Third Quarter 2017 Update
October 23, 2017
The S&P 500 continued its winning streak, with the index appreciating in value by 3.96% for the quarter (see chart below). This market barometer was up all three months of the quarter, with August being the most stubborn month of the quarter. Third quarter’s performance was driven by strong earnings, good economic data, and the average investor’s ability to ignore geopolitical static.
Third quarter’s performance added to what has already been a strong year for the markets. The S&P 500 has appreciated 12.53% year-to-date (see chart below). The S&P 500 nished the quarter at record highs, 62% above the highs prior to the Great Recession in 2007.
Themes for the Rest of the Year (and 2018)
According to the International Monetary Fund (IMF) World Economic Outlook, released in July 2017, emerging and developing economies are projected to see a sustained pickup in activity, with growth rising from 3.2% in 2016 to 3.5% in 2017 and 3.6% in 2018. This uptick in economic growth is not, however, expected to be as a result of an increase of economic activity in the United States. In fact, the IMF lowered growth expectations in the U.S. for 2017 from 2.3 % to 2.1%, and lowered 2018 expectations to 2.1% from 2.5%, due to revised assumptions that scal policies will have less impact on our domestic economy. Europe, Japan, and emerging markets were all revised up, impacting the overall global expansion projections.
Polaris Greystone is already well positioned for these projected economic expansions in our global strategies, overweighting our international positions as compared to a typical allocation to this area of the markets.
The dollar’s strength played a big role in the earnings recession that we experienced during the second half of 2014 and through 2016. The chart below shows the exchange rate between the euro and the U.S. dollar. When the chart is dropping, the dollar is strengthening to the euro. Conversely, when the line is rising the dollar is weakening to the euro.
As you can see from the chart below, the euro weakened to the dollar from March of 2014 to March of 2015. The exchange rate between the euro and dollar remained trade ranged until making its low in December 2016. The euro then strengthened, moving from 1.04 up to 1.20 dollars to buy one euro.
So why does this matter? Currency is a double-edged sword. On the one hand, a weak dollar means that foreign products are more expensive for us to buy. On the other hand, it means that our goods are cheaper to sell abroad. According to S&P Dow Jones, 44.3% of S&P 500 companies’ sales comes from overseas. According to FactSet, the information technology sector has almost 60% of its sales from abroad. The next highest sectors for international sales are materials and energy, with 47% and 43% of their sales outside of the U.S., respectively. For our purposes, as investors, a weak dollar can drive up international sales, thus improving earnings.
There is an 88% chance that the Federal Reserve will raise interest rates before the end of the year.
There is only a 3% chance of rates remaining were they are today, with a 70% probability that the Fed will raise rates at least two times or more by their September 26, 2018 meeting.
As we’ve discussed in several prior quarterly reports, we su ered through a six-quarter earnings recession. We’ve been out of that earnings recession for over a year. As you can see from the chart below, the consensus analyst estimates for the next four quarters is very strong.
There are multiple ways of determining if an index is over or undervalued. The chart below shows the historical forward P/E ratio (or forward price-to-earnings ratio) readings of the S&P 500. We are slightly overvalued as compared to the 25-year average. There are several valuation measures that show the S&P 500 as slightly undervalued as compared to its historical norms.
Longer Term Perspective
As an investor with Polaris Greystone, you certainly know several of the themes that we have been focused on for years. We will conclude our overview by reiterating some of our perspectives and why we have them.
Under Allocated Bonds
We are under allocated to bonds, and most likely will be for some time given our low interest rate environment, the almost certainty of unfavorable Fed action in the coming years, and the $15 trillion in international sovereign debt with negative yields. One of the most attractive bonds is the 10-year U.S. Treasury. The chart below shows its nominal yield. An investor can currently get a 2.33% yield by investing their hard-earned money in this 10-year investment. But this doesn’t provide the full picture. Let’s just assume that our investor has an e ective tax rate at 20%. Their earnings have now dropped to 1.86%. Then we have to look at in ation, which is now 1.69%. Our investor earns 0.17% net of taxes and in ation. If in ation picks up our investor could lose their purchasing power.
Should you abandon your xed income investments entirely? No, we don’t think that it would be prudent to give up on bonds entirely, but we do think that you need to be creative. For example, we currently hold convertible bonds, international bonds, and oating rate bonds (that move up with interest rates) in our balanced strategies. We would caution you to not invest in leveraged xed income products, go out beyond 7 to 10 years on the yield curve, or chase yield in derivative products.
Over Allocated Stocks
We think that there is a lot more upside to the U.S. stock market and a lot of opportunity in the international stock markets. As we discussed, earnings expectations look good, valuations are mixed but at the very worst slightly overvalued. While economic activity is not robust, it’s not weak either.
The stock market tends to move in long-term, secular movements. The average secular bear market lasts 13 years, while the average secular bull market lasts 14 years. We went through a secular bear market from 2000 through 2013. The last secular bull market was from 1982 through 2000. There are cycles within these secular movements. For example, we had bear cycles in 1987, 1990, and 1994 during the last secular bull market. Just like we had bull cycles from 2003 through 2007, and 2009 through 2013, during the last secular bear market.
The shortest secular bull market in our history was nine years. We could arguably say that our secular bull market should go until at least 2022 at the shortest, and if average we could see our markets generally rise until 2027. This does not mean that we won’t experience setbacks in the market. No market goes straight up or straight down.
We do not see anything that should impede the markets from continuing their upward trend. We will continue to be over allocated to stocks until our research indicates that risk is increasing beyond what we feel is appropriate for your portfolio.
If you have any questions regarding anything that you have read in this article, please feel to reach out to your Polaris Greystone wealth advisor and schedule a time to meet.
As always, I welcome your comments and questions.
Jeffrey J. Powell
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