the primary destination for advertising the valuations are either justified or the companies are reaching the law of large numbers and simply can’t grow enough to justify their valuations.  Apple which I would view as most vulnerable to challenges trades well below the overall market valuation with a p/e of 14.5.

The top performing sector for the quarter was technology (ETF XLK) up 8.4% nearly twice that of the overall market.

The major concern voiced by market observers are the historically high valuations of the US market (which is partly a product of the stocks mentioned above). As can be seen from the chart below we are at relatively high historical valuations. It must be noted that this concern that this has been the case for several years as the stock market continued to rally. Those that have timed to market because of valuations have missed out on the market gains.

S&P 500 Price Earnings Ratio Current 25.18 Long Term Mean 15.67

Part of the underpinning for the market rally has been better economic conditions and growth in corporate profits which seems likely to continue. Of course, the strong rise becomes self-reinforcing due to the well-known momentum behavior of investors.

  Also supporting the equity market was the low interest rate policy of the Federal Reserve since 2008. That easing cycle has ended with a gradual increase in interest rates. This has begun to remove one of the factors making investors feel they had “nowhere else to put their money” in a world of near zero interest rates. This movement away from seeing stocks primarily as a “bond replacement” can be seen in the recent underperformance of dividend weighted ETFs as well as REITS.

One widely observed measure of the attractiveness of stocks vs bonds is comparing the dividend yield of stocks vs. bonds. As can be seen from the chart below recent rises in stocks have tilted the measure in favor of stocks. Further increases in rates will accelerate this trend.

While high valuations and higher interest rates should be a drag on US equities but likely not enough to spark a sharp drop and for the nearer term positive although lower returns than we have seen as late. This would be due to the positive fundamentals: low inflation, good economic growth and continued positive trends in earnings.

 Combining market cap weighting with “smart beta” holdings in small value and minimum volatility should shield portfolios a bit from any market declines.

US Equities		3 Q	1 yr.	3yr
VTI	US total Stock Market	4.5%	19.6%	35.7%
PRF	US Fundamental Large/Mid Cap	4.2%	17.9%	29.7%
VBR	Small Cap Value	4.5%	18.7%	37.2%
MTUM	US Momentum	7.9%	25.8%	53.2%
USMV	US Minimum Volatility	3.3%	13.6%	42.2%

Non- US Equities have outperformed the US of late with European equities hitting record highs and emerging markets showing their best performance since 1979.

European economies across the board have been improving and markets have already factored in the impact of Brexit for the Eurozone –and even for the UK which shows strong performance although well below the Eurozone. Unlike the US the European central bank has given little indication of moving to raise rates. Lower valuations, underweighting of many portfolios to non- US stocks, and a positive interest rate environment make for a benign environment for European stocks possibly continuing their outperformance vs. the US.

 A tilt towards the core Eurozone countries and specifically Germany has continued to be a more profitable strategy vs. an allocation to the overall developed market which includes the UK and the perennial laggard Japan. This reinforces an argument I have made about both the developed market asset class which includes the diverse markets of Europe and Japan in a single index.

Emerging Markets have continued to show extremely strong performance based on a benign political and economic environment. China’s growth remains strong as does that of the export oriented countries in the rest of Asia. Tensions with North Korea and the risk of economic crisis in China are always potential negatives for the Asian markets but the latter would likely impact markets around the world as well. While overall emerging markets which include Latin America and Russia the Asia only emerging markets have shown better performance illustrating here too that the asset class of emerging markets including Asia, Latin American and Russia is not particularly useful way to allocate portfolios.

Looking forward strong fundamentals remain in emerging markets, Institutional investors as well as individuals are underweighted in these markets factors likely to generate more buying.  Emerging markets always have “hot money” flows which chase performance which would drive performance in the short run. But investors in the long term are better off sticking to their allocation in emerging markets rather than chasing performance.

A performance chaser in emerging markets would have likely wound up selling at extreme lows and buying well after market recoveries begun. Emerging markets are only for those with a strong stomach and a commitment to keep to their allocations.