Market Review 2017 and 2018 Outlook

Year End Review 2017

2017 was an excellent year for virtually every asset class around the world. It was a year in which economic growth showed positive trends globally. In fact, in a bit of a “catch up” and as a response to lower valuations non-US stock returns exceeded those of the US. Technology stocks dominated equity markets both in the US and abroad.

US Markets

The S+P 500 had an excellent year with a return of 21.7%

The buzzword in the US stock market was FAANG (Facebook, Apple, Amazon Netflix and Google) as a shorthand for the dominance of these few technology companies in the market rally. More correctly one would substitute Microsoft for Netflix in the list due to its much larger market cap/weight in indices.

 Facebook, Apple, Amazon, Microsoft and Alphabet (Google). Those stocks together increased in value by 43%, The overall technology index grew 33.2%.

Some attribute the rally to a “Trump bump” in reaction to regulatory changes and changes in tax rates. In fact, the large technology stocks already pay tax rates at or below the newer lower corporate tax rates and are not particularly impacted by those regulations that have been changed.

 Earnings growth has exceeded expectations been strong benefiting from improving economies around the world. The trends in technology among the big four profit opportunities for others in areas such as semiconductors and cloud computing.

The Federal reserve has continued its long anticipated “unwind of QE 2” or in simpler terminology it has begun to raise short term interest rates. After raising short term rates once in 2016 rates were increased three times in 2017 to a current level of 1.5% on the Federal Funds rate.  The stock market showed no negative reaction to the rate hikes likely both because the move was so anticipated and because rates remain so low. Thus far Employment has grown without wage increases .

With the concentration in technology and thus large cap growth stocks large cap and small cap value showed smaller gains. Large cap value stocks which have a high weighting in financials sector that benefit significantly from the lower taxes. Towards the end of the year large value outperformed the S+P 500.

Viewing the market based on “smart beta” factors it shouldn’t be surprising that the momentum factor (ETF) significantly outperformed the S+P 500 (37.5% vs. 21.7%).

 Pessimistic observers continue to point to the historically high market valuations particularly in the next year when we will see further increases in interest rates. The extremely low volatility during the past year is seen by many as complacency with investors underestimating the possibility of a market drop.

While it is unlikely to see the type of returns we had in 2017 (numbers few if any predicted at the beginning of the year) the positives for the market seem to significantly outnumber the negatives.

The high market valuations cannot be considered a bubble; certainly nothing akin to the tech bubble of the late 1990s. Sometimes it really is “different this time”. The p/e of the S+P 500 at 25.7 is well above its long-term average of 15.7. But part of that high valuation is due to the high p/es of the tech giants…and p/e is an incomplete measure of their worth

The leaders in the market (except for Apple with a p/e of 18.4) have high valuations.  Facebook at a p/e of 34, Google at 35, Microsoft at 30.24. But these companies are sitting on massive cash holdings which can be used for stock buybacks, dividends and acquisitions.

 Both Microsoft (1.94% yield) and Apple (1.49% yield) pay dividends. In fact, one could argue the market is “rational” and conservative in its low valuation of AAPL which is most vulnerable to the success of a single product line: the iPhone. Amazon has a massive p/e of 298 but obviously short term profits are not a major objective of its strategy at this point. 

 With their domination of their respective markets a case can be made to justify the valuation of the small group of tech stocks that dominate the market. That group in turn pushes up the overall valuation of the broad indices.  And the derivative effect of the growth of those companies pushes demand for other technology sectors such as semiconductors. Many of those stocks already pay dividends.

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Major US Indices

Market Sector	symbol	4q	2017	3 year
total US	VTI	6.5%	20.8%	35.9%
SP 500	SPY	6.8%	21.0%	36.6%
PRF	PRF	6.6%	15.7%	30.8%
US Small Value	VBR	4.6%	11.4%	31.8%
US Momentum	MTUM	8.1%	35.4%	56.3%
US Minimum Volatility	USMV	5.3%	18.5%	37.1%

Non US stocks

Both developed and emerging markets performed even better than the US markets in 2017.

Developed Markets

European stocks continue to benefit from lower interest rates even as the US Federal Reserve has begun to raise rates. The European economic recovery is at earlier stages than the US. Concerns related to Brexit have faded from the market and even signs of possible change at the top in Germany and the Catalan crisis in Spain had no impact on the market. Valuations in Europe are low relative to that of the US.

The Japanese stock market also showed a very strong performance accelerating from a recovery that began in 2016 after years of poor performance

Emerging Markets

These markets also outperformed the US in 2017. Much as in the US the gains were in the technology sector and thus the highest performance was in Asia. The Asian market’s tech giants like Alibaba, Baidu, China Mobile, and Tencent dominate the indices and the technology weighting of the Emerging Asia ETF (GMF) is 32%. Looking forward the earnings growth forecasts are strong and Asia trades at only a p/e of 13; far lower than either the US or Europe. Emerging markets tend to be a place where investors chase performance (buying high and selling low) but for the long term investor the additional flows into this area should be an additional positive factor.

Market Sector	symbol	4q	2017	3 year
Developed Markets	EFA	3.3%	25.5%	21.8%
Eurozone	EZU	0.6%	28.7%	26.7%
Germany
Emerging Markets	IEMG	7.2%	36.6%	29.9%
Emerging Asia	GMF	6.9%	36.6%	35.9%

Looking Forward

The economic environment seems benign with interest rates rising slowly, low inflation, earnings growth and consumer consumer confidence high. As was the case both in 2016 and 2017 a reasonable forecast would be for single digit returns this late in a bull market in the US…but such forecasts were wrong in both cases.

The tax reform legislation puts an incentive on companies to bring the billions in cash they have abroad back to the US. Two industries: technology and pharmaceuticals have the bulk of the all the cash holdings by US companies abroad. Neither industry is likely to relocate jobs or manufacturing back to the US.  But they are likely to use the cash for dividends and stock buybacks a boost for the stocks. The technology giants may also use their cash to continue acquisitions further increasing their dominance of their market niches. If anything, this makes the case for those top performing large cap tech stocks to remain attractive.

The lower tax rates and increased domestic demand will likely be a positive for domestically oriented small cap stocks giving a further positive for the US market. Changes in the regulatory environment seem to be making corporations more comfortable expanding operations.

It did seem reasonable to forecast higher returns outside the US for 2017. Given the lower relative valuations and earlier stages in the recovery.and low interest rates in Europe that is that is likely to repeat itself in 2018.

What could go wrong?

It seems that the greatest risks to the equity markets come from the political risk side.

Regulators around the world may tighten regulations around the tech giants such as Google, Facebook and Amazon. This in turn would lead to a decline in the stocks of these companies that have been responsible for so much of the rise in the US market.

Geopolitical risk: the probability of an escalation in tensions with North Korea reaching military confrontation may be underestimated by the public and certainly by the financial markets in the US and abroad. It is of course impossible to predict how this would play out politically or in the markets.

China could always be a source of political or economic instability with consequences for the global market.

Nafta repeal of Nafta would be a negative for the US economy although not likely one that would cause extensive damage to the overall economy.

Trade wars In addition to Nafta repeal there is a possibility that the US will use tariffs or other measures to counter countries exporting heavily to the US. That would be destabilizing to the world economy and ultimately increase costs to US consumers.

Within the United States an extensive investigation into the relationship between the Trump campaign and Russia could lead to an administration bogged down in dealing with a crisis associated with this issue.

Bond Markets

The Federal Reserve raised interest rates  3 times in 2017 in its unwinding of the “quantitative easing” in the aftermath of the 2008 financial crisis. Looking at the recovery in the economy without any major increase in inflation or economic or further financial market instability it is hard not to call the QE with the near zero interest rates to spur the economy a major success.

The Federal Reserve will continue to try to sort out the question of whether” it’s different this time” when making its decisions to raise interest rates. We all know economics is not a science and one of the basic assumptions of classical macroeconomics seems not to be in place. Unemployment is extremely low, yet wage growth and overall inflation are low.

The macroeconomics that people like Yellen learned and taught includes the assumption of the “Phillips curve” That view of the world stipulates that low unemployment leads to high wages and inflation. In that environment the Federal Reserve would need to raise rates to lower inflation.

The federal reserve has an inflation target as 2% as representing the right level to keep inflation in check and allow for economic growth. Yet inflation persists below that level. That leaves the Federal Reserve in the position of raising rates amid low inflation…the reason the Yellen Fed has been so slow to raise rates. Signs of wage and inflation increases would hasten the pace of rate increases. The market seems to anticipate 3 increases over the course of 2018.

The bond market seems to be voting with its money that inflation is not on the horizon. As the Federal Reserve has raised short term interest rates, longer term interest rates which would react to long term inflation expectations have remained steady. The ten year Treasury bond yield ended the year pretty much where it started at 2.4% showing little concern with inflation. The long term inflation expectation as reflected in inflation protected bonds has moved up a bit this year but is just under 2%.

 The impact of the rate increases can be seen in the bond market in the “flattening of the yield curve” a decline the differential between long term and short-term interest rates. The difference between the 10 year and 2 year bond yields has reached a ten year low of .5% down from 1.2% at the beginning of the year a dramatic move. 

In the corporate bond market, the market has been characterized by a combination of a “search for yield’, optimism on economic conditions and what many would argue is complacency. This has led to strong performance (low yields) for investment grade and high yield bonds.

The spread of high yield bonds to Treasury bonds has fallen to record lows at 3.5% vs. 4.1% a year ago. The drop-in spreads for investment grade bonds has brought them down to record lows of 1% down from 1.3% a year ago.

These low spreads could only be justified by extremely low levels of default risk. Even with benign economic conditions it seems clear that the risk is for yields on these bonds to widen. Of course, this was a reasonable forecast at the beginning of 2017 and it proved to be wrong.

Looking Forward

The current market is characterized by low short term rates likely to rise, a flat yield curve with extremely low long term interest rates and very tight credit spreads. The most prudent strategy would seem to be to keep maturities short across a mix of bonds in terms of credit quality.

Bond Indices

Market Sector	symbol	4q	2017	3 year
US Aggregate Bond	AGG	0.6%	3.9%	6.8%
US Govt	IEF	-0.3%	2.9%	6.8%
US Corporate Investment Grade	LQD	1.3%	7.2%	12.4%
US High Yield	HYG	0.0%	6.1%	13.9%
Short Term Bond	BSV	-0.3%	1.2%	3.5%
Short Term US Govt	VGSH	-0.3%	0.4%	1.7%
Short Term Corporate	VCSH	-0.2%	2.3%	6.2%
Short Term High Yield	SJNK	0.3%	5.2%	12.6%